Academic journal article The McKinsey Quarterly

Managing Risk in Healthcare

Academic journal article The McKinsey Quarterly

Managing Risk in Healthcare

Article excerpt

Why margins are becoming ???

Do you understand your exposure

As in banking, risks can be unbundled

The business of healthcare is becoming riskier. Capitation is increasing the risk providers must assume; expansion of the populations they cover makes health-related events (and the cost) more difficult to predict: and competition among providers is eroding operating margins, making the effect of risk on profitability more pronounced. At the same time, the management of risk is becoming more complex as the delivery of healthcare becomes ever more fragmented.

Each trend implies a serious threat to healthcare organizations. HMOs for example, face two options for trading off risk against profitability in the future - they can accept lower margins in the more commodity like low risk business, or take on higher risk for potentially higher margins [ILLUSTRATION FOR EXHIBIT 1 OMITTED]. But each also provides opportunities for players who manage risks well and develop a risk portfolio that suits their appetite for risk, their skills, and customers' needs. This is because healthcare organization margins are actually a "risk premium": the reward for taking on risk.

To take advantage of the opportunities, risk must be treated as a core business activity for which responsibility is taken at senior level, rather than as a technical skill to be handled by specialists. As competition and pressure on costs reduce margins, and covered populations become riskier, a more sophisticated approach to risk management is required. By understanding care provision in terms of risk as well as average cost, a payor or provider can evaluate all the available risk management roles and strategies to optimize its performance. The winners will be those that excel at this and integrate risk management thinking into all aspects of their operating strategy.

Principal types of risk

To manage risk, healthcare organizations must first understand the size and characteristics of its four principal types:

* Clinical operating risk - the risk of variations in the costs incurred by a payor or provider in providing clinical services.

* Event risk - the risk associated with fluctuating demand for healthcare in the covered population

* Pricing risk - the risk inherent in setting prices given the unpredictable expenses of event risk.

* Financial risk - the basic business risks faced by all companies: capital, partner insolvency, cash flow, liability, and regulatory risks.

The first three are especially important to healthcare organizations, which stand or fall by their ability to manage them. Managing and mitigating financial risk is also important, but because it is a risk all businesses face, we will not discuss it further here (Exhibit 2).

Event risk. is determined by the characteristics of the pool of covered lives - the members of a healthcare plan or the population managed by a risk-bearing provider - and has two elements: incidence and severity. The greater the variation in occurrence of any one condition among a given population over a year, the higher its incidence risk. Severity risk is determined by variations in a condition's seriousness and in how much treatment is required.


Take asthma. Of any population, the number who will be diagnosed with asthma and who seek treatment will vary. There will also be variations in the amount of treatment each patient requires, depending on the severity and course of the disease. Together, these two variables form the event risk for asthma for the covered pool of lives.

A subset of event risk is catastrophe risk. Catastrophe risk is determined by the probability of an abnormally high incidence and/or severity of a given condition, which would result in an extremely high total treatment cost. Because of the remote likelihood of such catastrophes - an epidemic, for example - this risk is usually managed as a distinct type. …

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