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Health Plan Valuation Part Three: Due Diligence Process

Health Plan Valuation Part Three Web

Due to an increasing amount of consolidation among health plans, it is important not only to offer the correct purchase price but also to complete a thorough due diligence process. Due diligence involves a series of legal, financial, operational, and compliance reviews to determine that the company being acquired does not have any undisclosed conditions that would negatively affect the value of the health plan being acquired and ensure that the plan has operated in accordance with the representations and warranties about its condition.

How Valuation Informs the Due Diligence Process

A careful review of management’s forecast of health plan performance can reveal future risks and opportunities. Quite often, these risks and opportunities are related to past performance for which the required full-year data is not available at the time of valuation (e.g., risk adjustment) or for changes in performance occurring between the date of executing merger documents and closing the transaction (changes in membership, revenue, costs—whether new or for a partial period, or reserves and income). Where the engagement includes both a valuation and due diligence review, ECG uses the valuation process to identify previously unknown risks and opportunities. The following are examples of criteria that are reviewed during valuation and due diligence:

  • Compliance: A review of original source documentation is conducted to validate assumptions underlying management’s forecast. During this review, it is not uncommon to identify compliance risks in the current operation. While these risks may be addressed in the ordinary course of a due diligence review, some of the risks can affect licensure, rights to enroll members, revenue recovery, contract renewal, or penalty avoidance. The cost of compliance can also be an issue.
  • Risk Adjustment: Risk adjustment presents one of the most challenging areas of small-plan performance, and a review of plan risk adjustment operations can both raise warning signs and present opportunities for performance improvement. Risk adjustment methodologies for Medicare Advantage, Medicaid, and commercial individual and small group markets have different algorithms, data submission requirements, and methodologies to calculate patient risk scores and the amount of the adjustment. As an example, Medicare Advantage plans are in the middle of three significant changes in methodology.
    • Risk Adjustment Processing System (RAPS)to–Encounter Data System (EDS) Transition: Prior to 2016, health plans determined qualifying diagnoses from claims based on the plan and submitted to CMS under the RAPS. Beginning in 2016, health plans had to submit encounter data, including diagnoses, services, and other health status data, using the EDS. CMS adjudicated the encounter data using Medicare fee-for-service (FFS) rules as adjusted for differences between benefits allowed under Medicare Advantage and Medicare FFS. Generally, smaller plans have been found to be less adept at managing EDS data and have a higher percentage of encounters disallowed under EDS, resulting in lower risk scores and risk adjustment allowances.
    • RAPS/EDS Blend: With the introduction of EDS in 2016, CMS began blending the results under the RAPS and EDS programs, with 2020 requiring a 50-50 blend, up from 25% EDS and 75% RAPS in 2019. With lower risk scores under EDS and an increased reliance on EDS performance to calculate risk adjustment going forward, management estimates of plan revenue related to risk adjustment can be optimistic.
    • Risk Adjustment Methodology Change for Number of Conditions: The 21st Century Cures Act required CMS to modify the risk adjustment methodology to take into account the number of member conditions in calculating risk score, and CMS subsequently added new condition categories. In addition, the EDS component of the risk score is calculated using the new “number of conditions” methodology, while the RAPS component uses the risk adjustment model in place since 2017 (which incorporated Hierarchical Condition Categories changes to better reflect the cost of treating disabled members).
  • Medicaid Revenue Adjustments: As noted in part two of the series, Medicaid managed care programs often have a number of services that are subject to unique revenue arrangements, often for maternity or behavioral health services or high-cost drugs, with interim payments and a final settlement after the close of the plan year. When a transaction occurs during the Medicaid contract year, health plan accruals should be tested for accuracy, with potential purchase price adjustments.
  • Medicaid Allowable Cost: Most Medicaid programs use two-year historical costs—trended to the rate year for utilization, unit cost, and benefit coverage changes—to calculate the PMPM rate. A review of plan cost disallowances over the last several rate-setting cycles helps identify documentation deficiencies and future rate risk.
  • Quality Program Performance: Medicare Advantage and Medicaid often impose quality programs that present opportunities for the health plan to capture additional revenue. Often, management will forecast an improvement in quality program recoveries in future years. The due diligence process can include a review of quality program operations and results to determine whether quality program performance is sustainable or susceptible to improvement. In addition, where a Star Rating score barely exceeds the 4-star threshold or the plan underperforms in Star Rating measures that will be subject to a higher weighting in future years, a closer look at quality program performance can indicate rising risks that may jeopardize future quality program revenue.
  • Provider Contracts: During the course of the valuation, especially in the case of government programs, ECG often inquires about the payment methodologies and payment rates by line of business for major service lines (e.g., hospital inpatient and outpatient, primary and specialty care professional services) to identify any atypical arrangements (e.g., professional fees greater than the Medicaid fee schedule). Obtaining a general sense of contract rates can inform the decision on whether to conduct a black box assessment of provider contract rates during the due diligence process.
  • Large Group Account Quality: Health plans with fully insured large group business may experience margin pressure for benefit-rich HMO plans in slice accounts. The due diligence process can include a review of the performance of selected accounts to determine account quality, risk of enrollment loss, and margin performance and sustainability.

In summary, the review of management’s forecast provides great insight into areas of health plan operations and performance that merit closer examination during the due diligence process. A carefully crafted process can assist legal counsel in structuring purchase price changes, governance rights adjustments, or indemnification provisions to provide protection for the acquiring organization.

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