Weak Growth in Both Intensity and Pricing; Intensity is Slowly Improving but Pricing is Stagnant

We expect 1Q14 health services demand growth (y/y, nominal) of 3.5%, the product of 2.5% growth in intensity and 1.0% growth in nominal pricing (Exhibit 1). Our estimate of y/y growth in intensity is 20bp above 4Q13 actual, and a 10bp increase from our interim 1Q14 estimate. Our nominal pricing forecast is a full 30bp below last quarter (and unchanged from the initial and interim 1Q14 estimates) – and 10bp below the multi-year low observed during 3Q13. Separate from our growth rate forecast, we run an independent model which handicaps the odds of a trend break in demand. This model continues to indicate strong odds (89%) of accelerating sequential demand during 1Q14

Public-Payor Price Losses Stabilizing, But Now Commercial is Weakening

Weak pricing is the product of multiple underlying trends. Medicaid pricing weakened as states’ budgets came under post-financial crisis pressures, and Medicare weakened sharply as a result of the +/- 2% sequester cuts placed in effect at the beginning of 2013. Both of these public-payor effects are being anniversaried, only to be replaced by a weakening commercial pricing trend (Exhibit 2). Name brand hospitals arguably enjoyed commercial pricing power as health plans felt the need to include recognizable brands in their offerings on the Affordable Care Act’s health insurance exchanges (HIEs); however in the wake of slow initial enrollment this source of hospital pricing leverage arguably has been lost. And, because HIE based plans have substantially increased the percentage of insured persons’ claims that are paid directly by the beneficiary, hospitals’ collection rates from these insured patients are falling[1]. We have no reason to expect an improvement in hospitals’ near-term pricing power, though we do see an eventual chance of improved commercial pricing as employer-sponsored beneficiaries move to private exchanges, where the inclusion of preferred hospitals may be an important factor in capturing these newly shifted beneficiaries

Intensity Growth Weak; Stronger Growth Requires Stronger Employment Gains

Per-capita hours worked in hospital settings is a key variable driving our estimates of demand intensity. The simple logic is that hospitals produce no inventory, thus the number of variable hours used in production, adjusted for population size, is (both theoretically and demonstrably) correlated with the intensity of demand for health services. Since an initial post-financial-crisis spike in early 2011, hours per-capita have grown very slowly (Exhibit 3). The ‘true’ demand trend thus far this year is a bit better than Exhibit 3 would indicate; 2013 demand was influenced by a very strong flu season, which has lowered measured growth in 1Q14 demand intensity by about 40bp. This rough estimate of ‘true’ intensity growth (2.5% per the model + 0.40% to account for flu season effects) is still well below ‘normal’ intensity growth. Demographics alone drive roughly 1.5% growth in intensity (80bp population growth + 70bp aging effect); on top of this demographic baseline, historic per-capita age-adjusted intensity growth has averaged roughly 2.2%, thus a reasonable estimate of ‘normal’ intensity growth is 3.7%

The key determinant of demand intensity continues to be the rate of growth in employment; on an age- and income-adjusted basis uninsured persons and households increase their healthcare consumption by roughly 3x (18 months) after gaining employment and employer sponsored insurance. A return to normal employment would be expected to drive intensity growth well above the 3.7% ‘normal’ until employment levels stabilized, at which point the 3.7% rate of intensity growth would be the likely equilibrium

The contribution of the Affordable Care Act’s (ACA) health insurance exchanges (HIEs) to demand intensity has been modest. Net gains in numbers of insured are roughly 2.3M[2]; however provisions of the ACA have resulted in much higher deductibles for much larger numbers of persons who were already insured in the individually-purchased health insurance markets[3]. As such, the gains in demand intensity from increasing the numbers of insured is at least partly offset by diminished demand intensity amongst persons previously insured. The net reduction in uninsured as a result of the Medicaid expansion is roughly 3.6M persons[4]; the increase in demand from these persons is mitigated by the limited generosity of Medicaid coverage. At the very most we would expect these 3.6M new Medicaid beneficiaries to account for 50-60bp of additional intensity growth in 2014 v. 2013

Exhibits 4, 5, and 6 provide time series of actual v. projected unit demand, price growth, and total demand, respectively

2013-2014 Flu Season

As of the end of calendar 1Q14, we reiterate our estimate that the flu-related headwind for total y/y health services demand growth during 4Q13-1Q14 was roughly +/-30bp: +/-20bp during 4Q13 and +/-40bp during 1Q14. The net hospitalization rate for this flu season has leveled off about 25% below 2012-2013 (Exhibit 7)