Throughout the national municipal market healthcare institutions are in need of financing for new construction, renovations, expansions, and modernizations. And despite the endless and painful debates in Washington, these needs must be met now.

Bond insurers -- the investors who cannot sell -- are thus faced with making commitments based on a host of uncertainties.

It is clear that reform will take place, but how that reform will affect the bonds being insured yesterday or those insured five years ago is anything but clear.

One element of the marketplace that proceeds apace, regardless of the discussions in Washington, is competition. As a result, current analysis of healthcare facilities or systems must treat the sector as if it were a free market even though governmental payors and a highly regulated environment are enormous restrictive factors.

In fact, healthcare in America is undergoing a basic shift, from an industry whose first concern was providing services to patients to one that seeks a profitable bottom line.

Sacred Heart Hospital in Norristown, Pa., is striking example of this trend. The hospital closed its doors last week and may default on about $25 million of debt service payments, leaving Municipal Bond Investors Assurance Corp. to foot the bill.

Norristown, it turns out, is an "overbedded" community incapable of keeping its four hospitals' profitable. From a free-market point of view, something had to give.

To determine which institutions will be standing and profitable in 20 or 30 years, everything from management quality and employees satisfaction to patient (i.e., customer) demographics and the mix of services offered must be examined -- precisely as if this financing were not tax-exempt and had nothing to do with public policy or social welfare. If a healthcare operator has a history of mismanaging its own finances, for example, its 30-year bonds are suspect.

Looking at the healthcare industry as if it were not a public policy issue, it is possible to characterize some of the general themes likely to emerge before the 1996 elections.

* Managed competition will result in more cost-efficient services provided by hospitals and hospital systems with larger revenue bases. As the weaker operations are gradually forced out of business, their customers will seek services from the larger, surviving systems.

* Mergers of institutions in overlapping serve areas will take place, with similar-sized providers launching takeovers of their regional brethren. Not only will this "horizontal" affiliation result in collectivized inpatient admissions, but the physicians themselves will be courted as valuable ~assets" of the acquiree. Over time, a strategy of buying specialty groups -- staffs with expertise in expensive procedures, such as heart surgery' -- can be predicted. Physician groups in clinics that emphasize primary care have also been courted by and folded into hospitals' competitive arsenals, thereby enhancing their own ability to be attractive to managed care providers.

* Insurance providers could encounter substantial pressure from employer to lower premiums. The legislative discussions include proposals that saddle the larger employers with most of the bill, and these unhappy' customers could become an effective lobbying group.

All of the above predictions do not point to a generalized credit-quality erosion in the healthcare sector. Certain facilities undoubtedly will grow stronger as they merge with better-run operations and benefit from size efficiencies.

Getting on Right Side

The trick for investors and insurers, then, is to single out which facilities will be on the right side of the reform equation. In seeking the answer, Capital Guaranty examines a host of factors: The quality of existing management and their proven track record; the mix of payors (including insurance providers) comprising a facility's revenue stream; competitive position within a community; utilization; and an institution's ability to attract and maintain reputable physicians, including both valuable specialists and primary care doctors.

This last point will be critical as mergers take place and institutions start jockeying for competitive advantages. Already, we are seeing advertisements that tout the quality of certain facilities, and we can expect promotions featuring the experience or surgical feats of this or that physician.

Considering these characteristics and examining other financial statistics, it is possible to arrive at an institutional profile that is both insurable and therefore long-lived.

* Dominant well-established hospitals such as the Cleveland Clinic or Greater Baltimore Medical Center, which can be expected to continue to do well and possibly expand through purchasing smaller facilities in neighboring markets or other states.

Strength in Diversity

* Hospital systems with a number of facilities that covers a given market. Just as portfolio managers diversify risk, systems with multiple facilities -- often including clinics, outpatient sites and ambulatory surgicenters -- can be expected to weather any one downturn or setback better than a stand-alone specialty institution.

* Systems displaying ~cradle-to-grave" vertical integration, or a facility such as HealthSpan Health Systems which can literally handle your healthcare needs from outpatient primary care to inpatient specialty care to nursing home services and home health.

* Facilities that already are successfully navigating managed care environments. ServantCor in Champaign and Kanakee, Ill., for example, has been able to sign up many managed care providers before their competitors. And the system already has witnessed the closure of a hospital in its service area while maintaining its vitality and competitive edge.

* Other institutional involvement: If a system or hospital is affiliated with a strong university, a well-capitalized foundation, or a philanthropic foundation which shores up the credit strength and is likely to come to the rescue in rough times, it is a far stronger bet than purely independent institutions.

* The actual support of the community: Many rural county-owned or district hospitals enjoy a "double-barreled" security for payment of debt service by obtaining tax revenues or other financial support from the towns or counties. This feature can go a long way' to mitigating the risk of long-term competitive pressures.

Despite the media attention and the political angst associated with healthcare reform, Capital Guaranty expects reform to be an inevitable result of the existing market dynamics. Patients and employers will have major changes imposed on them by legislators, but the fundamentals for healthcare analysis are already in place.

In fact, state programs, such as those in Hawaii and Minnesota are pointing the way. Hawaii covers all of its residents and is a model for the Clinton Administration's proposals. Minnesota has enacted a plan that covers uninsured or under-insured residents through a 2% tax on hospital revenues.

In Washington, healthcare could end up being rationed to some extent, much like the painful process Oregon recently went through in putting together its new Medicaid program to provide as much coverage to as many as possible while still being cost-effective. But it won't change the fact that there will still be some non-paying patients and expensive procedures for which hospitals are not fully reimbursed, and this must be identified and factored into analyses.

Big business could foot the bill for a disproportionate amount of coverage, as is currently being proposed by Sen. John Breaux, D-La. Yet who pays in the end will matter less to a bond investor than the fact that someone will.

What concerns credit-quality watchers is more than the commitment to pay. It is also the willingness to pay on time. On this front, it will be important to scrutinize the flow of funds from Medicaid reimbursements. Certain states, such as Illinois already have established patterns of delayed payments and can be expected to pay late in the future.

Some hospital currently receive additional Medicaid funds, called disproportionate share payments for serving a high number of Medicaid patients. These add significantly to the bottom line, but if the Medicaid program is changed -- as is now being discussed -- these payments could dry up.

The Norristown, Pa., situation is alarming, but to some extent it was a statistical certainty. In the end, the holders of MBIA-insured Sacred Heart Hospital bonds will be paid.

Capital Guaranty' meanwhile, has never had to pay a claim, but that does not mean that risks are not present in the healthcare sector or the broader municipal market. Going forward, Capital Guaranty and the other bond insurance companies do not have the luxury of awaiting the outcome of either natural selection or the debates in Washington. The industry has demonstrated that it can help communities and healthcare institutions lower interest costs by taking real risks.

Institutions nationwide still must finance their needs immediately, and the bond insurance community will not shy away from those needs. We will continue to insure quality healthcare credits, regardless of Norristown and regardless of the fireworks on Capital Hill.

Laura Tauber is a senior underwriting officer at Capital Guaranty Insurance Co.

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