A.M. Best Special Report: HMO Impairments Hit All-Time Lows in 2003 and 2004.

OLDWICK, N.J. -- After undergoing a solvency crisis in the late 1990s, the health maintenance organization (HMO) industry has emerged stronger and more stable. This is evidenced by the 90% decline in financially impaired companies (FICs) between 1998 and 2004.

The improving solvency is related primarily to the industry's consolidation into fewer, better capitalized companies, with generally improved underwriting discipline. A.M. Best Co. believes the declining trend in the number of financially impaired HMOs may not be sustainable in the near term. Pressures on profitability are expected to increase due to a combination of rising enrollments in the less-profitable Medicaid business and increased competition for both commercial and Medicare members, which could cause some carriers to loosen their underwriting and pricing guidelines in upcoming years. Additionally, A.M. Best's industry loss ratio data indicate that the profitable underwriting cycle for HMOs may be flattening.

Over the period measured in this study, impairments have trended steadily downward, from a high of 22 in 1998 to five in 2003 and two in 2004, according to this 2003 and 2004 update of A.M. Best's HMO insolvency database.

In general, the surviving companies were able to benefit from slower growth in health-care cost trends and an improved operating environment. The HMO industry also has become better capitalized, primarily due to a healthier level of retained earnings. In recent years, some regulators also have imposed higher capital requirements on HMOs by increasing the minimum required risk-based capital (RBC) levels.

These changes have required a number of HMOs to maintain greater levels of capital at the operating company level. This is somewhat of a divergence from the practice of some larger parent organizations that generally have felt capital was better utilized elsewhere in the organization. A.M. Best favorably views this trend in bolstering capitalization at the various operating subsidiaries.

A.M. Best expects the exceptionally low level of HMO impairments in 2004 will be difficult to sustain much beyond 2006. Profitability is expected to remain adequate, but margins may be pressured as companies underwrite and price closer to health-care cost trends.

The HMOs, both commercial and government sponsored, that are expected to experience the most stress have one or more of the following characteristics: They have smaller membership; are unaffiliated with a larger group; operate in a single state; lack a competitive advantage; have less solid network relationships; and already are experiencing poor or deteriorating financial results. Pressures on pricing and margins, industrywide, also are coming from the race to acquire and maintain members in the more profitable commercial sector.

Competition for members is becoming more intense as the potential HMO market pool diminishes due to employers' and consumers' preferences for preferred provider organizations (PPOs) and concern for quality care.

A.M. Best believes that HMOs with larger parent holding companies or affiliates willing to continue making capital infusions, or that are able to build capital organically, will perform better than smaller, nonaffiliated HMOs with limited resources for obtaining capital.

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A.M. Best Co., established in 1899, is the world's oldest and most authoritative insurance rating and information source. For more information, visit A.M. Best's Web site at www.ambest.com.