While health insurers and health plans have historically assumed most of the risk associated with managing the healthcare dollar, recent trends towards capitation and bundled payments show providers having an increased appetite for risk (some experts view this as health plans attempting to offload their risk). This means that the actuarial domain is expanding to encompass risk-assuming providers since actuaries have undergirded risk management in the insurance industry since its inception. Investment bankers and private equity managers have always recognized the importance of actuarial input when facilitating mergers or acquisitions of insurers. However, transactions involving risk-bearing providers will require a valuation toolkit that extends beyond what is traditionally taught in MBA programs and fortunately for actuaries is the core of their educational pathway.
The focal point of M&A due diligence is the valuation. It is beyond the scope of this article to provide a detailed explanation of all methods, for which many textbooks and papers have been written. However, valuation techniques can be generalized into three distinct categories:
- Comparable Company Analysis – valuation “multiples” of comparable companies with known valuations (typically publicly traded companies) are applied to the target company’s financial metrics to derive a potential valuation range.
- Comparable Transaction Analysis – financial data from recent mergers and acquisitions that are reflective of the target company’s operating characteristics and business model are applied in a similar way as the comparable company analysis to derive a potential valuation.
- Discounted Cash Flow (DCF) – this technique discounts future after-tax cash flows over a given time period to a present value. There are many accounting and financial considerations in this analysis, and it is very common among investment bankers.
Actuarial expertise is a valuable contributor to all these valuation techniques when applied to insurers, hospitals, and other healthcare providers. Furthermore, at the time of this article’s publication the COVID-19 pandemic is still waging onward. Although counterintuitive, most health services were suppressed during the initial months and the organizations that thrived were those under some degree of capitation arrangement. This has captured the attention of many healthcare providers who now have evidence of financial upside associated with risk assumption. COVID-19 has simultaneously created a healthy M&A environment, creating demand for actuarial expertise when accompanied by increased provider risk-sharing. Actuaries possess a unique skillset which can enhance M&A due diligence for insurers and providers in a variety of contexts.
Actuaries possess a unique skillset which can enhance M&A due diligence for insurers and providers in a variety of contexts.
Given their centrality to most aspects of an insurer’s operations, the role of an actuary in due diligence of insurance companies is more obvious. Below are a few ways actuaries are relied upon during these efforts.
Actuarial Appraisals – One of their primary contributions is an actuarial appraisal, which is a discounted cash flow analysis that is heavily relied upon for other due diligence efforts. The actuary determines a discount rate and cost of capital that appropriately reflects the insurer’s business model and conducts sensitivity analysis on important assumptions. The appraisal is completed on both a statutory and GAAP accounting basis and is used both to determine a purchase price (or test the reasonableness of a proposed purchase price) and establish the opening balance sheet after the transaction is completed.
Reserves and Reinsurance – Insurers require a variety of reserves and liabilities to ensure solvency over the regular course of its business. The process of reserving involves complicated quantitative techniques as well as subjective expertise. Examples of these reserves include IBNR, contract reserves, premium reserves, loss adjustment expense, deferred acquisition cost, premium deficiency reserves, outcome-based reserves, and more. A critical piece of due diligence is to vet the reserving methodology and adequacy. Furthermore, this is complicated by reinsurance contracts and the impact they have on financial performance. These can take many forms and it is important for someone with relevant expertise can adequately model their effect.
Regulation – Insurers also encounter significant regulation on both the state and federal level that is not experienced by most businesses. Actuaries are experts in many facets of the ACA, which range from allowable rating characteristics to minimum loss ratios and much more. Furthermore, many states have their own regulations pertaining to insurers in the area especially pertaining to Medicaid. States also set up their own exchanges for individuals to purchase coverage. While healthcare lawyers are best suited to navigate the legal challenges for any merger or acquisition, actuaries understand how the regulations will impact financial statements and reserves.
Interest Rates – Certain insurance products, such as long-term care (LTC) or long-term disability (LTD), have liabilities with long durations (potentially beyond the discounted cash flow projection period). Such liabilities and their reserves are extremely sensitive to interest rate fluctuations as well as equity market performance. This is another area where actuaries can provide insight during the due diligence process.
The actuarial educational pathway provides unique training to successfully navigate challenges posed in a risk-centric environment.
Actuaries have always played a pivotal role for insurers and consulted during due diligence processes for mergers and acquisitions. The actuarial educational pathway provides unique training to successfully navigate challenges posed in a risk-centric environment. As risk becomes increasingly shared with providers, many of these challenges will be encountered when completing their due diligence as well.
Not every aspect of vetting an insurer will also be applicable to providers, but actuaries are still a valuable contributor to any due diligence team for provider mergers and acquisitions.
Regulation – Unless a provider also becomes vertically integrated as a licensed insurer, they may not be subject to all the statutory accounting or some of the other insurer-specific regulations. However, as the counterparty to the insurer in any reimbursement schedule it would benefit to have some degree of familiarity with the issues insurers face. This will enhance contract negotiations and inform providers where they might have leverage in a particular situation.
Contract Review – A thorough due diligence process for any healthcare provider will include a review of contracts with payors. In the past this might have primarily consisted of fee-for-service (FFS) schedules; however, any provider under capitation or with bundled payments is assuming some financial risk previously undertaken by the insurer. Who is better than an actuary, the one typically setting these rates for insurers, to review these contracts to understand whether the payment rates are sufficient? Furthermore, even if the provider is reimbursed under a FFS schedule, actuarial due diligence could reveal if there is value to be realized by transitioning to a capitation arrangement because the provider is achieving target outcomes with best-in-class utilization. Actuaries can use their expertise with claims data to validate or negate strategic value for any given transaction.
Incentive Programs & Reserves – Many providers engage in incentive programs with insurers. This can take the form of quality bonuses, based on non-financial metrics, or sharing in unexpectedly good/poor financial results in reference to a loss ratio or healthcare budget. Once again, these are arrangements that actuaries play a pivotal role in establishing on behalf of the insurer, so providers would benefit from engaging with actuaries as well. A due diligence effort should include an actuarial review of these arrangements and their accounting treatment. Like insurers, any risk assumption should be accompanied by adequate reserving. Any target company in a merger or acquisition should have its reserving methodology reviewed to ensure there are no surprise liabilities or adverse restatement.
Risk Adjustment – Risk adjustment has become an increasingly important factor in any financial arrangement. A thorough due diligence effort of providers would benefit from a review of risk-adjusted performance, otherwise recent financial experience may be misleading. For example, consider Provider A whose average RAF score of patients is 1.1 will have higher utilization and costs than Provider B whose average RAF score is 0.95. Simply comparing their profitability might be misleading and incorrectly identify Provider B as the better financial target even if Provider A is more efficient on a risk-normalized basis. Due diligence of risk adjustment could identify value in the target or indicate that an alternative reimbursement arrangement is preferable. Actuaries are well-suited to make such a judgment.
As the traditional business models of insurers and providers begin to merge with risk sharing, the actuarial toolkit becomes increasingly pertinent to providers. Furthermore, an active M&A environment could lead to unidentified risks or opportunities if due diligence is limited to a traditional approach and ignores the complications associated with risk-bearing entities. Actuarial involvement is an effective way to optimize the value of a transaction and effectively mitigate liabilities post-close.
 One obvious exception is providers in California who when assuming certain types of risk are required to obtain a Knox-Keene license which is nearly the same as required for health plans in the state. Providers often obtain a restricted or limited Knox-Keene license.
 Risk Adjustment Factor