3. The Case of Humana and Vertical Integration

Humana, Inc., is one of the largest publicly traded managed care companies in the United States. The company has about 6.2 million enrollees in 16 states. It offers primarily HMO and PPO plans, along with Medicare and Medicaid insurance products and other administrative health services. Early in its history, however, Humana pursued and seemingly failed to carry out a vertical integration strategy. The company began in the nursing home industry, developed into a sophisticated integrated healthcare company, and then divested to become a managed care company. This case poses many questions regarding the value and difficulty of becoming a large, vertically integrated company.

Humana is a good subject for analysis and highly relevant to typical corporate healthcare decision making because it has experienced multiple stages of diversification and development, on both a product line and companywide basis. At one time, it was one of the largest hospital companies in the United States, known for its efficiency and centralization. It fervently pursued expansion into health insurance and offered this product first in January 1984.

Humana’s History

In 1961, four friends put up $1,000 each to found a nursing home. Subsequently they expanded into more than 40 facilities, and by the late 1960s their company, Extendicare Inc., was one of the largest nursing home companies in the United States. With the passage of Medicare, they branched into the hospital business and by 1970 owned ten hospitals, which became so profitable that they divested their nursing homes in 1972.

They changed the company’s name to Humana in 1974. Through intense cost controls, centralization, and high volumes from growth, Humana achieved economies of scale and continued to earn significant profits. By the early 1980s Humana was one of the largest hospital companies in the United States. Humana determined that owning its own insurance products could benefit its hospitals by garnering 70 percent of referrals, and so it began to offer health plans. However, in reality Humana was unable to attract more than 46 percent, and difficulties and conflict erupted among its hospitals, insurance divisions, and medical staff members.

By the late 1980s, Humana’s net income plunged, prompting the company to restructure its hospital and insurance businesses. By the early 1990s, its managed care plans were generating more than $2 billion in revenues and had become more profitable than its hospitals. Finally, in 1993, Humana spun off its hospital division of 76 facilities into a company called Galen Health Care Inc., which merged with Columbia Hospital Corporation six months later (see www.fundinguniverse.com/company-histories/humana-inc-history/).

A number of significant problems motivated Humana to divest its hospital business. The first problem was the conflicting economic objectives of the health insurance business and the healthcare-providing business. The purpose of a health insurance company is to sell insurance policies by keeping its premiums low. The best way to control its expenses is to minimize its customers’ use of healthcare services. The majority of a health insurance company’s savings result from lowering the incidence and length of hospitalization. In contrast, healthcare providers increase their income by increasing utilization. They have an incentive to give their patients the best and most of everything. In this way, they maximize their patients’ welfare and their own.

Second, transfer pricing encouraged the use of non-Humana hospitals. Humana, like all integrated companies, used transfer prices (see chapter 4) to account for the sale of its hospital services to its insurance division. Generally, transfer pricing may be set at full charges, at cost of goods, or at a discounted rate. But surprisingly, despite the financial expertise of Humana cofounder David Jones, Humana set the transfer prices for its own hospitals higher than the market prices for its competitors’ hospitals. As a result, Humana’s insurance division preferred to refer its patients to non-Humana hospitals. After all, the hospitals that were not owned by Humana charged the insurance division less. Ironically, the vertically integrated firm was paying to put its patients in competitors’ hospitals while beds in its own hospitals stayed empty.

Third, Humana’s relationships with its physicians were problematic. Predominantly, Humana organized its HMOs around physician practices known as IPA-model HMOs instead of employing doctors directly, as did staff-model HMOs. What Humana recognized too late was that the IPAs often did not represent Humana’s best interests. Humana’s HMOs, like others in the industry, tried to trim costs by cutting the amount of money they paid doctors. Because Humana’s doctors were not on the company’s staff but under a contractual relationship with Humana as well as other HMOs, the doctors could—and did—retaliate when Humana lowered the amount it paid to the IPA physicians, referring patients away from Humana’s hospitals and into competitors’ beds.

Another problem concerned doctors not selected to be on Humana’s HMO panels. Physicians who had been excluded from the Humana insurance plan were often angry—so angry that they also started referring more of their patients to non-Humana hospitals. Humana welcomed these physicians too late into the insurance plan. When it finally included them, yet another problem surfaced: Humana had diminished its power to influence these physicians’ behavior. Humana’s health insurance plan was not a significant part of these newly included doctors’ practices; it covered only a few of their patients, and Humana therefore had little power over them. This lack of incentive and influence bred indifference among physicians and occasioned an increase in the length of Humana enrollees’ hospital stays—and many of these extra hospital days were spent in non-Humana facilities.

The fourth problem was costs. Humana’s hospital costs grew because the hospital division’s management was distracted by many of the company’s new acquisitions and lacked experience in the insurance area. David Jones had started the health insurance division precisely because of the large number of empty beds in Humana’s hospitals. The salaried physicians in Humana’s primary care centers did little to enhance referrals to Humana’s hospitals. Humana’s tightly centralized hospital management had no experience in guiding salaried physician practices and could offer little advice to their physician managers. The physicians earned the same salary regardless of the number of patients they saw, and many of them failed to develop a patient following in their communities. As an owner rather than a renter, Humana was forced to pay the full costs of its hospitals and full salaries to its physicians whether they had patients or not.

In the early 1990s, Humana found that owning both HMOs and hospitals put it at a disadvantage when it came time to sign contracts. Jones stated,

After the strategies began to appear to some extent incompatible, we started having trouble carrying water on both shoulders. It seemed that if we solved a problem for the hospital it would create a problem with the health plan, and [vice versa]. We could see that conflict, but amazingly enough, it did not surface for a number of years. We started in 1983 being an integrated company, and the strategy worked reasonably well for a while. But it got more difficult as we got larger, which surprised me. I would have thought it would have gotten easier as we got larger. (Luke, Walston, and Plummer 2004, 243)

After the hospital divestiture, Humana divested and outsourced other operations. It exited numerous underperforming markets, divested a unit that sold and administered flexible spending accounts, sold its wholly owned health centers, transferred the risk and administration of its long-term disability products to Duncanson & Holt Services, and sold its Medicare supplement and workers’ compensation businesses.

These transactions enabled Humana to focus on a core business of health insurance and to invest in technological enhancements. The company sought to position itself as a leader in the “digital health plan industry” and possibly as the first health plan to operate fully through the Internet. During the 1990s, Humana made more than 20 corporate acquisitions and became one of the United States’ largest managed healthcare plans. By 2011, Humana’s medical benefit plans had grown to about 11.2 million members and its other specialty products to approximately 7.3 million people, with 76 percent of its revenues coming from contracts with the federal government (Humana 2012).

At one time, Humana was one of the most powerful vertically integrated players in the healthcare field. As a result of both environmental pressures and the difficulties of sustaining a vertical organization in healthcare, Humana has become a strong health insurance business.

Questions

What can hospitals considering vertical integration learn from Humana’s mishaps?

Why did Humana integrate and then evolve into a managed care company?

Did Humana act most efficiently by divesting its provider assets? What might the company have done to overcome the problems inherent in managing both provider and insurance operations?

Did Humana have difficulty transferring managerial knowledge across business lines? Why or why not?

Was vertical integration an issue as a result of the four problems mentioned in the case, or is it an issue in all large organizations? How can largeness affect the managerial ability of a company such as Humana?

What problems did Humana’s choice of transfer pricing present? Why were the transfer prices of Humana’s hospitals set higher than market prices? What recommendation would you have given to Humana?

What were the specific reasons physician relationships and incentives caused problems? What structural or incentive plans might have helped resolve these problems?