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The failure rate of provider-owned health organizations has been pretty high to date, but don't be in too big a hurry to write them off yet, say some observers.

Many managed care health organizations owned by physicians or hospitals are either posting losses or already have been sold because of a variety of problems, including insufficient capital, poor management and doctors' inclination to reimburse themselves overgenerously.

Furthermore, even those provider-owned health organizations doing relatively well still shrink in size beside the health care giants that have risen in the field, such as Aetna U.S. Healthcare and Kaiser Permanente.

For these reasons, among others, some dismiss the concept of provider-owned health organizations as inherently flawed.

But others say this segment of the health care market is only experiencing a rocky start to what could potentially become a lucrative business once these organizations move further along the learning curve.

They also note that the entire concept is getting a boost from the federal government. Legislation approved last year encourages the disbursement of Medicare funds to "provider-sponsored health organizations." It is only a small additional step for these PSOs, which have been set up to accept Medicare funds, to offer the same services to the commercial market as well, say some experts.

Employers say they are favorably inclined toward the idea behind these organizations. "I like the concept," said Fred Hamacher, vp-compensation and benefits for Minneapolis-based Dayton-Hudson Corp. "It puts more players in the field vs. just the traditional health plans and insurance company plans," he said. "It adds another player in the game with a little different focus."

"I can't think of a reason why they couldn't be successful. It's a matter of understanding what they need to do and being pretty diligent about it," said Mr. Hamacher.

Andrea Velasquez, division president in Coral Gables, Fla., for Vincan Group, a professional employee organization, said although her firm's experience dealing with several provider-owned health organizations has been a mixed bag to date, "I think over time, as they evolve and develop their management systems, that's going to be the way to go, because of the elimination of the middleman and the patient focus that's been lacking in managed care."

Critics of provider-owned health organizations say a major reason many have been unsuccessful to date is a failure to recognize that running a managed care organization is a whole different animal than caring for patients.

"Historically, doctors have not been very good managers," said Jack Doerr, national group benefits practices leader for Sedgwick Noble Lowndes in Chicago. "They're excellent care givers, but they are not professional managers. And even though they hire professional managers to run the organizations, they still have ownership and they're still on the board of directors and they still have the ultimate say in the important decisions that are going into it. I don't think they are able, by virtue of their background and training and probably inclination, to manage as effectively and profitably as professional managers do."

Providers are "excellent at providing care, but there's another set of capabilities that's necessary in order to run a health plan," said Greg Yust, president and chief executive officer of Carmel, Ind.-based Sagamore Health Network Inc., which is sponsored by four Catholic organizations. Sagamore's core product, a preferred provider organization network, covers 700,000 lives.

"It takes a great deal of discipline to make it work and have it work effectively," said Patrick Aberle, senior vp-managed care for Sacramento, Calif.-based Sutter Health, which is now considering whether to sell or seek a capital partner for its majority-owned Omni Healthcare health maintenance organization, as well as its Sutter Preferred Health & Life Insurance Co.

"I think a lot of providers have discovered that they do a good job of running hospitals or providing medical services to enrollees, but few of them have the skill sets to really run a health plan. They don't have the core competencies inside their organizations, and they don't have the discipline to do that," said Mr. Aberle.

It is kind of like assuming that because you can drive a car, you can build one, said Don Gasparro, managing director at Princeton, N.J.-based Apex Management Group Inc. There is more involved than "putting the engine on a chassis and taking off."

A hospital administrator will say, for example, "We want to put together a managed care plan and compete with United to get our days up," said John Erb, area vp for Gallagher Benefit Services in Boca Raton, Fla.

"Well, no," Mr. Erb continued. "In insurance, you want your days to go down, not up, so there's kind of an inherent conflict between being the deliverer of this service and being the payer of these services, and that's the hurdle they can't get over."

Stuart Veach, vp at Winston-Salem, N.C.-based PARTNERS National Health Plans of North Carolina Inc., a health care organization operated by the Novant Health hospital system, said, "Where I have seen failures with this type of arrangement is because the HMO is not allowed to operate independently, so it doesn't, you might say, act like an insurance company."

"We have had the good fortune here to be able to operate independently," added Mr. Veach. "The board of directors that has governed the plan has been able to have the vision to recognize that that was the best way to do it," he said. "Their decisions are driven from the standpoint of what's best for this company, not necessarily what's best for providers."

Physicians have the idea they want to cut out the middleman, said Dr. Peter Kongstvedt, health care partner with Ernst & Young L.L.P. in Washington, D.C. "What they fail to realize is the middleman does a lot of stuff, and you actually can't cut out the middleman."

"All you can do is recreate them," Dr. Kongstvedt said, and they must do a better job than that of competing organizations.

Furthermore, physicians normally start out by enrolling their own patients, and "that generally means you're getting a sicker than normal group" and adverse selection, he said.

A related problem is physicians' tendency to give themselves too generous reimbursements, compared with those offered by other plans. "If you have a bunch of physicians who own a managed care network, the question is, are they going to really cut their own fees and are they going to cut the fees of the other physicians who have invested in the networks?" said Barry Barnett, principal at PwC Kwasha in Fort Lee, N.J. "It's the nature of the beast," he added.

"The biggest problem has always been (that) it's kind of like the fox watching the henhouse. They're always reluctant to police themselves," said Mr. Barnett.

Provider-owned organizations "are not as tough on themselves" as independently owned organizations would be, and, as a result, they find themselves at a disadvantage in the marketplace because of their higher cost, agreed Doug Werner, San Diego-based senior vp-strategy planning and business development for Foundation Health Systems Inc.

"These are often the kinds of plans we buy," said Mr. Werner, who noted that FHS now is con-solidating three Connecticut provider-owned operations it bought in Shelton, Conn. He admitted, however, that some of these organizations do thrive in areas where there is little competition.

Undercapitalization is another problem for provider-owned operations, say some experts. "In fact, it's pretty common that they never get off the ground because of that issue," said Dr. Kong-stvedt.

Providers should have $4 million to $5 million on hand before launching a provider-owned health organization, said Dr. Kirit Patel, president and chief executive officer of Stockton, Calif.-based Medcore Medical Group. Medcore, previously known as Omni Independent Physicians Assn., had been a part owner of Omni. This total, Dr. Patel said, includes $1 million to obtain the license and start the management services organization to run the health plan, $1.5 million to market the plan for two years, and another $1.5 million to support the system for two years until it breaks even.

Size is a problem as well, said Glenn Smith, senior health care consultant for Watson Wyatt Worldwide in San Francisco. "They tend to be very parochial in their view of the market," he said. A provider-owned organization may have 150,000 or 160,000 members, and that is "just not enough folks to be able to afford all the support systems and still manage their costs at competitive levels."

Mistrust of providers has been another factor, said Ken Jacobsen, national director-health care practice for the Segal Co. in Atlanta. "From a financial standpoint, it makes people a little bit nervous," he said. "Nobody wants to see medical inflation again. And if the doctors are in control, there's a perception, at least, that some of the utilization and cost control measures may be relaxed."

Despite all these problems, however, some believe the essential concept behind provider-owned organizations is sound. None of the provider-owned organizations' problems is irreparable, said Paul Makens, senior vp and national practice leader for Aon Consulting Worldwide's health care industry practice in San Francisco. Mr. Makens said he views it as a situation of people getting their toes wet in the water and finding out what they do not know.

"I think you're going to go through a period of time where there's going to be a lot of work done to turn the situation around," he said.

"I think the concept makes a lot of sense," said Rowayton, Conn.-based Dr. Nirmal Patel, medical director for Hewitt Associates L.L.C. "I think that there are many physicians who are now acquiring the business skills that are necessary to be successful in that type of environment."

"I think there's an opportunity for them, and that opportunity rests in the public backlash against managed care," said Watson Wyatt's Mr. Smith. "If provider-sponsored plans can be financially competitive and deliver a message to the market that the providers are in control, they could make market gains, because the big commercial HMOs have a cloud hanging over them, and that is a certain level of consumer distrust."

Consolidation will encourage development of these organizations, said Tom Beauregard, a Hewitt consultant in Rowayton. "The managed care industry continues to consolidate rapidly," he said. "That, in turn, creates more pressure on physicians, because the managed care plans will have more leverage to negotiate deeper discounts, which in turn will cause physicians to organize more effectively."

"I think there are a lot of opportunities for the provider groups to build local organizations," and build outward from there, said Apex Management's Mr. Gasparro, who also noted that health care delivery is a "very local issue."

"I think that it can be done," said Joan Levinson, vp-sales and marketing for Oakland, Calif.-based California Advantage Inc., a managed care operation created by the California Medical Assn. that filed for bankruptcy in June.

In California Advantage's case, Ms. Levinson said, the organization failed due to problems that included poor planning and timing and insufficient capital. "If California Advantage had started out with a different situation, we could have been successful," she said.

Meanwhile, provider-owned health organizations are getting a boost from the federal government. The PSOs established by the 1997 Balanced Budget Act have lower minimum enrollment requirements than other plans participating in the new "Medicare + Choice" plans, as well as temporary waivers of state licensing requirements.

Once the PSOs are in place, "then the transition to the commercial marketplace is relatively easy," said Aon's Mr. Makens.

After they are established, "many of them are quickly discovering it's not much more trouble to go after the commercial population as well," said Sandy Wolff, director of health plan and provider consulting for Buck Consultants Inc. in Los Angeles. Furthermore, she said, "it makes a lot of sense."

"I think that it's basically a given, once they become established, it's going to be very easy for them to expand their network," said Dr. Ted Lewers, vice chairman of the board of trustees of the American Medical Assn. "I think the patients and the public are going to demand that they move into that market."