Kenneth Kaufman

In the wake of the subprime mortgage crisis, it is time for risk to receive the attention it deserves in executive suites and boardrooms of the nation's hospitals and health systems.

At a Glance
Five strategies can help hospital financial leaders balance their organizations' financial and risk positions:

  • Understand the hospital's financial condition.
  • Determine the desired level of risk.
  • Consider total risk.
  • Use a portfolio approach.
  • Explore best-case/worst-case scenarios to measure risk.

The subprime mortgage crisis of 2007, whose effects continue to be felt throughout the capital markets, is demonstrating to many healthcare financial executives the downside of risk. Up to the point when hospitals felt the impact of this crisis, finance-related risks-such as credit risk, put risk, interest rate risk, basis risk, and failed auction risk-were perhaps underappreciated by managers and board members alike.

The importance of understanding risk on the clinical side of the healthcare enterprise is well recognized. But not all senior hospital financial leaders recognize the importance of fully understanding the organization's financial risk position. Insufficient attention to overall financial risk, particularly in a challenging environment, can lead to strategic and financial decisions that greatly increase the day-to-day risk of operating the hospital. To illustrate this point, consider the following scenario. A hospital in a rapidly growing region has positive business fundamentals, such as a good medical staff and good commercially insured patient volume. But competition from organizations eager to capture a piece of the growing market has increased during the past decade. To handle growth and solidify its long-term competitive position, the hospital has been steadily increasing capacity and investing in its facility, programs, equipment, physician-alignment strategies, and staffing.

Because this hospital has been borrowing and spending aggressively, its financial position is not particularly strong. The hospital may make a small profit, but its balance sheet has been weakened by its aggressive spending to defend its market position.

This situation is not uncommon for hospitals. The leaders of such hospitals often are highly focused on what it takes to stay competitive and serve the community over the long run, and they too often are inattentive to the total amount of risk the organization is taking as it tries to move to its desired strategic position.

As a result, the organization's risk position may be much greater than its financial position would warrant. Hospital leaders may be borrowing more money than the hospital can really afford, and the type of borrowing, structured to lower the cost of capital, may be significantly increasing the total amount of financing risk. The leaders also may be making strategic decisions that lead to reduced profitability, or even operating losses. When an organization in this high risk-leveraged condition encounters an unanticipated event risk, the financial harm will almost always be greater than expected.

To ensure their organizations are appropriately focused on risk, hospital senior financial executives should raise the following questions:

  • What risks should financial leaders address as part of their financial oversight responsibilities?
  • What creates risk related to an organization's financial performance?
  • What might occur if risk is not properly understood or effectively managed?
  • How much risk is too much risk and how much risk may not be enough?
  • Can risk be managed to strategic advantage, and if so, how?

The answer to the first question-the types of risk that should be of concern to senior financial leaders-is provided in the sidebar.

Exhibit 1

exhibit-1-Managing Risk in a Challenging Financial Environment

Types of Risk

In common usage, risk is defined as the possibility of something occurring that will have a negative impact on the achievement of objectives. Three distinct forms of risk should be of concern to every healthcare executive: business risk, financing risk, and event risk.

Business Risk

Incurred by opening the doors and operating the hospital each and every day, business risk is created by many factors, including cost inflation, compliance issues, consumer demand shifts, services offered, staffing, geographic market, and facilities.

For example, a hospital, located in a region with particularly acute staffing shortages, borrows a significant amount of capital to build a large outpatient center. To address the business risk posed by staffing shortages, hospital executives have taken extensive steps to recruit staff. However, six months prior to opening, it becomes apparent to them that proper staffing of the facility is not achievable. As a result, the hospital will be able to open only a small portion of the facility. Such portion will not generate the targeted revenue required to ensure that the project is financially viable.

Financing Risk

Financing risk is the risk that the cost of capital or the return from an investment will be different from what's expected. Often defined as the unexpected variability or volatility of capital cost or return, financing risk could include both better-than-expected and worse-than-expected scenarios. In general usage, however, it usually applies to negative situations.

In essence, there are at least seven types of financing risk:

  • Interest rate-the risk of interest-rate variability borne by the holder (or the borrower) of an interest-bearing asset
  • Liquidity-financial risk due to uncertain availability of capital
  • Basis-the risk that offsetting investments or debt products in a hedging strategy will not experience price changes in entirely opposite directions from each other (Imperfect correlation between the two investments/debt products, such as with variable-rate debt hedged with a fixed-rate payer swap, creates potential losses or, in some instances, gains.)
  • Put-risk that bonds can be "put" back to the hospital by the lender
  • Bank-risk that renewal of a bank letter or proof of credit willcome at an inopportune time or be unobtainable for a variety of reasons
  • Credit-risk that an organization's credit rating or the rating of a credit enhancer changes while using certain programs that are dependent on the organization/credit enhancer being at a certain credit level
  • Failed auction-risk that occurs when there are more sellers of an issuer's paper on an auction date than there are buyers, and the whole offering is not resold

In hospitals and health systems, as in all organizations, these risks are built into capital structure on the liability and the asset sides of the balance sheet and on the interrelationship between the two.

Liability-side risks.These risks include basis, put, bank, credit, failed auction, and interest-rate risk. Variable-rate debt, characterized by periodic resets of the interest rate, exposes the borrower to the risk of rising interest rates and to credit risk, which may result from organizational or credit enhancer downgrades. Using a mix of fixed-rate and variable-rate debt generally minimizes interest-rate risk.

Recent turmoil in the capital markets underscored for hospital leaders the negative impact of various liability-side risks. Downgrades of "AAA"-rated bond insurers significantly decreased the value of financial products used by many hospitals, thereby increasing hospital interest rate costs. As a result of failed auctions, hospitals experienced interest rate increases for auction-rate debt to as high as 15 percent. Put risk rose with variable-rate instruments that were insured by bond insurers with weakened credit positions. Perhaps the least understood risk-basis risk-increased during the current market turmoil, resulting in significantly decreased savings from fixed payer interest-rate swaps, which hospitals were using to hedge variable-rate auction securities.

Asset-side risks. These risks include, in addition to the risks described above for the liability side, market and liquidity risk as applied to investments, such as equities (stocks), bonds, securities, and property, plant, and equipment. For example, an organization that has most of its capital invested in equities would suffer significant loss related to high market risk if the stock market declined 3,000 points.

Hospitals and health systems typically retain cash reserves, which they invest in short-term fixed-income securities. Cash-like securities are considered liquid and safe, but the recent turmoil in the auction-rate securities market shows that the definition of "safe" products can rapidly change.

The interrelationship of asset-side and liability-side risks. This interrelationship is a critical issue for hospital leadership. A best practice approach to balance sheet management requires careful management of asset/liability risks and returns in concert with one another rather than as separate management functions. The adverse effects of not having such an approach can be considerable.

For example, consider a hospital whose debt portfolio contains mostly variable-rate debt and whose asset portfolio contains mostly equities. As interest rates rise, the stock market often declines. The organization's borrowing costs thus would increase at the same time as its investment earnings decline. One market condition would bring negative occurrences to both sides of the balance sheet, thereby putting this organization at significant financial risk and certainly in a position of suboptimal financial performance.

Financing risk often must be addressed when an organization is least equipped to deal with it and limited in its options. Higher capital costs and lower investment returns are likely to reduce capital capacity and limit access to capital at the most inopportune time.

Event Risk

The "killer of all risks," event risk is the risk of an unexpected external event, such as a severe economic downturn, natural disaster, or major regulatory change, which is entirely beyond the hospital's control. Sept. 11, 2001, represented an event risk for the U.S. economy in general and for specific businesses, such as airlines and other travel-related companies.

Today's big event risk in the financial world relates to the dislocation created by the subprime mortgage market crisis, which, as it ripples through the capital markets, is significantly impacting hospital auction-rate debt programs and capital access and cost.

Total Risk

An organization's total risk is the sum of these three kinds of risk. The total risk of some hospitals and health systems exceeds the organizations' financial position, meaning that the organizations are not achieving strong enough financial performance to warrant the level of risk they are incurring. Such organizations are highly "risk-leveraged."

A concept normally used in the investment world, leveraging involves using borrowed funds or debt in an attempt to increase the returns to equity. The leverage concept, however, is equally valid in relationship to total risk. Leveraging an organization's total risk can amplify the potential gain from something, but it also increases the potential loss by magnifying any internal or external adversity that may be encountered, and accelerating the organizations' negative risk position. If things go bad, they go bad that much faster. A highly risk-leveraged organization cannot respond with the strategies that would be available to an organization with strong financial performance and low total risk leverage.

On the other hand, some organizations may not be adequately risk leveraged; their financial performance may exceed actual total risk incurred, meaning that the organization is in a position to take on more risk than it currently does. By not doing so, the organization, in fact, may be incurring a hidden "opportunity cost," defined as an expected return that is forgone due to an overly conservative approach to risk.

Organizations compete most effectively when there is relatively little difference between their financial position and actual level of risk on the total risk/financial strength continuums. Executives must understand the organization's risk profile and its financial ability to handle that risk, so that the two are in sync.

Rigorous application of the following strategies will help executives address the remaining questions and more effectively balance their organizations' financial and risk positions.

Strategy #1: Understand the Hospital's Financial Condition

This strategy informs all others. Thorough financial and credit analyses enable financial executives to identify their organizations' financial strengths and weaknesses. An organization rated "AA," with an operating margin of 5 percent and 300 days cash on hand, will be able to take on more financing and business risk and will be better able to handle a certain amount of event risk than an organization with a "BBB" rating, a 1 percent operating margin, and fewer than 100 days cash on hand. If the latter organization incurs strategic business risk or financing risk or both at the same time, the organization's leaders should not be surprised at the depth of organizational financial pain when an unexpected event occurs.

The point is that risk incurred should be related to the organization's financial condition. If the hospital's financial position is mediocre, its leaders should be conservative about the risk taken. If the hospital's financial position is extremely strong, its leaders should recognize that incurring some risk may benefit the organization.

Strategy #2: Determine the Desired Level of Risk

Application of this second strategy, which also informs all others, is clearly a joint responsibility of an organization's board and senior executives, who are accountable for managing the organization in a manner that ensures achievement of strategic financial goals. Risk is inherent at each step of the management process.

It is up to each organization's leaders to determine the organization's tolerance for risk and the desired balance of financial offense and defense. The risk that is right for one organization may not be right for another.

What is the "right" level of risk? Even renowned corporate finance textbook authors say this: "We wish we could give general guidance on what bets the firm should place and what the appropriate level of risk is, but less risk can't always be better. The point of risk management is not to reduce risk but to add value" (Brealey, R.A., and Myers, S.C., Principles of Corporate Finance, 2000). The task for boards and executives is to develop and faithfully implement a risk strategy that adds up to "a sensible whole."

Strategy #3: Consider Total Risk

As described earlier, an important aspect of organizational risk tolerance is the issue of how many risks are taken at the same time and the resulting level of consolidated risk. Hospital boards and executive teams often struggle with this issue.

For example, if a hospital has a large facilities project under way that involves considerable business and operating risk, the organization should not be taking on a lot of financing and other strategic risk concurrently. During the construction phase of the project, the organization's senior financial executive may wish to reduce financing risk so that such risk doesn't combine with operational uncertainty to elevate total risk.

On the other hand, if an organization's operations are in really good shape and it has no major capital projects occurring at the moment, then the organization is in a position to assume more financing risk. The senior financial executive must function as the organization's chief risk officer to ensure the effective management of the organization's total risk.

Strategy #4: Use a Portfolio Approach

Since development of the portfolio theory in the 1950s, diversification has been recognized and used as the mainstay of risk reduction. The theory holds that investors can reduce the standard deviation of portfolio returns by choosing stocks that do not move in exactly the same way together. Diversification works to reduce the unique risks represented by one company's stock, but market risk, which threaten all businesses, cannot be trimmed.

As sophistication of the products offered by the capital markets increases, it often is difficult to determine which asset and debt instruments are linked and likely to be moving together. With the recent subprime mortgage turmoil, for example, numerous asset classes, such as real estate, equity, and bonds, all moved in the same direction-downward. As one financial writer noted recently, "When you have systems with lots of moving parts, some of them are bound to fail. And if they are tightly linked to one another-as in our current financial system-then the failure of just a few parts cascades through the system" (Surowiecki, J., "Bonds Unbound," The New Yorker, Feb. 11 and 18, 2008).

Diversification of both debt and investment portfolios is highly recommended as a strategy to increase the margin of safety. Unfortunately, with the demise of auction-rate securities as a properly functioning debt program, not-for-profit hospitals are limited to variable-rate demand bonds for variable-rate debt, which effectively increases the overall risk profile of hospital debt portfolios.

One of the most important lessons of the past year is that diversification across a capital structure is an important risk management objective. When this objective cannot be reached, a hospital's leaders need to be careful in selecting their organization's capital partners and then need to pay close attention to the integrity of each partner's position in the market (Jordahl, E., "Capital Markets Update," Kaufman Hall eReport, May 2008).

Strategy #5: Explore Best-Case/Worst-Case Scenarios to Measure Risk

Hospital and health system leaders should ensure that their management staff conduct sensitivity analysis around variables that create risk throughout the capital management cycle, from assessment of strategic initiatives, to allocation of capital to a portfolio of strategies, to funding such strategies, to investment of capital returns.

The common practice of relying on best-guess averages for planning assumptions at each stage, such as volume, revenue, and inflation during the strategy-assessment phase, can be very dangerous. Use of simulation and sensitivity techniques, available with numerous software tools, enables executives to obtain a more accurate estimate of the true risks associated with the options they are considering. Such techniques assess the broad range of risk elements and indicate a distribution of possible outcomes.

For example, due to the high level of uncertainty about Medicare and Medicaid payments, one hospital used sensitivity analysis to assess the range of possible reimbursement options, setting the deviation for reimbursement at plus or minus four percentage points. The analysis showed hospital executives that given potentially higher reimbursement variation, the most likely scenarios for operating income and operating margin were significantly lower.

As a result, management updated its baseline financial plan to factor in that reality. The danger of not doing so would have been that the organization would have overstated its financial capability, which ultimately would have led to an overstatement of what it could afford to spend on capital.

As another example, a small community hospital used sensitivity analysis to assess the viability of building and financing a new facility to replace its aging facility. The hospital's leaders looked at volumes and projections, capital requirements, and cash flow to identify if and when they could go to the bond markets. Sensitivity analyses around growth rates, volumes, changes in payer rates and mix, and FTEs per adjusted occupied bed enabled the leaders to identify the possible impact of differing performance levels on the benchmarks associated with the hospital's current "A" credit rating. The analyses made it clear that, given current performance levels and realistic projections for the future, the hospital was not going to be able to afford the cost of the new facility.

The use of sensitivity analysis to measure the risk incurred by the organization should be a core component of the hospital's continuous financial planning process. Hospital financial leaders who use such a process have a "live" roadmap to navigate through unexpected risks and economic uncertainties, and better defend their organization's financial integrity.

A Proper Balance

In times of changing market and financial conditions, characterized by uncertainty and risk, strong and steady financial leadership is an absolute requirement. Hospital executives should seek a proper balance between operating the organization as aggressively as possible in the competitive marketplace and maintaining a conservative approach to fiscal management that recognizes fiduciary responsibility. A balanced approach means taking risk that is appropriate to the hospital's financial and competitive positions as well as financial goals and objectives, and consistent with the risk preferences of the board and management. At the end of the day, appropriate risk management creates an organization sufficiently flexible and maneuverable to weather uncertain times and succeed in its market.

Kenneth Kaufman is managing partner, Kaufman, Hall & Associates, Skokie, Ill., and a member of HFMA's First Illinois Chapter

Publication Date: Friday, August 01, 2008

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