Page images

On page 13 of our testimony we discuss the issue of rate of return, which is addressed in section 46 of the bill. We urge the committee to provide for a rate of return equal to industries of comparable risk. That, we believe, should be the test, rather than any single number.

A study was contracted for by us with ICF, Inc., a Washingtonbased consulting firm. The study was released this morning. I would like to leave a copy for insertion in the record, with the permission of the chairman.

Senator TALMADGE. Without objection, so ordered.

[The executive summary of the study referred to follows. The balance of the study was made a part of the official files of the committee.]


Executive Summary


The purpose of this study is to determine the rates of return on equity (ROEs) that the Medicare program should pay to investor-owned hospitals (IOHS) for services to Medicare patients. This report is intended to provide an analytical basis for evaluating changes in the present ROE payment formula under Medicare, and for identifying a range of average ROE levels that is appropriate under any type of reimbursement system, including incentive or prospective reimbursement systems.

This analysis assumes that Congress intended for the Medicare program to pay the full reasonable cost of equity capital, and that the cost of equity capital for IOHS is equivalent to the rate of return earned by investors in industries. of comparable risk. The first assumption is based upon the regulations for the Medicare program, which state that:

"the share of the total institutional cost that is borne by the [Medicare] program is related to the care furnished beneficiaries so that no part of their cost would need to be borne by other patients," and


"an allowance of a reasonable return on equity capital invested and used in the provision of patient care is allowable as an element of the reasonable cost of covered services to beneficiaries by proprietary providers." "

Implicit in this assumption is the fact that certificate-of-need and Section 1122 capital disallowances, not Medicare ROE payments, represent the Congressionally-mandated approach by which unnecessary hospital investments are prevented. This approach is consistent with the need to ensure the availability of capital to maintain existing hospital investments and to make new investments where Health Systems Agencies authorize them. This approach also ensures that non-profit hospitals and investor-owned hospitals are treated evenhandedly, without regard to their tax status.

The second assumption is based upon the principles that have been established in federal rate-setting proceedings conducted by state public utility commissions and regulatory agencies such as the Federal Communications Commission. These principles, based primarily upon the 1944 Hope Natural Gas case, state that private businesses which employ their assets in service of the public interest should be paid rates of return which :

Protect their financial integrity;

Reward their investors at a level commensurate with the risks the investors assumed in making their investment; and,

Permit the companies to attract new capital for purposes of maintaining and expanding their operations.

These principles form the basis for determining appropriate rates of return in virtually every regulated industry, and, therefore, appear to be well-suited to the Medicare program.

120 C.F.R., § 405.402 (a).

220 C.F.R., § 405.429 (a).

3 Federal Power Commission vs. Hope Natural Gas Company, 320 U.S. 591 (1944).


The basic approach was to examine the financial characteristics of the investorowned hospital industry and to compare the riskiness of IOHS with that of other consumer product and service industries. Using this comparison, we identified other industries of similar risk and established a range of appropriate rates of return on equity for IOHS for the years 1969 through 1975. A range was used rather than a single ROE because it is not possible to measure industry risk precisely.

In order to analyze IOH financial characteristics, we first compiled financial data on ten major hospital management companies whose financial statements are filed annually with the Securities and Exchange Commission. Those companies operate about 42 percent of all IOH beds and over 80 percent of the beds owned by hospital management companies. Hence, they represent a major portion of the IOH industry. In addition, although independent IOHS tend to be smaller, they seem to have risk and return characteristics which are similar to the larger hospital management companies in our sample. As a result, we are confident that our findings can be safely applied to investor-owned hospitals in general.

We next compared the financial data on these ten hospital management companies with similar information on 24 major consumer product and service industries. These comparisons focussed explicitly on the average returns earned by these industries over the 1969-75 period in relation to four measures of risk: Variability of profit margins, which measures the uncertainty of the earnings in an industry and, thus, the exposure to demand or competitive factors which increase the risk to stockholders;

Financial leverage, which measures the proportion of an industry's capitalization that is financed by debt. Leverage reflects the risk assumed by stockholders because it indicates the extent to which lenders have a prior claim on assets when a default occurs,

Interest coverage, which measures financial risk in terms of the adequacy of firms' profits to cover their interest payments; and,

Stock price volatility (beta values), which indicates investors' overall perception of industry risk as reflected in movements of firm's stock price relative to the stock market average.

Based upon the analysis, we identified those industries which were definitely less risky than the IOH industry over the period to establish an appropriate lower limit on the range of ROES that IOHS should have earned during 1969-75. Then, we identified industries of comparable risk over the period and used the ROES earned by these industries as the basis for an appropriate upper limit on the ROES that IOHS should have earned over the same period.

Using these ROE estimates, we examined how the present Medicare costreimbursement formula could be modified to provide appropriate rates of return. Specifically, we analyzed the impact of alternative Hospital Trust Fund multiplier values on Medicare ROES over the 1969-75 period and evaluated the use of alternatives to the interest rate on bonds purchased by the Hospital Trust Fund.


1. The IOH industry faces above average financial and business risk in comparison to other consumer product and service industries.-Using measures of the variability of profit margins, financial leverage, interest coverage, and stock price volatility, we found that IOHS face risks which are viewed by investors and bankers to be similar to those of industries in the second highest quartile of risk (see Table 1 on page 7). These industries include broadcasters, brewers, shoe manufacturers, food processors, leisure industries and dairy products. Although some claim that providing care to Medicare patients entails less financial risk than providing care to private patients, we could find no support for that claim among those who provide capital to all types of hospitals.

2. To achieve ROEs commensurate with this risk, the IOH industry should have earned rates of return on equity between 11 and 16 percent over the 1969-75 period. Average after-tax Medicare ROEs during this period ranged from 4.7 to 6.3 percent, and overall hospital ROES averaged between 10.0 and 12.2 percent over these years. The Standard and Poor's 400-stock average over this period was 12.3 percent. Hence, IOH earnings were in the low range of appropriate ROES for their

risk, and Medicare paid a substantially smaller share for equity costs than other hospital patients (see Table 2 on page 7). This share was even below the ROES earned in low risk regulated industries such as electric utilities. Thus, non-Medicare patients subsidized the use of hospital services by Medicare patients to the extent of the difference.

3. Under the Medicare ROE formula, return on equity payments should have been based upon a 3.7 Hospital Trust Fund multiplier rather than the current 1.5 multiplier.—A multiplier equal to 3.7 would have yielded IOH rates of return on equity which were commensurate with their risk during each year of the 1969-75 period. If Medicare recognized taxes as an allowable cost, then the corresponding appropriate Trust Fund multiplier should have been 2.0. In 1976, the use of a multiplier of 3.7 would have increased total Medicare costs (net of taxes) by about $28 million or less than 0.3 percent of total Medicare program costs.

4. Medicare disallowances of certain unavoidable hospital expenses or investments can produce effective Medicare ROEs which are below the appropriate nominal rates identified above.-Consequently, higher Hospital Trust Fund multipliers might be needed to ensure that effective ROEs are commensurate with the ROES in similar risk industries. Such unavoidable costs disallowed by Medicare include income taxes, routine SEC registration costs, and other stock maintenance costs. If such disallowances represent three percent of total costs attributable to Medicare, then a Trust Fund multiplier equal to 5.1 rather than 3.7 would have been required to provide the appropriate average ROEs during 1969-75. Medicare equity disallowances include denial of fair market value assessments of IOH land used for hospital expansion and of hospitals acquired through the exchange of stock. When three percent of the value of such investments is disallowed by Medicare, then the Trust Fund multiplier needed to provide appropriate ROES during 1969-75 would have been 3.8.

5. Medicare ROE payments in the indicated range would allow IOH8 to reduce non-Medicare patient charges by at least two percent, or reduce the amount of debt capital employed by some IOHs.-By eliminating the current subsidy of Medicare patient expenses by other payors, hospital charges could be reduced on average by about two percent without reducing overall IOH profits. In areas where third-party cost-reimbursement covers a larger than average proportion of all patients, non-Medicare charges could be reduced even more. Alternatively, these ROE payments could permit IOHS to raise additional equity and thereby reduce some of the risk created by the use of large amounts of debt. The higher Medicare ROES might thus tend to be offset by the lower interest rates and payments which result from a less risky capital structure. Under certain circumstances, this return to a more balanced capital structure would produce lower total capital costs.

6. Under alternative Medicare reimbursement systems, IOHs should still receive ROEs which on average are consistent with the 11 to 16 percent returns.— Although our analysis focussed specifically on changes under the present Medicare cost-reimbursement system, most experts agree that Medicare reimbursement should be reformed to promote greater efficiency among hospitals. If a different reimbursement approach is adopted through legislation or changes in DHEW policy, then the new approach should still provide a target average industry ROE of at least 11 to 16 percent, because the IOH industry continues to face the same business and financial risks as before. Indeed, a new reimbursement system could actually increase industry risk. This seems to have occurred in other regulated industries that are naturally competitive, such as airlines and nursing homes.

7. Future analysis should focus upon three key factors which affect the determination of appropriate ROEs for investor-owned hospitals.-Specifically, future work should focus upon :

The degree to which certain unallowable costs and investments are simply unavoidable in IOH operations and thus may unreasonably reduce the effective return on equity:

The potential impact on return on equity and capital structure of alternative Medicare reimbursement proposals; and,

The degree to which full payment of IOH debt costs and partial payment of equity costs affects total costs of capital and the resulting capital structure.

These factors are important in the establishment of an appropriate regulatory policy for hospital reimbursement and were simply beyond the scope of this study.

[ocr errors]



Highest risk.
Medium risk.

Year: 1969 1970.






Financial leverage t

Low risk..
Very low risk.


1 Total assets divided by equity.

* Standard deviation of profit margins divided by average profit margin.

Source: Tables 14, 15, 16, and 17 in ch. II.


2. 14



Average, 1969-75.



in profit
margin 3













1 Sales-weighted average of 10 major hospital management companies. Source: Tables 3 and 4 in ch. II.



Range of appropriate ROE's




[In percent]

Pretax interest























Market price volatility (B)





1. 19













11. 1


Mr. BROMBERG. That study finds that the aftertax return on equity in comparable industries was 11 to 16 percent. The law has been interpreted to make our return on equity a pretax return. Under present law, we would only get 5 percent after taxes. As the bill is written, under section 46, that would be increased to 7 percent after tax.

We think the study will document the need for higher return.

I would like to make a comment on the administrative reforms of the bill. On page 22 of our testimony, in addition to the concerns that the chairman and others have expressed we have another one, and that is, that the quality of care may be subordinated to budgetary problems unless this new Health Care Financing Administration is either placed under the Assistant Secretary for Health or under a new Under Seeretary for Health.

We do not think it is really possible to separate quality and cost issues. We are afraid that having one agency concerned with costs separated from the top position in the Department of HEW that those issues will not be properly addressed.

Finally, at the end of our testimony, starting at page 25, we make the following conclusions. This bill is a result of a great deal of wellthought-out labor on the part of the subcommittee chairman, the mem

bers, and the committee staff. On its own, it may be considered to be a bill with a great deal of merit; compared to arbitrary cost control schemes, it is particularly commendable.

The impact of this bill, S. 1470, on reducing the rate of inflation in cost reimbursement under medicare and medicaid should automatically impact non-Government program costs. Charges to private patients, for example, should rise less sharply because actual costs will be moderated and will be rising at a much slower pace as a result of your bill.

For this reason, together with our opposition to any Government price controls over one industry, we urge you to limit application of your bill to medicare and medicaid. We will be very much willing to work with the staff to see how the bill can be applied to ancillaries. We would like to see the concept limited first to medicare and medicaid and with respect to other patients to make sure that there is no shifting of costs.

We would recommend use of a general jawboning policy particularly emphasizing public disclosure, rate review, and public finance. It seems to us that there is not enough disclosure in the hospital field. Not only do consumers not pay at the time they get the service, they make payments, but do not pay at the time they get it, but also they are not aware of what the competitive charges are.

It seems that the first step to stimulate the competition would be disclosure.

Second, the threat of adverse publicity, for example, from findings of local insurers or the President's Council on Wage-Price Stability in the cases of unjustifiably high rate increases, the threat of adverse publicity in itself would create a problem which most hospitals would attempt to hold down climate increases.

A national guideline for hospital price increases could be established, with review of such increases by the President's Council, utilizing publicity.

We commend the committee for taking the lead in changing the medicare and medicaid programs, and thank you for this opportunity to present our views.

Senator TALMADGE. Thank you, Mr. Bromberg, for your constructive testimony.

Do you have any questions, Senator Dole?

Senator DOLE. Just briefly. It is an excellent statement.

I asked the previous witness why does not the free market operate in the medical care arena and I just noted that you were sort of nodding your head. I could not get that in the record. I thought I would ask you the same question.

Mr. BROMBERG. Let me take a shot at it, Senator. I think, Senator, it has not worked because nobody has let it work. I think this bill, S. 1470, is the first effort I have really seen in the Congress to inject competition. I think competition can play a role.

I agree that hospitals are not like automobile companies, but there are certain analogies. We do not, for example, say that there should be a 9-percent limit on automobiles or food or housing, although people spend almost as much on food and housing as they do on health.

We do say if you want to buy a Cadillac instead of a Chevrolet you have that right. We are not going to take that away from you and

« PreviousContinue »