Managing Health Care Reserves: Aligning Operating Assets with Broader Organizational Goals Enterprise Risk Management for Health Care Organizations June 2017 Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc., an Aon Company. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice. Risk. Reinsurance. Human Resources.
Key Points Health care finance continues to be challenged on multiple fronts as hospitals and health care systems grapple with business environment complexities such as health care reform, hospital consolidation, and profit margin pressures all placing greater reliance on reserve investments amidst an environment of rising interest rates and muted return expectations. For many health care organizations, operating reserves have grown substantially over the years and have become an important pillar in supporting financial goals to maintain or improve credit ratings, provide adequate liquidity to cover expenses, and avoid violating bond covenants. Using an Enterprise Risk Management (ERM) framework for stress testing through stochastic simulations of both investment returns and key operating metrics is necessary to reveal short-term stresses that could lead to ratings downgrades or bond defaults. Asset allocation policy should be dynamically implemented and reviewed periodically as business needs and investment opportunities evolve. Introduction According to the American College of Healthcare Executives 2016 annual survey of top issues confronting hospitals, financial challenges continued to rank as #1. Health care reform continues to challenge cost containment given the need for significant upfront investments in technology along with increasing costs of attracting top talent. In addition, increased enrollment and reduced Medicaid reimbursement rates hurt revenue, leading to squeezed margins on both sides. Even the most successful health care organizations register only slim operating margins of 3% 5%.1 Low margins will likely force many to rely more on their operating investment portfolios for additional sources of income and liquidity. Without the buffer provided by strong operating margins, weaker investment outcomes may have a greater impact on key financial metrics that could, in turn, result in credit rating downgrades, risk bond covenant violation, and even default. Policy uncertainty further emphasizes the need to maintain a strong financial position and build a financial buffer. In this environment, it becomes critical to consider the interlinked effects from changes in investments and in financial metrics within an Enterprise Risk Management (ERM) framework. ERM can be thought of as the process of managing risks by considering how they affect the broader enterprise and how risks across the enterprise are correlated. This approach should enable health care organizations to better assess overall enterprise risk-bearing capacity and how best to manage risks within their operating investments. Why an Enterprise Approach? We begin by recognizing that most operating portfolios do not have explicit return targets aside from a general desire to preserve capital while generating some level of real return. This broad objective understandably leads to a preference to err on the side of conservatism and simplicity in structuring the portfolio, such as a plain vanilla portfolio of 50% public equities and 50% bonds. As some organizations have recognized the benefit of greater diversification and even embraced increasing complexity to 1 According to Standard & Poor s most recent report in 2015, health care systems median operating margin was 3.6%, a steady improvement over the past five years. Only systems rated A+ or better delivered a median margin above 4%. Managing Health Care Reserves 1
achieve better risk-adjusted return potential, how diversification explicitly ties back to the organization s financial goals often remains nebulous. Generally, any risk-based decision making and strategy development can be enhanced by ERM. An ERM framework helps identify and assess risks and opportunities on a cross-functional basis, and where risks in one part of the organization might influence the type of risk taking in other parts of the organization to maintain or improve a desired financial position. In the context of health care operating reserves, enterprise wide financial risks and finance decisions made could affect the desired risk profile of the reserves and how the investment strategy is implemented. Importantly, we believe an enterprise approach creates a clear link between investment decisions and the organization s operational and strategic financial objectives. It allows organizations to holistically evaluate the impact of various financial decisions across asset pools. Specifically with the importance of operating reserves to support credit ratings, understanding how different enterprise risk thresholds 2 may affect investment decisions (and vice versa) is necessary. This understanding would allow resource- and timeconstrained staff, as well as finance and investment committees, to better address inter-related questions more effectively. Some of those questions may include: Can the portfolio take on additional liquidity risk while staying within key ratio thresholds? What is the impact of a recession scenario on investment income and the organization s financial profile? Is there any knock-on effect from issuing new debt to fund a pension shortfall? How can the portfolio structure be better calibrated to meet near-term cash flow needs? How might the risk-bearing ability of pension, operating, and other assets be impacted by a potential merger? Establish Risk Tolerance Aligning Investment Horizon with Asset Purposes The first step in determining the appropriate risk levels within the operating assets is to project net cash flows that impact the operating reserves. The amount and timing of cash flows from operations must be projected in order to properly assess the ability to assume risk and set the appropriate asset allocation. Managing operating assets is complex because they can have multiple uses. Most health care organizations have five-year budgets that attempt to forecast revenues, expenses, capital expenditures, and net cash flows. The cash flow profile will be determined by the intended purposes of the operating assets. More emphasis on shorter-term needs such as working capital, debt coming due, or large capital projects over the next few years will typically dictate a lower risk profile. Conversely, more emphasis on long-term initiatives and rainy day funds will typically dictate a greater ability to take on risk. Exhibit 1 below presents one view of aligning purpose to investment horizon. 2 Some key financial metrics that help identify enterprise risk thresholds are discussed in detail in the Appendix. Managing Health Care Reserves 2
Exhibit 1: Operating Assets Segregated by Purpose and Investment Horizon Operating Assets Investment Horizon Purpose Short Term 1 to 3 years Working capital needs and any other short-term cash needs Medium Term 3 to 10 years Self-insurance and malpractice pools, bond sinking funds, funded depreciation, and capital projects Long Term > 10 years Long-term strategic initiatives and rainy day funds Having a clear understanding of the purposes of operating assets and the cash flow demands across investment horizons, we can determine preliminary asset mixes based on the risk tolerance of the organization. Exhibits 2 and 3 present simplified asset allocation scenarios and their corresponding probability of loss and pessimistic case (5th percentile) loss over various time horizons. For example, if we determine that the assets have an aggregate investment horizon of five years and the organization is comfortable with a less-than-10% probability that the operating asset will take a loss, and a pessimistic annualized return with a slight loss (e.g., 1%), a portfolio with a risk and return profile closely aligned to that of a 50% equity/50% bond portfolio may be appropriate. Realistically, an assessment of risk tolerance is neither simple nor clear-cut. Determining the appropriate portfolio diversification would require refining through other financial inputs and decisions at the enterprise level that may be interlinked to operating portfolio risks. Exhibit 2: Probability of Loss for Various Asset Mixes and Investment Horizons Time Horizon (Years) 100% Short Bonds 100% Intermediate Bonds 20% Equity/ 80% Bonds 40% Equity/ 60% Bonds 50% Equity/ 50% Bonds 70% Equity/ 30% Bonds 1 6% 18% 20% 26% 28% 31% 3 0% 5% 8% 13% 15% 20% 5 0% 2% 3% 7% 9% 14% 7 0% 1% 1% 4% 6% 10% 10 0% 0% 0% 2% 3% 6% Exhibit 3: Case (5th Percentile) Annualized Return for Various Asset Mixes and Investment Horizons Time Horizon (Years) 100% Short Bonds 100% Intermediate Bonds 20% Equity/ 80% Bonds 40% Equity/ 60% Bonds 50% Equity/ 50% Bonds 70% Equity/ 30% Bonds 1 0% 2% 4% 7% 9% 13% 3 1% 0% 1% 2% 3% 5% 5 1% 1% 0% 1% 1% 3% 7 2% 1% 1% 0% 0% 2% 10 2% 1% 2% 1% 1% 0% Note: Data presented in above table is for illustrative purposes only. The return probabilities are models and do not represent any actual client portfolios and are based on AHIC s Q1 2017 capital market assumptions for global equities, and short- and intermediate-term bonds Actual results will differ from those presented. Capital Market Assumptions are internally generated economic assumptions based on various economic and market data sources. Managing Health Care Reserves 3
Low Enterprise Health High Aon Hewitt Determine Risk Capacity Stress Testing Using an Enterprise Risk Management Approach Understanding the organization s financial condition is critical to making final investment decisions for the operating reserves. Broadly speaking, healthy organizations with greater financial strength and/or flexibility have the capacity to take on more risk in their investment portfolios. As Exhibit 4 highlights, financially weaker organizations tend to have more volatile operating results, negative operating cash flows, significant short-term liquidity needs, and high leverage, and they may be at risk of violating bond covenants or facing potential credit rating downgrades by rating agencies. These organizations are likely more sensitive to investment volatility and wider dispersion of investment outcomes. Therefore, their ability to take on risk is more limited. Exhibit 4: Enterprise Health vs. Risk Tolerance Positive net cash flows Stable operating performance Longer-term investment horizon Mostly fixed-rate debt Manageable debt service Large near-term cash needs Nearing bond covenant triggers Volatile operating performance High debt relative reserves Negative net cash flows Lower Investment Portfolio Risk Tolerance Higher By looking at the investment portfolio with an enterprise lens, we gain a better understanding of potential stress points that potentially impact operating reserves. For example, a health care organization that expects negative operating margins over the next several years may have to dip into the reserves to meet payroll or uncertainty around forecasts, which may force them to keep a larger buffer in working capital. On the other hand, organizations with very strong margins may be able to fund initiatives purely out of operating cash flow without tapping into reserves, thus requiring lower cash buffers for working capital. Stress testing can help determine whether the allocation can weather potential downside scenarios that may lead to a rating downgrade or bond default. Stress testing is typically performed over shorter-term horizons (one to five years) integrating investment returns of the operating pool with the organization s Managing Health Care Reserves 4
financial projections. Key inputs from the organization include baseline financial forecast (more than three to five years) and expected variance around the baseline projections. Important in this data-gathering stage is determining the standard deviation of operating revenues and operating margins, which are major drivers of the organization s financial position. The organization-specific data is then integrated with capital market forecast data, including expected asset class returns, inflation, and interest rate changes. From these parameters, 5,000 stochastic simulations are analyzed to provide a percentile distribution of investment outcomes and potential impact on key financial metrics. The results are compared to credit rating peer groups, which are used by rating agencies to evaluate financial performance of health care organizations. The below stress test example is analyzed based on a simple portfolio of 70% equities and 30% bonds for fiscal year 2017. The organization s baseline five-year operating forecast is typically provided by management and is shown in Exhibit 5. Exhibit 5: Baseline Financial Projections Provided by Health Care Finance Staff Baseline Projections FY2016 2017 2018 2019 2020 2021 Operating Revenues 304.0 310.1 316.3 322.6 329.1 335.6 Operating Expenses 294.0 304.0 308.5 313.0 317.5 324.0 Depreciation 12.0 12.0 12.0 12.0 12.0 12.0 Interest Expense 5.0 5.0 4.9 4.8 4.7 4.6 EBIDA Operating Expense 277.0 287.0 291.6 296.2 300.8 307.4 EBIDA Operating Margin 8.9% 7.4% 7.8% 8.2% 8.6% 8.4% Operating Margin 3.3% 2.0% 2.5% 3.0% 3.5% 3.5% Capital Expenditures 12.0 12.0 12.0 12.0 12.0 12.0 Principal Paydowns 2.0 2.1 2.2 2.6 2.0 1.9 New Debt 0.0 0.0 0.0 0.0 0.0 0.0 Other Cash Flows 0.0 0.0 0.0 0.0 0.0 0.0 Net Cash Flows 8.0 4.0 5.6 7.0 9.6 9.8 In order to provide stochastic simulations of financial projections, management provided standard deviation estimates for operating revenues of 5% and operating margins of 2%. In other words, they provided ranges around their baseline projections. For instance, fiscal year 2017 baseline operating revenues to-date are $310.1 million and are expected to fall within a range of $341 million to $279 million. Operating margins are expected to range from 6% to 0%. Higher uncertainty of financial projections will require higher standard deviation estimates. Given the declining expectation for operating profits in fiscal year 2017 and fairly high uncertainty (standard deviation) of financial projections, the portfolio could benefit by shifting to a more diversified 40/60 portfolio that includes core real estate and multi-asset credit strategies providing less downside risk. In the pessimistic scenario (a 5th percentile event), the more aggressive portfolio s key financial metrics can fall significantly below its peers, increasing the risk of a rating downgrade. The impact on key financial metrics and comparisons to peers are shown in Exhibit 6. Managing Health Care Reserves 5
Exhibit 6: Stress Test Results Enterprise Results 5.0 4.0 3.0 2.0 1.0 0.0-1.0-2.0-3.0 Operating Margins A+ Peer - 4.1 2.0-1.3 FY17 Base Case FY17 10 5 0-5 -10 Net Cash Flows $4.1 $(6.0) FY17 Base Case FY17 250 200 150 100 50 0 FY2017 Days of Cash on Hand 216 170 182 Base Case A+ Peers - 200 Proposed 40/60 6.0 5.0 4.0 3.0 2.0 1.0 0.0 4.8 Base Case FY2017 MADS A+ Peers - 5.0 1.8 2.6 Proposed 40/60 2.0 1.5 1.0 0.5 0.0 FY2017 Unrestricted Reserves to LT Debt 1.76 Base Case A+ Peers - 1.55 1.40 1.54 Proposed 40/60 Investment Results 15% 10% 5% 0% -5% -10% -15% -20% 5.9% Base Case Investment Returns -17.4% -7.6% Proposed 40/60 200 150 100 50 0 FY2017 Unrestricted Cash & Investments $173.4 Base Case $137.1 $150.0 Proposed 40/60 Incorporating ERM through stress testing revealed that the current financial position of the organization reduced the risk-taking ability of the operating assets portfolio. In our example, even though the initial risk tolerance analysis suggested a 50/50 allocation was reasonable (Exhibits 2 and 3), further review through stress testing indicates liquidity measures such as days of cash on hand and unrestricted reserves to long-term debt could potentially drop too far below peer group medians, which ultimately led to the selection of a more conservative 40/60 portfolio with greater diversification. Investment of operating assets requires periodic review as funding needs change according to the strategic and operational needs of the health care organization. This dynamic requires some portfolio flexibility with particular attention to portfolio risk-taking ability. Notably, being able to exercise this flexibility through investments in illiquid assets such as private equity and real estate may be limited to those organizations with healthy operations and strong reserves relative to debt that are designated for long-term uses. Managing Health Care Reserves 6
Conclusions Health care organizations continue to face financial pressures as they navigate a changing delivery model and policy uncertainty. In this dynamic environment, the operating reserves have become more critical in sustaining a financial position that can weather changes in the industry and volatility in the capital markets. To ensure that the operating portfolio is aligned to enterprise financial goals, an enterprise-oriented approach is necessary to clearly understand risk tolerance and risk capacity. It integrates enterprise operating and investment performance using short-term financial forecasts and forecast variability and allows scenario and stress analysis to better assess near-term stress points. Changing financial conditions or business plans requires reassessment of the risk profile on a continuous basis. Finally, it is important to call out that in practice, many operating portfolios have evolved beyond simple long-only equity and bond portfolios and continue to further diversify. Different diversification choices can lead to different outcomes depending on the strategies and implementation approaches chosen. To affirm that the right diversification strategy is in place, it must always be aligned to the specific financial circumstances and expectations of the organization as well as with the appropriate governance and implementation model to ensure execution success in achieving the desired outcome. Managing Health Care Reserves 7
Appendix Key Financial Metrics Numerous metrics on operating liquidity, debt burden, and profitability provide a snapshot of a health care organization s financial position. Ratio analysis is an important tool used by credit rating agencies to not only assess the financial profile of individual organizations, but also shed light on industrywide trends. Some key metrics are described here. Days cash on hand (DCOH) is a key liquidity ratio that determines how many days an organization can support its operating expenses without collecting any additional cash. DCOH = unrestricted reserves (operating expenses excluding depreciation 365) Operating margin (%) measures profitability level: operating revenues operating expenses. Operating margins in the low single digits indicate that cash flows tend to be low or negative, which may risk unexpected or unsustainable capital draw from the operating reserves. Only a handful of health care organizations are able to consistently generate margins above 4%. Maximum annual debt service (MADS) measures the ability to cover the highest possible interest and principal payments using cash flow from all revenue sources. Higher ratios indicate a greater ability to take on more debt. MADS = (operating income + non-operating income) (interest + principal payments) Unrestricted reserves/long-term debt (%) provides a measure of balance sheet leverage. Higher ratios indicate a stronger balance sheet and all else being equal, a greater capacity to take on more debt. The highest-rated organizations tend to have two to three times more reserves than long-term debt. Exhibit 1: 2015 Standard & Poor s Health Care System Peer Medians AA+ AA AA- A+ A A BBB+ BBB Below Days Cash on Hand 426 293 258 200 183 157 149 95 74 Operating Margin 6.2% 4.9% 3.5% 4.1% 3.6% 2.9% 0.8% 0.6% 1.7% Maximum Annual Debt Service 7.3 6.5 5.8 5.0 4.1 4.1 2.5 1.8 1.6 Unrestricted Cash/LTD 305% 251% 181% 155% 116% 140% 160% 67% 82% Capital Market Assumptions Model Methodology (2017) The capital market assumptions were developed by Aon Hewitt's Global Asset Allocation Team and represent the long-term capital market outlook (i.e., 30 years) based on data at the end of the fourth quarter of 2016. The assumptions were developed using a building block approach, reflecting observable inflation and interest rate information available in the fixed income markets as well as Consensus Economics forecasts. Our long-term assumptions for other asset classes are based on historical results, current market characteristics, and our professional judgment. Managing Health Care Reserves 8
Contact Information Zoltan Karacsony, CFA Senior Consultant, Investment Policy Services Aon Hewitt Investment Consulting, Inc. +1.312.381.1322 zoltan.karacsony@aonhewitt.com Lila Han, CFA, CAIA Senior Consultant, Non-Profit Solutions Aon Hewitt Investment Consulting, Inc. +1.312.381.3801 lila.han@aonhewitt.com Managing Health Care Reserves 9
About Aon Hewitt Investment Consulting, Inc. Aon Hewitt Investment Consulting, Inc. (AHIC) is the U.S. investment consulting practice of Aon, with headquarters in Chicago, Illinois. AHIC is a Registered Investment Advisor with the U.S. Securities and Exchange Commission (SEC) under the Investment Advisers Act of 1940, as amended. AHIC is also registered with the Commodity Futures Trading Commission (CFTC) as a commodity pool operator and commodity trading advisor, and is a member of the National Futures Association (NFA). About Aon Aon plc (NYSE:AON) is a leading global professional services firm providing a broad range of risk, retirement and health solutions. Our 50,000 colleagues in 120 countries empower results for clients by using proprietary data and analytics to deliver insights that reduce volatility and improve performance. Aon plc 2017. All rights reserved. Investment advice and consulting services provided by Aon Hewitt Investment Consulting, Inc. The information contained herein is given as of the date hereof and does not purport to give information as of any other date. The delivery at any time shall not, under any circumstances, create any implication that there has been a change in the information set forth herein since the date hereof or any obligation to update or provide amendments hereto. This document is not intended to provide, and shall not be relied upon for, accounting, legal, or tax advice or investment recommendations. Any accounting, legal, or taxation position described in this presentation is a general statement and shall only be used as a guide. It does not constitute accounting, legal, and tax advice and is based on AHIC s understanding of current laws and interpretation. This document is intended for general information purposes only and should not be construed as advice or opinions on any specific facts or circumstances. The comments in this summary are based upon Aon Hewitt Investment Consulting s preliminary analysis of publicly available information. The content of this document is made available on an as is basis, without warranty of any kind. Aon Hewitt Investment Consulting disclaims any legal liability to any person or organization for loss or damage caused by or resulting from any reliance placed on that content. Aon Hewitt Investment Consulting reserves all rights to the content of this document. Managing Health Care Reserves 10