1. Healthcare Vertical Integration and Internal Audit’s Role in Strategic Transactions September 2014

2. Page 2 Agenda I.Healthcare vertical integration II.Internal Audit’s role in strategic transactions

3. Page 3 Health industry integration is not black or white Shades of collaboration exist, although the trend is strongly to the right Source: www.accountablecarefacts.org Single MDs; small groups; single hospitals Independent physician associations, single specialty groups, hospital chains Hospital staffs (primary care physicians employed by hospitals), some university/faculty practices Multispecialty group practices (primary care- based practices with full complement of specialty services) Clinically integrated delivery systems (multispecialty groups with hospitals) Clinically and financially integrated systems (multispecialty medical groups integrated with hospitals and health plans) Less integrated or organized systemsMore integrated or organized systems Horizontal Vertical Most ACOs are formed in this space

4. Page 4 Vertical integration has three primary objectives Payers and health systems are increasingly willing to accept non-traditional risks to preserve their positions in the healthcare supply chain ObjectiveAcquirerTargetBenefitRisk 1. Strengthen revenue streams Health System PhysiciansIncrease referrals and admissions Provider productivity decline post acquisition, inability to influence physician decisions Health System PayerIncrease patient volume and reimbursement rates through a restricted network and reduction in payer margin Financial losses due to under- estimation of member utilization and unit cost PayerHealth SystemCapture enrollment through health system regional presence and brand Acquire disproportionately high-cost members due to health system loyalty 2. Improve control of supply costs PayerHealth System, Physicians Improve ability to manage population health and control medical expense Capital-intensive investment erodes financial viability and flexibility without improving health cost management 3. Defend against disintermediation or exclusion PayerHealth SystemGuard against integrated delivery systems contracting directly with employers or government payers as ACOs Lose network breadth due to reluctance of providers to participate in network of a direct competitor Health System PayerOffset potential exclusion from narrow networks Lose overall managed care volume due to commercial payers unwilling to contract with a direct competitor Health System PhysiciansAvoid disproportionate admissions to competing health systems Physician unwillingness to modify referral or admission practices

5. Page 5 Integration activity has come in waves Beginning in the 1980s, a surge in managed care growth fueled health industry integration, both horizontal and vertical Element Trends 1980 – 2000s Observations Payers -Managed care organizations grew membership and implemented cost control techniques -Payers consolidated -Large managed care organizations used their leverage to negotiate lower cost provider contracts Health Systems -Hospital networks, such as HCA, began to expand by acquiring other hospitals -Hospitals began to form managed care networks -Health systems formed health plans -Larger health systems struggled to create economies of scale or reduce cost -Provider-sponsored health plans initially generated large cash flow; however, months/years later struggled with growth and survival Physicians -Physicians tended to operate independently from each other -Hospitals experimented with employing physicians -Physician groups experimented with starting health plans -Care coordination hampered by a lack of communication channels and incentives -Hospital-physician organizations and physician group-owned HMOs disintegrated over time due to poor management and diverging interests Reform -No economic or political forces driving for lowering the cost of care -Expected Clinton-era reforms failed to become a reality -Providers were not externally incentivized to coordinate care. Revenue could still be driven through volume. Reimbursement -Fee for service (FFS) reimbursement was the industry standard -FFS created an environment where providers and payers existed with inherent, opposing interests -Providers were not incentivized to reduce the cost of care

6. Page 6 Vertical integration failure is common While the benefits of integration are appealing, realization has been a challenge for most organizations 1945: Permanente Health Plan (later named Kaiser) opens to the public, providing both health coverage and access to hospitals 2010 1965 Rise of managed care organizations and new reimbursement methodologies (e.g., DRGs, per diems, case rates, carve outs) 1992: Humana spins off 77 hospitals as Galen Health Care to focus exclusively on insurance 1972: Humana shifts focus from nursing homes to hospitals, eventually acquiring 77 facilities Traditional fee for service dominated the market 1947: Group Health Cooperative opens in Seattle Washington as a PSHP 1980: Geisenger Medical Center starts the Geisenger Health System (a PSHP) 1969: Harvard Community Health Plan opens as a PSHP 2013: Kaiser sells Ohio health plan to Catholic Health Partners (Health Innovations Ohio) 2014: North Shore LIJ opens CareConnect 2014: Piedmont Healthcare and Wellstar Health System start Piedmont Wellstar Plan 2000: Rush University Medical Center sells Anchor HMO to WellPoint 1971: Rush Univ. Medical Center opens Anchor HMO 1980 1995 1998: UPMC launches UPMC Health Plan 1984: Sentara opens Optima HMO Health Plan Passage of the Affordable Care Act 1983: Intermountain Healthcare creates SelectHealth, a non-profit health plan 2002: Piedmont separates from Promina Health, exiting the health plan market 1994: Promina Health founded by Piedmont Healthcare 2012: Sutter Health launches Sutter Health Plus 2001: UniHealth divests its medical and insurance practices 1993: Sutter Health opens Omni Healthcare Plan 1999: Sutter Health sells Omni Healthcare to BCBSCA 1986: HealthWest (later UniHealth) launches CareAmerica 2011: Highmark acquires West Penn Allegheny Health System 2011: Humana acquires 300 clinic Concentra Health 2011: UnitedHealth Group acquires 2,300 physician Monarch Healthcare 1990: Cigna acquires majority ownership of Lovelace Health Systems 2002: Cigna sells Lovelace to Ardent Health Services 1998: AHERF files for bankruptcy 1986: Allegheny Health, Education, and Research Foundation (AHERF) begins integration efforts, purchasing physician organizations and hospitals

7. Page 7 Strategic, Financial and Operational Risk Vertical integration is fraught with risk Endeavors have failed for myriad reasons, but at the core is typically an under-estimation of the risks to be managed Limiting financial wherewithal by taking on too much at once Inadequate physician alignment, particularly within primary care Paying for productivity gains that do not align with the acquired entity’s new incentives Inability to effectively coordinate care across the integrated delivery system Insufficient capability to execute core new functions (e.g., pricing, reserving, practice management) Not clearly defining each entity’s role within the system Developing organizational capabilities too far in advance of market demand Optimistic assumptions regarding willingness of business partners to make concessions

8. Page 8 Element Trends 2010-2014 Observations Payers -Slower membership growth due to escalating premiums -Reduced ability to limit risk through underwriting; forced to manage risk once “in house” -New regulations and taxes negatively impact profitability -Selective vertical integration through medical group or facility acquisition, or partnerships with health systems -Pressured to effectively manage medical expense -Working towards ACO-like payment methodologies (rewarding quality and care coordination) -Increasing member engagement Health Systems -Renewed focused on acquisition/merger activity to increase scale -Rapid EHR adoption driven by financial and care coordination incentives -Payments increasingly tied to quality metrics -Increasing acceptance of risk through ACOs -Positioning for inclusion in narrow payer networks and alternative contract arrangements -Focused on clinical/operational excellence -Patient demand for price transparency -Technological advancement opening new communication channels for providers and patients Physicians -Rapid movement towards health system employment -Physician group consolidation -Primary care shortage -Broader acceptance of evidence-based medicine, standards of practice and clinical pathways -Improved ability to coordinate care and control costs -Gradual movement towards transparency of outcomes Reform -ACO and patient centered medical home development -Health Insurance Exchanges provide new forum for individual and small group market competition -Increasing public acceptance of cost control techniques (e.g., narrow networks, Medicare Shared Savings Services Program) -Health Insurance Exchanges increasing patient volume will likely challenge primary care capacity -Quality programs are necessary core capabilities -Transparency in quality measurements is increasing consumer driven health care Reimbursement -Value-based reimbursement models -Shared reward systems (e.g., MSSP) -Compliance contingent reimbursement (Meaningful Use, Medicare STARS Program) -Increased provider risk acceptance -Payer and provider incentive alignment -Risk-based payer revenue The next wave is upon us Regulatory and market changes are prompting both defensive and opportunistic integration moves

9. Page 9 Integration is being initiated from all directions Health systems and payers are both testing new positions along the supply chain ► Provider sponsored health plans – Sutter Health Plus (Sutter Health) – CareConnect (North Shore Long Island Jewish) – Piedmont Wellstar Health Plans (Piedmont and Wellstar Health Systems) ► Health plan hospital/provider acquisitions – West Penn Allegheny (Highmark) – Concentra clinics (Humana) – Diagnostic Clinic Medical Group (Florida Blue) ► Accountable Care Organizations (ACOs) – More than 500 Medicare and Commercial ACOs have formed since 2010 – Most are hospital or health system led – More than 10 million members are enrolled in commercial ACOs – Major, national health insurers have announced intentions to significantly increase their volume of ACO contracts

10. Page 10 Where to begin? Avoiding the mistakes of the past begins with an assessment of the factors that drive success and failure Gate 1 Objectives and risk identification ► Clarify strategic intent and desired competitive position within market context ► Identify licensure requirements ► Perform high-level capability analysis – Patient services and network coverage – Financial risk management – Payer or provider operations ► Identify risks and potential mitigation actions Gate 2 Capability assessment ► Identify the core capabilities required to effectively manage population health to create a positive return on investment ► Determine the level of capability maturity needed to successfully compete in the targeted market ► Identify the capability gaps to be addressed before launching new product or services Gate 3 Build versus buy analysis ► Evaluate the feasibility and level of effort required to develop required capabilities in house ► Assess the opportunity and associated risks of partnership arrangements ► Determine the costs and advantages of acquiring existing capability providers ► Conduct initial due diligence on acquisition targets ► Develop a recommended approach to obtaining each capability Gate 4 Business case development ► Determine availability and cost of capital ► Determine start up costs, to include capability investments, capital requirements, talent acquisition and marketing ► Forecast cash inflows driven by patient and premium revenue and investment income ► Estimate cash outflows based on the timing and magnitude of claims payments, operating expenses, interest payments and taxes ► Determine NPV and/or ROI of the health plan investment

11. Page 11 Agenda I.Healthcare vertical integration II.Internal Audit’s role in strategic transactions

12. Page 12 Background Strategic transactions like mergers and acquisitions (M&A) and divestitures remain some of the most risk-heavy initiatives that any organization can undertake. The proactive involvement of Internal Audit (IA) before, during and after the merger, acquisition or divestiture can help management identify issues and opportunities related to the transaction that might not otherwise be addressed. Acting as an advisor to the program management team, IA is ideally positioned to assess and monitor program management activities, review controls and provide key insights while maintaining independence and objectivity.

13. Page 13 How IA can help during strategic transactions ► Provide increased visibility into key risks related to strategic transaction changes (e.g., Finance, IT, HR, Operational risks) ► Reinforce that risks and controls are the responsibility of management ► Identify gaps in the integration or separation project management plan ► Suggest opportunities for synergies that would boost the acquisition’s return on investment (ROI) or actions to increase separation-related cost savings ► Highlight the impact that the acquisition and its integration, or the divestiture, may have on other parts of the business ► Identify potential gaps in the internal control structure ► Support management’s prioritization of transition and organizational readiness risks

14. Page 14 Role of IA during M&A ► There are four key areas where IA can play a crucial role in an organization’s M&A lifecycle: Throughout the M&A process, IA should form a part of the program management team so that it can assess and monitor activities and provide key insights. IA can also audit program management activities to highlight process gaps and areas of future improvements.

15. Page 15 Role of IA during M&A: Strategy

16. Page 16 Role of IA during M&A: Due diligence

17. Page 17 Role of IA during M&A: Deal approval and close

18. Page 18 Role of IA during M&A: Integration

19. Page 19 The role of IA during divestitures ► There are four key areas where IA can play a role in the divestiture lifecycle: Leading practice calls for IA to be embedded as part of the program management team and be involved throughout the divestiture life cycle.

20. Page 20 The role of IA during divestitures: Strategy

21. Page 21 The role of IA during divestitures: Due diligence

22. Page 22 The role of IA during divestitures: Deal approval and close

23. Page 23 The role of IA during divestitures: Separation

24. Page 24 Key benefits IA provides a critical perspective to strategic transaction deals that many executives may not consider. Without that perspective — right from the start — the organization could find out far too late that the price was not right, or that it has to spend a significant amount of money to fix issues that IA could have identified and helped the organization avoid ►Strategically, IA can determine an organization’s readiness for the transaction ►During due diligence, IA can alert the organization to potential risk, control or regulatory issues that would cause the organization to overpay or undervalue ►Prior to deal close, IA can help prevent deal value leakage ►Post-transaction, IA’s involvement can lead to organizational efficiencies and strengthened control monitoring

25. Page 25 For further information ► See the full “Internal Audit’s role during the strategic transactions life cycle” report ► For further GRC thought leadership, please refer to our Insights on governance, risk and compliance series on: www.ey.com/GRCinsights ► Please contact: ► Sean Lueck, EY Healthcare Advisory (904-505-6572) ► Wally Ward, EY Healthcare Advisory (704-331-1907)