PacifiCare's Iffy Prognosis

The giant HMO is a turnaround in progress, but one that continues to be too dependent on Medicare

By Arlene Weintraub

In a down market, health-care insurers have been among Wall Street's darlings. And why not? While medical costs have skyrocketed, the industry has consolidated, giving giant health-maintenance organizations the ability to force employers into paying double-digit premium hikes. That pricing power, rare in this economy, has restored vigor to health insurers' once-anemic bottom line.

No one should be happier than Howard Phanstiel, 53, CEO of beleaguered PacifiCare Health Systems (PHSY ). Since joining the company two years ago, Phanstiel has cut costs, unloading 350,000 unprofitable Medicare customers, while taking a painful $897 million writedown this year in connection with a 1997 acquisition.

So far, the regimen has worked, reversing years of declining earnings. PacifiCare's third-quarter net soared 157%, to $43.8 million, despite a 6% drop in revenues, to $2.8 billion. The stock has jumped 20%, to around $29, since the Oct. 30 earnings announcement.


  It isn't time for shareholders to declare this HMO cured yet, though. Phanstiel has made great strides, but PacifiCare's long-term outlook is still a bit murky. Employers nationwide are starting to revolt against high health-care premiums, and many are leaving more expensive plans. Moreover, half of PacifiCare's $12 billion in annual revenues still come from Medicare policies, which remain chronically underfunded by the government. As a result, 9 of the 13 Wall Street analysts who cover PacifiCare still have a sell rating on the stock.

Phanstiel's biggest challenge hasn't changed much at all, it turns out. He needs to morph PacifiCare from a "one-trick HMO," as he calls it, into a more diversified business. Despite the improved earnings, PacifiCare is still one of the largest Medicare insurer in the U.S. "We have to rebuild brick by brick," he says. Phanstiel's goal is to double revenues from non-Medicare products to about $10 billion by 2008. To achieve that, he needs to boost membership in more lucrative commercial plans and raise premiums on existing accounts.

Those Medicare blues won't be easily cured, however. PacifiCare recently found out the hard way that it can boost prices only so far. This year, it lost its biggest customer, California State pension fund CalPERS, which said no to a hike that would have raised rates by 27% to 37% in 2003. That cost PacifiCare 100,000 customers.


  To lure new business, PacifiCare has developed 20 new products it feels would be attractive to budget-conscious employers -- and that might make higher payments easier to swallow. So far, however, it has recruited only 65,000 new members.

And one of the key products PacifiCare was counting on to help generate new business has caused controversy in the health-care field. Its "narrow network" HMO provides access to fewer than half the number of doctors and hospitals offered by a standard HMO, in return for premium savings of up to 16% per year off its standard HMO plan. The less costly alternative involves extra charges for members who choose a more expensive hospital, when the "same quality" service is available elsewhere at a lower price.

Much to the chagrin of the hospitals, PacifiCare wants to be the one to determine what "quality" means. The insurer had planned to release new hospital ratings this fall -- first in California -- before rolling out a similar program nationwide. When some hospital executives saw the ratings, however, they screamed. Many worried that they favored hospitals that agreed to take the lowest reimbursement rates from PacifiCare.


  "It's not about quality, it's about negotiating power, and the consumers are stuck in the middle like pawns," says Jan Emerson, spokesperson for the California Healthcare Assn., a trade group representing 500 hospitals. Dr. Sam Ho, PacifiCare's chief medical officer, maintains that the ratings are fair because the company used more than 60 factors to determine quality, including patient satisfaction and mortality rates. Nonetheless, PacifiCare delayed releasing the quality report cards until early 2003, as it negotiates with the hospitals to develop ratings that everyone can agree on.

Hospital execs aren't the only ones on PacifiCare's back. The Texas Attorney General's office may demand that the insurer pay an estimated $100 million in past-due medical claims. That dispute is expected to go to mediation shortly. With $1.6 billion in cash, it has "adequate reserves" to deal with the legal burden, says General Counsel Joseph Konowiecki. Still, the legal expense isn't helping. PacifiCare's sales and administrative expenses jumped 16% last quarter, due partly to the litigation.

Such costs, however, are the least of PacifiCare's problems. Phanstiel's main challenge is to draw more commercial customers to PacifiCare's 20 new plans. Indeed, that's the only way he'll be able to prove this stalwart Medicare insurer can learn new tricks.

Weintraub covers health-care issues from BusinessWeek's Los Angeles bureau

Edited by Douglas Harbrecht

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