Regional News

Highmark Has West Penn Allegheny; Now It Must Make the System Work

Highmark Inc. got its long-awaited regulatory approval this week to take over West Penn Allegheny Health System and immediately closed on a $604 million deal that it says averted a West Penn bankruptcy.

But with the ink dry on the agreement between the two Pittsburgh organizations that puts the insurer in command of the faltering hospital system, Highmark faces a “now what?” moment.

Heightened rating-agency glare followed the announcement.

Moody’s Investors Service, citing “considerable risks,” late Thursday night downgraded Highmark’s insurance financial strength rating to Baa2 from Baa1 and senior unsecured debt rating to Baa3 from Baa2, citing its loan to fund the purchase of West Penn bonds.

Standard & Poor’s, which revised its outlook on an A rating to negative in January, is also scrutinizing Highmark, as are many others.

Blue Cross Blue Shield insurer Highmark, now Highmark Health Services, aims to compete head-to-head with regional behemoth University of Pittsburgh Medical Center – their respective buildings tower over downtown Pittsburgh – but first it has a cleanup job to do with teetering nonprofit West Penn, which has struggled since emerging from the ashes of bankrupt predecessor Allegheny Health, Education and Research Foundation in 2000. West Penn’s bonds have never been investment grade.

AHERF’s $1.3 billion Chapter 11 case in 1998 was by far the largest health-care bankruptcy filing at the time.

Highmark rebranded West Penn as part of a seven-hospital Allegheny Health Network and named John Paul as its chief executive. Paul, who oversaw Highmark’s up-and-coming hospital and provider unit the past two years and will retain his former title, is a former executive vice president at UPMC, where he orchestrated an acquisition binge in the mid-1990s.

He becomes the sixth CEO in 14 years at West Penn.

“This is a compelling story locally, but there really should be larger-scale national interest,” said Stephen Foreman, an associate professor of health care administration at Robert Morris University in Moon Township, Pa. “These two folks, Highmark and UPMC, have been fighting for the longest time, and West Penn is part of that fight.”

Foreman sees Highmark’s strategy – an insurer looking to move into direct health care – as a national test tube of sorts. “If this model pans out, a lot of other insurers will be taking on hospitals to erode the bargaining power of hospitals in negotiations. If this works out for Highmark, we’ll see a lot more of it,” he said.

“The reality is that this is part of a broad strategic shift you’re beginning to see in certain markets, where an insurer is moving into providing direct health care service,” said Standard & Poor’s healthcare analyst Martin Arrick. “That’s the reverse of hospitals starting their own insurance subsidiaries, a la UPMC. Pittsburgh is so unique, it’s hard to generalize. But insurers are moving into the provider space, and it could be a year or two, maybe, before we see how if this broad strategic shift is successful.”

Highmark’s biggest challenge is “turning around West Penn so that it’s at least no longer losing money,” said S&P credit analyst Jon Reichert.

“We should have a good sense of how Highmark is doing with its turnaround efforts with West Penn within a year,” he said.

Foreman agreed. “I think that’s a great number because losses at West Penn are pretty substantial. I actually believe that Highmark will make West Penn break even, but I think there will be secondary fallout, such as reimbursements to West Penn and pulling some patients out of other hospitals.”

Highmark, which is absorbing an additional 11,000 employees, finalized the $604 million deal, in which bondholders were offered a haircut on all Series A bonds that the Allegheny County Hospital Development Authority issued for West Penn in 2007.

Holders were offered 87.5 cents per dollar of principal, plus accrued interest through closing date, on the $709.7 million outstanding debt.

“Highmark Inc. purchased a substantial majority in principal of amount of the bonds,” according to a disclosure notice filed Tuesday with the Municipal Securities Rulemaking Board’s EMMA website.

Moody’s reported West Penn’s operating loss in fiscal year 2012, based upon unaudited financial information, at $113 million, exceeding that of the previous fiscal year.

After the two parties revealed plans for a tie-up in November 2011, payments from Highmark helped prop up West Penn, whose unrestricted investment and cash position as of June 30, 2012, was a “weak” $273 million, according to Moody’s.

The credit rating agencies reacted quickly on West Penn bonds earlier this week. Moody’s raised its rating to Caa2 from Ca, while Standard & Poor’s lowered its rating to D from CC, citing its automatic D rating for any distressed exchange that involves a bondholder haircut. Fitch Ratings, which downgraded West Penn to C from CCC in January, put that rating on credit watch evolving. Fitch does not rate Highmark.

The ratings affect roughly $730 million of Series A bonds West Penn issued through the Allegheny County Hospital Development Authority, the largest municipal junk-grade issue until Iowa Finance  Authority surpassed it Tuesday with a $1.2 billion issue for a fertilizer plant.

Standard & Poor’s, said Reichert, reviewed its A rating on Highmark when the parties announced the tender offer in January, and revised its outlook.

“While we felt comfortable that the current rating was still appropriate at that level of commitment, we were concerned about the possibility for additional financial commitments that would cause further decline in Highmark’s capitalization, and that contributed to our negative outlook,” said Reichert, who expects Highmark’s return on revenue to decline to around 1.5% in 2013 from an estimated 2% in 2012.

Although the state insurance regulator cleared the deal, it attached conditions, notably requiring Highmark to inform patients and subscribers about the possible termination of its provider contract with UPMC in 2015. UPMC has its own insurance plans.

“We’d like to have a relationship with UPMC,” said Highmark chief executive William Winkenwerder.

Without that renewed agreement, Highmark would have to convince members to switch from UPMC to West Penn’s hospitals, no small task.

Other stipulations include limits on contracts between Highmark and other hospital networks to five years, with state approval necessary for those longer; a ban on “most-favored nation” contracts enabling Highmark to treat West Penn more favorably than other area hospitals; and clauses that require state approval for Highmark to spend more than $250 million or if any spending puts Highmark’s “risk-based capital” ratio below 525%.

UPMC issued a terse statement on Monday.

“Highmark’s ownership of a provider network introduces more complicated insurance choices for employers and consumers. We urge Highmark to work with UPMC now as there will be no new UPMC contract or extension when the current one expires in just 19 months.”

Pittsburgh Mayor Luke Ravenstahl filed legislation two months ago challenging UPMC’s nonprofit status. He applauded the Highmark-West Penn deal.

“Two things jumped out at me about the conditions,” said Foreman. “First, the insurance commissioner [Michael Consedine] isn’t going to unwind the transaction and second, with one possible exception, violating the conditions is the way to turn around West Penn.” He cited patient transfers and the $250 million capital spending limitation as examples of the latter.

Foreman also pointed out that Paul’s dual role of overseeing Highmark’s insurance arm and its provider wing could conflict with the “firewall” Highmark must implement to prevent West Penn from sharing with Highmark confidential business information obtained from other health insurers during contract negotiations.

“Safeguards have been put in place to protect the community and consumers,” Gov. Tom Corbett said in a statement this week. “Highmark will be accountable for policyholder savings and maintaining competition, and has made a long-term commitment to charitable endeavors within the community.”

Dennis Fisher, spokesman for state Attorney General Kathleen Kane, said Friday: “We review all hospital mergers from a charitable trust perspective and an antitrust perspective. We have completed our review, and we found no reason to object to the merger on either score.”

If West Penn’s problems match those of predecessor AHERF, so does its knack for the bizarre.

A deal that seemed routine 18 months ago took several crazy turns before Tuesday’s announcement. In April 2012, one week before a scheduled Insurance Department hearing, Highmark fired chief executive Kenneth Melani – who until then had considerable political pull – after he had a public fistfight in suburban Oakmont with his girlfriend’s husband that left Melani’s right eye swollen shut.

Winkenwerder succeeded Melani and insisted that West Penn file for bankruptcy before the merger. West Penn pulled out, then returned to the table when an Allegheny County court ruled that West Penn could not talk with other suitors. Bondholders agreed to the haircut in January.

AHERF in the 1980s transformed from the old-money Allegheny General Hospital into an expansionist behemoth under the eccentric Sherif Abdelhak. Debt spiraled, however, and before the 1990s wound down, reports of financial problems, opaqueness and siphoning of money among groups were widespread.

“I was working for the Pennsylvania Medical Society in the late 1990s and I just shook my head at the time,” said Foreman.




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