It’s easy to forget the humble beginnings of America’s health maintenance organizations (HMOs). Conceived as an experiment in providing care to a small number of members for a set monthly fee, they are now among the most potent forces in US healthcare. One in five Americans belongs to an HMO. Compound annual growth has averaged 12 percent during the past decade. And the industry has spawned several profitable publicly traded companies.

What accounts for this remarkable success? The simple story is that HMOs offered the right product at the right time. Employers were looking for ways to contain the escalating cost of insuring their employees. HMOs were offering comprehensive coverage for a fixed fee—often more than 30 percent below indemnity prices. They soon found they could use their growing patient flows to squeeze healthcare providers (chiefly hospitals and physicians) on costs, winning savings that they were able to pass on to customers or keep for themselves.

Healthcare markets across the United States have followed a consistent pattern. At first, providers do little or nothing as HMOs begin gaining share. As penetration increases, they enter a price war to preserve share—and HMOs strengthen their position as a result. Providers finally figure out the new game just as HMOs are reaching the height of their share penetration. When they do, their impact on HMO performance can be considerable.

Only a few markets have reached the stage in their evolution where providers are becoming a competitive force. HMOs in these markets are often genuinely surprised to find providers flexing new muscles. They tend to assume that the skills that helped them prosper during the early days of managed care growth will also ensure their success as markets mature. In fact, they risk losing substantial shareholder value over the next few years if they fail to rethink their approach to managing provider relationships.

Many HMOs in less mature markets will soon face the same challenge. Changing market conditions mean that they must develop new strategies and capabilities if they are to play a central and profitable role in the healthcare delivery systems of the future.

The emerging challenge

HMOs have enjoyed a remarkable run of success. Earnings have grown at 45 percent a year, and market capitalizations for the top 25 publicly traded HMOs have risen by 33 percent a year since 1985.

In many markets today, a provider can walk away from its HMO and be sure that most of its patients will soon follow

But troubling signs can already be seen. Between March and August 1995, while market averages were at record highs, the same top 25 publicly traded HMOs saw their market valuations fall by 25 percent. This decline may reflect a growing awareness on Wall Street that many HMOs are no longer in a position to demand lower rates from providers or to dictate changes in their operations. Instead, it is providers that, having strengthened their relationships with patients and increased their influence over care delivery, are beginning to find themselves in a position to control and retain patients. The reality in many markets today is that a provider can walk away from the HMO upon which it had previously depended and be sure that most of its patients will soon follow.

This power shift is evident in local markets across the United States as they follow a consistent evolutionary path from a traditional, fee-for-service stage to timid, turbulent, and potentially restructured stages (Exhibit 1). The shift tends to begin in the turbulent stage of evolution—the one where HMOs are most at risk. The difficulties presented by this shift are already affecting some of the biggest US markets, such as Los Angeles. Many other major metropolitan markets, especially those on the East Coast, are likely to evolve to the turbulent stage within the next two to five years.

The turbulent stage

This evolutionary stage is characterized by intensifying competition as providers attempt to consolidate, to form horizontal and vertical alliances, and to reposition themselves with employees and consumers in order to counter the market power of fast-growing health plans and share in the opportunities created by restructuring markets. Employers respond by becoming more astute purchasers of healthcare. They develop their negotiating skills and, like providers, consolidate their market power via coalitions with other purchasers, and narrow their HMO relationships.

As these processes gain momentum, a harsh truth begins to emerge. If an HMO is not one of the top four or five players when the market progresses to the turbulent stage and reaches 20 to 25 percent managed care penetration, it will probably have difficulty retaining share and maintaining profitability. In the longer term, small plans may even find themselves out of the game.

But even a dominant share does not guarantee success in the turbulent stage. A strong position is a necessary—but not sufficient—condition for long-term prosperity. As we shall see, HMOs must also pay careful attention to building the competencies that the new competitive circumstances demand.

Physician strategies

As they look to increase their leverage over HMOs, physicians are adopting two main strategies. Both capitalize on their control of the patient relationship and their direct influence over healthcare costs and quality.

The number of practices with more than 50 physicians has grown by 60 percent over the past three years

Consolidation. As they recognize the opportunity to capture more of the excess medical costs being wrung out of the healthcare system, physicians are consolidating into group practices and forming tighter, more effective physician organizations. The number of large practices—those with more than 50 physicians—has grown by 60 percent over the past three years. These practices realize scale economies by consolidating administrative and medical staff support, and facilitate performance improvement by encouraging the sharing of clinical best practices among professionals.

Forming large practices also enables physicians to assume and manage substantial risk. As a practice grows to 50 or so physicians, it can take on greater inpatient and outpatient risks for an expanding group of patients without worrying that high-risk cases might threaten its solvency. Large groups also have the scale to invest in tools to manage these risks, such as systems for case management and for the tracking of quality, service, and cost by provider. Such systems make it possible to monitor and reward the performance of individual physicians and continually to improve overall performance through changes in care delivery.

Large practices also enjoy important advantages when it comes to building patient loyalty, resisting pressure from health plans for further fee discounts, and taking control of critical information associated with patient care.

Practice reforms. At earlier stages of market evolution, physicians were able to raise prices to indemnity insurers in order to offset the discounts they gave to managed care organizations. As managed care penetration increases, however, price shifting of this kind becomes more difficult, and earnings can be maintained only by increasing patient flow, cutting unit costs, or capturing a larger share of the surplus being extracted by other participants in the market. Successful physician groups do all three, leveraging patient relationships in order to increase patient flow while reducing practice variations to cut costs, and then exerting greater influence over hospitals.

If a major primary care physician (PCP) group can attain sufficient scale to channel the bulk of a local hospital’s secondary care, for example, it will gain tremendous leverage over the hospital and its specialist physicians. By using this leverage and its direct control over costs, the medical group can demand changes in the hospital and specialty delivery process, and force the hospital and specialists to pass the majority of the savings directly to it—rather than to the HMO.

Physician groups have shown themselves capable of bypassing HMOs altogether. In 1994, 200 physicians in El Paso, Texas formed the El Paso Community Health Plan. They went on to sign contracts with several major local employers, having argued that physicians are able to do the best job of protecting the interests of patients and their employers. Even though only a handful of physician groups run their own HMOs at present, the medical community is showing keen interest, and we may well see many more substantial attempts at integration in the future.

Hospital strategies

Hospitals have been forced to reduce inpatient lengths of stay and cut fees for managed care patients

Hospitals too have been under severe pressure from managed care in recent years. They have been forced to reduce inpatient lengths of stay and cut fees for managed care patients. While some have attempted to ease the pressure by extending outpatient services and raising charges for indemnity patients, hospitals’ financial performance has declined overall.

Hospitals have fought back by establishing local hospital networks, forming strong physician alliances, consolidating local market share, and building distinctive reputations. The recent dramatic rise in hospital acquisitions and horizontal alliances shows how widespread are these attempts to regain market power. Hospitals are also positioning themselves to share risk and thus participate in the upside as well as the downside of medical cost reduction. Some hospitals in more mature markets have succeeded in integrating with physicians, thus achieving greater access to patient flows.

Further consolidation and rationalization will occur as healthcare markets evolve—a process that is bound to yield winners and losers. The hospitals that survive will be better positioned than before to deal with HMOs, less agreeable to unilateral fee discounting, and more successful in capturing some of the value created by managed care.

Implications for HMOs

The radical measures taken by hospitals and physicians have two important implications for HMOs. First, they stand to forfeit power over providers in local markets as these groups consolidate and build on enduring patient relationships. Second, they run the risk of losing control of the care delivery process. As physicians and hospitals consolidate, assume greater risk, and take responsibility for cost management, they come to rely less on the HMO for assistance in care management.

In such cases, the HMO finds itself acting merely as the marketing, sales, and service arm of the integrated provider organization. At this point, the provider is in a position to squeeze the HMO—and, if it so chooses, to market directly to customers. This consigns the HMO to a future of shrinking returns and often difficult relationships with local providers.

What strategies can HMOs pursue to prevent such a bleak outcome? Two options are open to them. The first is to strengthen their market power by establishing a dominant local market position, developing a strong brand, and building bulletproof relationships with employers and individual purchasers. The second is to take steps to ensure that they become indispensable to providers and that their systems and technology become critical components of next-generation care (Exhibit 2). HMOs will only be able to share in the success of an integrated system if they are an integral part of its delivery.

What HMOs should not do is overplay their old aggressive approach to provider relationships. They should not, for instance, rely on tough negotiating to squeeze more out of providers unless they can offer the resources that will aid these providers’ success. Though such an approach helped HMOs prosper during the early stages of healthcare market evolution, it can today only speed their demise, increasing the incentive for providers to push them out of the delivery system.

The good news, however, is that most US markets have yet to reach the turbulent stage, and most HMOs continue to enjoy substantial leverage over provider groups and hospitals. In other words, there is still time for HMOs to make use of their present advantages to position themselves for the turbulence to come.

Superior marketing and service capabilities

If HMOs are to remain influential, they must attract and retain customers as managed care proliferates, new competitors enter the game, and established peers begin to get aggressive about protecting or building market share. By this point, most of the easily captured indemnity customers will already have been signed up, as will customers who will switch on the grounds of price. The strategy of competing on price will thus become less and less viable. HMOs must instead turn to new ways of sustaining high membership growth, such as acquiring competing health plans, targeting new geographic or market segments, and developing products for customers who demand greater provider choice.

One important source of growth over the past few years has been open-ended, point-of-service products that appeal to individuals who want to retain an external provider relationship while receiving other care from the HMO network. Moreover, a number of HMOs, especially on the West Coast, have tailored their business systems to meet the specific needs of Medicare members. Even though these individuals represent less than 15 percent of the US population, they consume 35 to 40 percent of healthcare dollars. Controlling the Medicare patient flow gives HMOs both revenue growth and leverage over providers.

To attract members in a maturing market, HMOs will have to improve their marketing and service skills

These sources will not, however, be enough to guarantee an adequate market share and operating scale. To attract members in a maturing market, HMOs will also have to improve their marketing and service skills, and in particular their ability to identify the needs of individual customer segments. The days of the "one size fits all" healthcare product are passing. HMOs must use customer needs as a guide in developing separate product, promotion, and channel strategies to fit each segment of their market. This will mean upgrading their customer and competitor intelligence.

PacifiCare/Secure Horizons demonstrates how an HMO can tailor its product to the needs of a customer segment. It structured an entire organization—product design, delivery systems, promotion, and sales—exclusively around the needs of the Medicare population. This tight focus has been wildly successful, with product growth of 27 percent per year. Approaches like this one have the potential to retain as well as attract target customers.

As the price gap between competing health plans narrows, advanced pricing skills will become increasingly important. Apart from its traditional role in managing risk, pricing can also boost earnings via differentiation. As HMOs improve their understanding of the needs of individual segments, they will find opportunities to set prices in line with customer price sensitivity, competitive pressures, and growth objectives.

Finally, HMOs will have to gear themselves up to serve more and more sophisticated employers and employer coalitions. Building local and national scale will strengthen their position, but they will also have to enhance their value to employers through national marketing programs and close partnerships designed to improve the quality and cost of care. National HMOs should be able to exploit unique marketing opportunities. By attracting employers that seek multiple market coverage and simplified administration, they can gain an incremental advantage over other HMOs.

Next-generation cost management

HMOs have a unique value proposition to exploit—albeit one that has yet to be fully articulated or developed

HMOs have a unique value proposition to exploit—albeit one that has yet to be fully articulated or developed. It has to do with their ability to develop the data and procedures needed to make fundamental changes in the care delivery process.

With the exception of some academic and other large institutions, few provider organizations are in a position to develop their own protocols and cost management procedures. To do so, they need systems that provide accurate, efficient integration of medical and pharmaceutical claims data, and that allow providers to review cases similar to that of their current patient so they can assess the treatments given by previous practitioners and understand how their decisions affected outcomes and costs.

HMOs can play a vital role in this process by building the internal expertise and resources needed to reduce practice variation, and by helping providers implement new care management approaches. They are uniquely positioned to capture and process information on the cost and quality of care in particular. Those that take the lead in working with providers and others to develop next-generation care procedures and in supplying tools to allow providers to get at and act on this information will gain a critical first-mover advantage (Exhibit 3).

As more and larger physician groups begin to emerge, HMOs can choose actively to shape their formation. They can cement early partnerships by providing resources and skills to support this consolidation. By transferring learning from other markets to inform tough decisions about physician governance, for example, an HMO can accelerate the growth of high-performing medical groups and demonstrate its value to them. Early investments in performance assessment for individual physicians will pay off by encouraging the best performers to consolidate into groups likely to cooperate with the HMO.

Other routes exist by which HMOs can lead consolidation in a favorable direction. One is to encourage the formation of medium-sized (30 to 50 physician) PCP medical groups. Such groups are likely to work well with HMOs. They have sufficient scale to assume and manage risk, but still have to depend on HMOs as a source of patients.

Very large medical groups of more than 100 physicians can prove demanding—indeed, threatening—to work with

Very large medical groups of more than 100 physicians can prove demanding—indeed, threatening—to work with once they have built substantial local market power. HMOs should therefore move quickly to forge strong links with such groups as they form. They will have to bring distinctive value by providing services more cheaply than the groups could do for themselves.

HMOs should also look to shape the evolution and performance of these networks, for two reasons. First, in the period before providers consolidate and integrate, an HMO can gain a valuable competitive advantage through the performance of its delivery system. Second, an HMO that has acquired market power in the early stages of evolution can use it to guide provider integration toward a favorable structure.

In fact, HMOs can help shape network development and performance at three levels—individual physician, physician group, and integrated provider—each at a different point in their market evolution. Early on, HMOs can exert influence over individual physicians. Later, as large physician groups begin to form, they can build on that influence. Those that get these two steps right will be better placed in the later turbulent stage to demon-

strate their value to the powerful integrated providers that emerge. Not surprisingly, different strategies are needed at each of these levels.

As managed care matures in a market, HMOs must become much more selective about contracting

During the early stages of market evolution, HMOs will concentrate on entering into contracts with a sufficient number of physicians to achieve adequate geographic coverage and provide adequate choice, but they will not usually demand changes in practice patterns. All they ask of doctors is that they provide care at a discount. If the savings are achieved by shifting costs to loosely managed plans, that is fine by the HMO. However, as managed care matures in a market, HMOs must become much more selective about contracting. They will need to weed out any physicians who are unwilling to change practice behavior to gain cost advantages, or who do not provide the quality of personal care that members demand.

A high-performance culture

The final piece to put in place is the all-important and always elusive "soft" lever of organizational culture. It is important to remember that the HMO industry, notwithstanding the enormous impact it has had on US healthcare, is still in its youth. Most HMOs consequently have management systems and cultures that are not yet mature. Many of them—even some of the most successful—manage themselves more like startups than established organizations. Their business systems need to evolve to support new skills and capabilities. This will mean focusing on three areas.

Executives must be able to guide organizations through the turbulent stage of market evolution

First, HMOs that do not already have them will need to seek highly skilled executives. These leaders must have the experience to guide their organizations through the turbulent stage of market evolution in which they are most at risk, and the ability to cultivate and reward the advanced skills that the new environment demands.

Second, they will have to instill a high-performance ethic that transcends organizational and functional boundaries. Such a culture must foster continuous improvement, encourage greater efficiency and effectiveness, and allow deft responses to market requirements. Developing a market-driven culture that senses and reacts quickly to customer, provider, and competitor dynamics will create an advantage that other HMOs will find difficult to counter.

The final point specifically concerns large HMOs, which must learn to leverage to the full their geographic reach and scale advantages over smaller rivals. A competitor in multiple markets that is merely a holding company of small local health plans cannot hope to realize its potential. All available benefits must be captured by sharing information, best practices, and skills systematically across different markets and operations.