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By Therese L. Wareham and Zachary Hafner
This is a sample article from HFMA's Strategic Financial Planning, a subscription newsletter that helps senior financial leadersrespond to reform and federal/state budget cuts, improve strategic planning, access and allocate capital, identify and respond to risk, and take advantage of growth opportunities.
Learn more and subscribe to Strategic Financial Planning.
Defined in its most basic sense, risk is the possibility that for any given action or assumption, there may be more than one possible outcome. Enterprise risk, which is experienced by all healthcare organizations, can be broadly categorized into three areas:
These three risk areas comprise an organization's total risk profile. Effective risk management involves carefully evaluating the level and degree of risk being assumed in each of these risk categories, and making calculated trade-offs to ensure that, in total, the organization does not have exposure beyond what the board and management team have defined as an acceptable level. For example, if a hospital is assuming considerable business risk, it might take steps to reduce the risks associated with financing strategies and capital structure.
Because the consequences of making a bad strategic decision can be severe, long-range plans need to be flexible and responsive, incorporating comprehensive risk analysis that devotes considerable attention to understanding, identifying, and quantifying risk. This provides leadership with the information and insight necessary to develop fact-based contingency plans, balance the timing and magnitude of total risk adoption, and ultimately, eliminate unnecessary or undue risk from future plans.
To demonstrate the value of risk analysis, we turn to the recent example of an urban hospital system that uses comprehensive risk analysis to identify not just the benefits of plan success, but the real dangers of its potential shortfalls. Using this approach, the system has successfully developed robust operating and capital plans that support its strategic objectives, while providing leadership with sharp focus on eliminating unnecessary risks that might otherwise put the organization's credit rating, or worse, its financial stability, in jeopardy.
The system is an A-rated credit with a multiyear track record of solid financial performance. Recently the system embarked on a major expansion initiative at its main campus. The system developed a strategic business case for the project, supported by an aggressive financing plan and detailed financial projections that indicated the organization would be just able to support the project's capital requirements while maintaining the credit ratios and metrics (for example, days cash on hand and cash-to-debt ratio) needed to preserve its A-category credit ratings.
The system began using risk analysis as part of its planning efforts in 2004, several years prior to beginning its campus expansion. At that time, the system recognized the need for major infrastructure investment but was in a considerably weaker financial position. By identifying areas of risk in its ongoing planning efforts, systematically eliminating key risks, aggressively executing on plan performance requirements, and updating plan targets on an annual basis, the system was able to position itself over a period of several years to undertake a major and strategically necessary capital expansion initiative.
The system's six-year campus expansion plan totaled nearly $1.5 billion; given this level of capital requirement, the organization would need to meet or exceed all operating performance targets defined in the plan to emerge from the project with its A-category rating intact.
Significant improvement in operating cash flow would be required on an ongoing basis, along with substantially higher philanthropic contributions than historically received. Even assuming this level of performance, the plan indicated that the system would be spending down a considerable portion of its cash reserve and issuing sizable new debt exceeding its up-front available debt capacity. The system, therefore, would also need to build considerable capital capacity over the course of the plan period to fund plan requirements and ensure adequate capital capacity to support future needs.
A preliminary capital position analysis, comparing anticipated sources and uses of cash over the six-year planning time frame, showed vulnerability-a significant shortfall in sources of funds on the order of $200 million. Management felt confident it could deliver operational improvements to close the gap, but clearly the plan as defined left little room for error. If left unaddressed or addressed unsuccessfully, any shortfall in operating performance could put the organization in financial jeopardy.
The first step in conducting project risk analysis is identifying the various categories of risk, and determining what level of influence can be exerted over the outcomes within each particular category. In managing risk, it is important for management to focus its energies on aggressively controlling factors that fall within the organization's control and to minimize-to the extent possible-exposure from factors that fall outside the organization's control (see exhibit 1; click to enlarge).
Execution risk (or the risk associated with completing a project according to plan specifics) represents mostly controllable factors related, for example, to project management, expenses, and other controllable variables. Execution risk requires vigilant management of cost and schedule-related issues.
Inevitably, financial projections will be most sensitive to changes in certain key variables, so identifying these variables and their ranges of possible outcomes is vital. In the system's case, the overall plan was most sensitive to changes in operating cash flow, which is itself dependent upon numerous underlying assumptions.
Traditional sensitivity analysis offers a powerful tool for identifying the key drivers of projected operating performance, defining the range of potential outcomes for each driver, and quantifying the actions/reactions needed to ensure that operations support project spending.
In the system's case, sensitivity analysis included testing scenarios related to volume, payer mix, Medicare and commercial insurer rates, bad debt, uncompensated care, productivity improvements, and salary increases.
Although these single-variable sensitivity analyses are useful in illuminating key areas of concern, a more robust analytic approach is required to fully understand and quantify the overall level of risk associated with a major multiyear strategic financial and capital plan. The Monte Carlo method defines reasonable ranges around key plan assumptions (high, low, and expected), "rolls the dice" to select values within each range, and then measures resulting plan performance. By running a very large number of iterations-5,000 to 10,000 or more-the analysis quantifies both the range of possible outcomes and the probability of achieving any given outcome, thereby quantifying risk exposure.
In the system's case, defining ranges around key plan variables revealed that management had been optimistic or aggressive in many of its planning assumptions (see exhibit 2).
The ranges indicated far greater downside risk than upside potential.
A capital position analysis incorporating possible risk ranges, which updated the analysis conducted earlier, showed an ending cash balance of $730 million (see exhibit 3).
But what was the likelihood of the system achieving this result?
Monte Carlo simulation of more than 10,000 trials showed that the system's projected ending cash balance of $730 million was a highly improbable and optimistic outcome (see exhibit 4).
At the 50th percentile (the mean, "most likely" outcome), the system's projected ending cash balance was $550 million, $180 million below the system's projected level.
Armed with this information, the system was able to quantify the magnitude of the contingency plan required for capital spending, namely $180 million. The organization's deferral or avoidance of $180 million in capital spending on operations-funded initiatives could be accomplished in various increments, depending upon how and which capital sources materialized in line with plan assumptions. At the very least, a decision to move forward with the project would be made "eyes wide open," with leadership understanding the full range
of implications and possible (probable) outcomes.
Comprehensive risk analytics provided the system with an accurate understanding of the level of business, investment, and financial/capital risk represented by its capital plan. Such understanding crystallized the need to achieve or exceed projected operating performance and to develop contingency plans to ensure that the campus redevelopment initiative did not diminish the organization's financial position.
Subsequently, system management began looking for ways to narrow the band of possible outcomes by focusing on the plan variables with the most significant ranges of outcomes and reducing or eliminating the potential variability (for example, by moving certain investments from variable-rate products to fixed-rate products, or using derivative instruments to fix debt service payments on variable-rate debt).
Risk analysis also provided the system with perspective going forward beyond the plan period. By incorporating robust risk analysis into its planning efforts, the system is well-positioned to accurately assess the viability of capital spending and the enterprise risk associated with future capital plans. The system's focus now and into the next decade will be on rebuilding capital capacity to ensure the strong financial performance required to meet ongoing needs.
Therese L. Wareham is a partner, Kaufman, Hall & Associates, Inc., Skokie, Ill. (firstname.lastname@example.org). Zachary Hafner is a vice president, Kaufman, Hall & Associates, Inc., and a member of HFMA's First Illinois Chapter (email@example.com).
Publication Date: Tuesday, December 01, 2009
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