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Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-K

 

 

(Mark One)

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended September 30, 2016

or

 

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                      to                     .

Commission File Number: 333-117362

 

 

IASIS HEALTHCARE LLC

(Exact name of registrant as specified in its charter)

 

 

 

DELAWARE   20-1150104

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

 

DOVER CENTRE

117 SEABOARD LANE, BUILDING E

FRANKLIN, TENNESSEE

  37067
(Address of principal executive offices)   (Zip Code)

Registrant’s telephone number, including area code: (615) 844-2747

Securities Registered Pursuant to Section 12(b) of the Act: None

Securities Registered Pursuant to Section 12(g) of the Act: None

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    YES  ☐    NO  ☒

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act.    YES  ☒    NO  ☐

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    YES  ☐    NO  ☒

(Note: As a voluntary filer not subject to the filing requirements of Sections 13 or 15(d) of the Exchange Act, the registrant has filed all reports pursuant to Section 13 or 15(d) of the Exchange Act during the preceding 12 months as if it were subject to such filing requirements.)

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    YES  ☒    NO  ☐

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ☒

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer      Accelerated filer  
Non-accelerated filer   ☒  (Do not check if a smaller reporting company)    Smaller reporting company  

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).    YES  ☐    NO  ☒

As of December 21, 2016, 100% of the registrant’s common interests outstanding (all of which are privately owned and are not traded on any public market) were owned by IASIS Healthcare Corporation, its sole member.

 

 

 

 


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CERTAIN TERMS

In this Annual Report on Form 10-K (this “Report”), unless otherwise stated or indicated by context, references to the “Company,” “IASIS,” “we,” “our” or “us” refer to IASIS Healthcare LLC and its affiliates. Unless the context otherwise implies, the term “affiliates” means direct and indirect subsidiaries of IASIS Healthcare LLC and partnerships and joint ventures in which such subsidiaries are partners. The terms “facilities” or “hospitals” refer to entities owned and operated by affiliates of IASIS and the term “employees” refers to employees of affiliates of IASIS. Our parent company, IASIS Healthcare Corporation (“IAS”), is our sole member.

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

Our disclosure and analysis in this Report contain “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), which involve risks and uncertainties. Forward-looking statements include all statements that do not relate solely to historical or current facts, and you can identify forward-looking statements because they contain words such as “believes,” “expects,” “may,” “will,” “should,” “seeks,” “approximately,” “intends,” “plans,” “estimates,” “projects,” “continue,” “initiative,” or “anticipates” or similar expressions that concern our prospects, objectives, strategies, plans or intentions. These forward-looking statements are subject to risks and uncertainties that may change at any time, and, therefore, our actual results may differ materially from those expected. While we believe our assumptions are reasonable, these assumptions are inherently subject to significant regulatory, economic and competitive uncertainties and contingencies, which are difficult or impossible to predict accurately and may be beyond the control of the Company. These factors include, but are not limited to:

 

    the effects related to implementation of the Patient Protection and Affordable Care Act, as amended by the Health Care and Education Reconciliation Act of 2010 (collectively, the “Health Reform Law”), potential legislative efforts to significantly modify or repeal the Health Reform Law following the 2016 Presidential and Congressional elections, the possible enactment of additional federal or state healthcare reforms, the outcome of court challenges to such laws;

 

    the possible impact of the 2016 federal elections and changes to federal, state, or local laws and regulations affecting the healthcare industry;

 

    our Health Choice managed care business’ ability to effectively manage costs of care, maintain its governmental contracts and achieve its service line expansion strategies;

 

    the effects of a shift in volume or payor mix from commercial managed care payors to self-pay and Medicaid;

 

    increases in the amount, and risk of collectability, of uninsured accounts and deductibles and c opayment amounts for insured accounts;

 

    a reduction in or withholding of government-sponsored supplemental payments to our hospitals;

 

    the effects of any inability to retain and negotiate reasonable contracts with managed care plans as a result of consolidation among managed care organizations or otherwise;

 

    if insured patients switch from traditional commercial insurance plans to health insurance exchange (“Exchange”) plans;

 

    industry trends towards value-based purchasing and narrow networks and related competitive challenges to our hospitals;

 

    possible changes in the Medicare, Medicaid and other state programs, including Medicaid supplemental reimbursement programs or waiver programs, that may impact reimbursement to healthcare providers and insurers;

 

    controls imposed by Medicare and third-party payors to reduce admissions and length of stay that negatively impact healthcare provider reimbursement;

 

    competition to attract and retain quality physicians, nurses, technicians and other personnel;

 

    the generally competitive nature of the healthcare industry;

 

    the possibility of health pandemics and the related impacts on our operations and financial results;

 

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    a failure of our information systems or breach of our cybersecurity protections;

 

    the costs and operational challenges associated with information technology and medical equipment upgrades;

 

    challenges associated with the implementation of electronic health records (“EHRs”) and coding systems;

 

    compliance with extensive healthcare industry laws, regulations and investigations, including those with respect to patient privacy and physician-owned hospitals;

 

    reliance upon services provided by third-party vendors;

 

    the effects of local or national economic downturns on our business lines;

 

    risks associated with our acquisition and development strategy, including liabilities assumed in acquisitions of facilities and physician practices and our need to effectively integrate acquired companies into our existing operations;

 

    increased lease rates and amended lease terms at certain of our facilities in connection with sale-leaseback transactions;

 

    risks associated with environmental, health and safety laws;

 

    risks associated with labor laws;

 

    potential adverse accounting impacts associated with goodwill carrying value;

 

    our dependence upon the services of key executive management personnel;

 

    our ability to maintain adequate internal controls over our financial and management systems;

 

    risks related to our indebtedness and capital structure; and

 

    other risk factors described in this Report.

Given these risks and uncertainties, you are cautioned not to place undue reliance on these forward-looking statements. Any forward-looking statement that we make in this Report speaks only as of the date of such statement, and we undertake no obligation to update any forward-looking statements or to publicly announce the results of any revisions to any of those statements to reflect future events or developments. Comparisons of results for current and any prior periods are not intended to express any future trends or indications of future performance, unless specifically expressed as such, and should only be viewed as historical data.

 

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TABLE OF CONTENTS

 

PART I

     1   

Item 1. Business

     1   

Item 1A. Risk Factors

     35   

Item 1B. Unresolved Staff Comments

     58   

Item 2. Properties

     58   

Item 3. Legal Proceedings

     60   

Item 4. Mine Safety Disclosures

     60   

PART II

     61   

Item  5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

     61   

Item 6. Selected Financial Data

     61   

Item  7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

     63   

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

     86   

Item 8. Financial Statements and Supplementary Data

     87   

Item  9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure

     132   

Item 9A. Controls and Procedures

     132   

Item 9B. Other Information

     133   

PART III

     133   

Item 10. Directors, Executive Officers and Corporate Governance

     133   

Item 11. Executive Compensation

     136   

Item  12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

     154   

Item  13. Certain Relationships and Related Transactions, and Director Independence

     156   

Item 14. Principal Accountant Fees and Services

     157   

PART IV

     157   

Item 15. Exhibits and Financial Statement Schedules

     157   

Signatures

     158   

 

 

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IASIS HEALTHCARE LLC

PART I

 

Item 1. Business.

Our Company

We are a healthcare services company headquartered in Franklin, Tennessee delivering high-quality, cost-effective healthcare through a broad and differentiated set of capabilities and assets that includes acute care hospitals with related patient access points, and a diversified managed care risk platform (“risk platform”). Our business model is centered on deploying our acute care expertise and risk platform, either separately or on an integrated basis, to manage population health, integrate the delivery and payment of healthcare services and ultimately expand our total market opportunities within our existing and new geographic markets. Our Company is comprised of our acute care operations, which include 17 acute care hospitals, one behavioral health hospital and multiple other access points, including 147 physician clinics, multiple outpatient surgical units, imaging centers, and investments in urgent care centers and on-site employer-based clinics, and our diversified and growing risk platform, Health Choice Arizona, Inc. and its affiliated entities (“Health Choice”). Through Health Choice, we operate managed Medicaid and Medicare health plans, Exchange plans, a management services organization (“MSO”) that provides management and administrative services to third-party insurers, as well as accountable care organization (“ACO”) networks consisting of our acute care facilities and affiliated physicians. We are a limited liability company organized under Delaware law following a reorganization with our predecessor company, which was founded in 1998.

Our business strategy and geographic market focus are designed to capitalize on the transition towards value-based care, the expansion of integrated healthcare delivery models, growth in managed care in government-sponsored health insurance programs, the growing need for cost-effective healthcare delivery models and the consolidation of physician groups and health systems. We believe that the growth of value-based care programs is accelerating and providers will assume increasing financial risk for the quality of care they deliver. We also believe traditional fee-for-service (“FFS”) reimbursement will become less prominent over time as the regulatory and business environment incentivizes better patient outcomes and increased cost efficiency. The nature of our presence in our existing geographic markets, and how we have leveraged our delivery and risk platform in multiple markets, are reflective of our business strategy and are discussed briefly as follows.

 

    Utah: We have built on the strength of our facility assets and physician relationships to expand our delivery and risk platform. Our integrated delivery network includes five acute care hospital campuses in the Salt Lake City metropolitan area, each supported by a diverse ambulatory footprint, including a new expandable inpatient and outpatient healthcare campus in fast-growing Lehi, Utah, and Riverwoods Surgery Center in Provo, Utah, which we acquired in November 2016. Our growing Health Choice presence includes a managed Medicaid health plan with 17,700 lives as of September 30, 2016 and an accountable care network, Health Choice Preferred ACO Utah, with 56,000 attributed lives and 1,300 aligned physicians as of September 30, 2016.

 

    Arizona: Our risk platform, Health Choice, which is headquartered in Phoenix, Arizona, continues to grow. As of September 30, 2016, its core health plan business manages 493,700 total Medicaid, dual Medicare and Medicaid eligible lives (“Duals”) and integrated acute and behavioral health plan lives state-wide. Health Choice, together with the Northern Arizona Behavioral Health Authority (“NARBHA”), a joint venture partner, operates an integrated acute and behavioral health plan in Northern Arizona. As of September 30, 2016, the joint venture, Health Choice Integrated Care LLC (“HCIC”) (our “Northern Arizona joint venture”), provides standalone behavioral health benefits for 225,100 plan members in Northern Arizona, and acute and behavioral care on an integrated basis for 5,400 members who are seriously mentally ill. As of September 30, 2016, we served 11,400 covered lives under our Exchange plan in Arizona, which predominantly serves the Phoenix market, and which we are discontinuing as of January 1, 2017.

We have leveraged our delivery assets in conjunction with Health Choice’s risk platform to develop an accountable care network with 28,300 attributed lives and approximately 1,400 aligned physicians as of September 30, 2016. Our delivery assets located in the cities of Phoenix and Mesa are core to our local accountable care network and include three acute care hospitals and a full-service, high-acuity behavioral health hospital, a growing number of patient access points and an employed physician group.

 

   

Texas: We have developed a diverse healthcare delivery presence through acute care hospitals in Odessa, San Antonio, Houston, Port Arthur, Beaumont and Texarkana, 52 physician clinic sites, multiple outpatient access points, employed physician groups and additional satellite campuses or related facilities in Odessa, Beaumont, Houston and Hope, Arkansas. Our strategic focus throughout our Texas market centers on integration of our hospitals and physician operations through developing a more extensive network of primary care physicians, the expansion of our physician alignment strategies and extending the reach of our outpatient business. In September 2015, we acquired the assets of Victory Medical Center in Beaumont, Texas, a physician-founded facility that is now a campus of our hospital in Port

 

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Arthur, The Medical Center of Southeast Texas, which has expanded the geographical footprint of that facility. Also in 2015, our hospital in Odessa, Texas, Odessa Regional Medical Center (“ORMC”), acquired the assets of Basin Healthcare Center, an in-market surgical hospital, expanding ORMC’s surgical and diagnostic capabilities by transitioning the acquired hospital into ORMC’s southeast campus.

 

    Louisiana: Our expanding delivery network in the West Monroe area includes an acute care hospital, an employed physician group and a growing affiliated physician network designed to compete in a value-based environment. During the 2016 fiscal year, we entered into a strategic affiliation agreement with Ochsner Health System (“Ochsner”), in New Orleans, Louisiana, identifying our West Monroe hospital with Ochsner’s statewide network as a partner in Northeast Louisiana. We continue to explore other in-market opportunities to expand our footprint and reach in this market.

 

    Colorado: We provide high-quality care through a critical access hospital in the Pikes Peak area of Woodland Park, Colorado.

We believe that our Health Choice risk platform is well-positioned to respond to the healthcare industry’s migration to cost efficiency and value-based reimbursement due to its breadth, ability to manage third-party, risk-based covered lives at scale and ability to deliver integrated care with IASIS-owned hospitals, ambulatory assets and physician provider networks. Our Health Choice risk platform includes the following capabilities:

 

    Extensive medical management experience: Health Choice’s 25-year history of continuously managing capitated covered lives (including under our ownership beginning in 1999) includes a large cohort of managed Medicaid lives in Arizona, a population with historically lower reimbursement rates that requires intensive care coordination and sensitivity to cultural and linguistic needs. We believe that Health Choice’s experience in managing Medicaid lives demonstrates its core competencies in care management, population health and global risk management. In recent years, through our Health Choice Preferred ACO networks and MSO, we have applied our experience to new populations, including attributed lives in Medicare, Exchange and commercial health plans, which we believe has been effective in improving patient outcomes and cost efficiencies. We have deployed our risk platform in conjunction with our hospitals and physicians to enter into Bundled Payments for Care Improvement (“BPCI”) Initiative contracts with the Centers for Medicare and Medicaid Services (“CMS”). This value-based CMS initiative structures reimbursement on an episode-of-care basis and rewards providers for quality of outcomes and cost efficiency.

 

    Geographic and product diversification: As of September 30, 2016, Health Choice’s related entities delivered healthcare services to 677,900 covered lives across three states. These include 276,800 managed Medicaid lives served primarily through Health Choice’s core health plan business in Arizona, 225,100 HCIC plan members, 9,500 Medicare Advantage members dually eligible for Medicare and Medicaid, 11,400 Exchange lives, 98,000 MSO lives and 85,200 lives attributed to our accountable care networks from multiple payors whose care is managed by our network providers, of which 28,100 lives are members in Health Choice’s managed Medicaid and Exchange plans (we are discontinuing our Exchange plan as of January 1, 2017).

Our Northern Arizona joint venture manages the standalone behavioral health benefit for 225,100 Northern Arizona Medicaid plan members and acute and behavioral care on an integrated basis for 5,400 such members who are seriously mentally ill. We believe that in the future, states other than Arizona may adopt this model of integration of acute and behavioral health benefits under one managed care organization, such as HCIC, our Northern Arizona joint venture.

 

    Physician-centric, value-driven care model: Our Health Choice Preferred ACO networks, working in conjunction with Health Choice’s MSO, allow us to provide cost-effective care in a manner that we believe is distinct among healthcare organizations that own both acute care and managed care assets.

As of September 30, 2016, approximately 2,700 physicians in our Utah and Arizona markets served as participating providers of our Health Choice Preferred ACO networks. These networks enter into provider contracts with third party health insurance plans, in which primary care physicians contracted with our networks serve as the central care coordinators for such health plan members. Our local hospitals serve as the core facilities of these “narrow” networks. Health Choice’s MSO provides our networks and its healthcare providers with administrative, medical risk and population health expertise, so that physicians, hospitals and other caregivers can make patient care decisions aimed at maximizing clinical outcomes and medical cost savings.

This combination of acute care, managed care and provider networking expertise allows Health Choice to enter into value-and risk-based arrangements with third party health plans, in which the compensation paid to our hospitals, our aligned physicians and Health Choice is tied to clinical effectiveness and cost efficiency. For instance, we have entered into “delegated risk” arrangements with third party health plans in Arizona and Utah. Under these arrangements, our network providers and Health Choice bear financial risk with respect to both the clinical quality and cost-effectiveness with which care is delivered to these health plan members. In some of these contracts, for instance, the network is at risk of forfeiting compensation or making a compensatory payment to the third party health plan if agreed to medical loss ratios and/or clinical quality benchmarks are not achieved. Outside of these value- and risk-based arrangements, our Health Choice MSO is also able to provide services to third party clients in an administrative services only capacity in which such managed care functions are provided for a fixed fee.

 

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We believe our risk platform enables us to: (1) enter new markets by utilizing our managed care and risk capabilities without expending capital in facility assets; (2) grow our physician network and patient lives base through an organized response to the growth of value-based reimbursement; (3) increase our overall growth opportunity in risk-based contracting and government-sponsored programs; and (4) enter new markets on an integrated basis through investment in acute care facility assets and the deployment of our risk platform.

In recent years, we have centered our growth strategy on a narrower set of geographies and the total healthcare services opportunity in each of our core markets. In support of this strategy, we have rationalized our business operations through the divestiture of non-core hospital operations and other related assets in Florida and Nevada and by raising capital for investment in our core markets. In our core markets, we seek to provide high-quality, cost-effective clinical care by expending capital on a disciplined basis to support and grow our delivery assets and using our risk platform where we believe it will enhance patient care.

For the year ended September 30, 2016, we generated revenues of $3.3 billion, with $1.96 billion, or 60.4%, of our revenue derived from our acute care segment and $1.29 billion, or 39.6%, of our revenue for this period derived from Health Choice. For additional information on our business segments, see Note 13, segment and geographic information, to our audited, consolidated financial statements included elsewhere in this Report.

Our principal executive offices are located at Dover Centre, 117 Seaboard Lane, Bldg. E, Franklin, Tennessee 37067, and our telephone number is (615) 844-2747. Our website address is www.iasishealthcare.com. The information on, or accessible through our website is not incorporated into and does not constitute a part of this Report or any other document that we file with or furnish to the SEC.

Healthcare Industry Overview and Trends

Cost-Conscious Healthcare Environment and Shift towards Value-Based Healthcare

The U.S. healthcare system is evolving in ways that favor cost-effective healthcare delivery, focusing on value-based payments and quality of outcomes. Many observers believe the traditional FFS reimbursement model is not the most effective or cost-efficient methodology for coordinating patient care, and that it has played a significant role in elevating both the level and growth rate of healthcare spending. In response, both the public and private sectors are shifting away from traditional FFS models and moving towards value-based reimbursement methodologies, including capitation payment models, that are designed to incentivize cost-effectiveness and quality. An estimated 30% of Medicare payments were tied to alternative payment methodologies, such as ACOs or bundled payments, as of January 2016. CMS has indicated that it aims to tie 50% of payments to such payments models by the end of 2018. In general, private payment reforms have evolved more slowly than changes to Medicare.

We believe that as governmental and private insurers seek to control healthcare costs and to increase quality of care, the use of value-based payment methodologies that tie payments, to quality and coordination of care will continue to grow. We believe that these reimbursement models will include bundled payments shared cost savings, and other cost-and quality incentive-based arrangements, along with programs that promote clinical integration and coordination of care, such as initiatives that incentivize effective use of integrated EHR technology. We also believe that patient-centered and disease state medical home reimbursement models, in which a primary care or specialty physician serves as a care coordinator, and risk-based arrangements that expose providers to both upside and downside risk will grow in prominence. Reimbursement trends are expected to further drive the critical importance of accurately measuring, analyzing, reporting, and improving patient outcomes. We believe we are well-positioned to capitalize on these trends as we seek to integrate, and drive synergies among, the core competencies of our managed care and acute care businesses.

Growth of Healthcare Spending

CMS reported that, in 2014, total U.S. healthcare expenditures grew by 5.3% to approximately $3.0 trillion. The most recent CMS projections, published in 2016, indicate that the rate of growth in health spending will decrease from an expected 5.5% in 2015 to 4.8% in 2016, largely due to the declines in the number of uninsured individuals that resulted from the Health Reform Law’s health insurance coverage expansions. Growth in national healthcare expenditures is projected to average 5.8% annually from 2015 to 2025. By these estimates, healthcare expenditures will account for $5.6 trillion, or 20.1% of the economy by 2025, compared to 17.5% in 2014, measured by total gross domestic product (“GDP”). These estimates do not take into account the potential impacts of the 2016 federal elections.

 

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The hospital services sector represents the single largest category of healthcare spending in the United States at $971.8 billion in 2014, the most recent year for which historical data is available. The hospital services category is anticipated by CMS to have grown 4.9% and 4.7% in 2015 and 2016 respectively, due primarily to the continued effects of the insurance expansions of the Health Reform Law. Continued population aging and the impacts of improved economic conditions are expected to be significant drivers of growth over the next decade. We believe that these factors will result in long-term utilization increases for certain healthcare services and the need for hospital networks that can provide comprehensive healthcare services in a coordinated, cost-effective manner.

Growth in Government-Sponsored Healthcare

Government-sponsored coverage is an important element of the U.S. healthcare system. According to CMS, healthcare spending by federal, state, and local governments is expected to have grown to $1.5 trillion in 2015, and is expected to continue due to rising medical prices, improvement in the economy and personal incomes, and expanding Medicare enrollment and usage. We believe that the enrollment in government-sponsored programs will continue to increase, primarily driven by an aging population. Managed care solutions have a well-established track record of helping governments improve healthcare quality and access for beneficiaries while strengthening the fiscal sustainability of these programs. As a result, we expect that government value-based models will also expand to manage costs and incentivize providers to deliver high quality, cost-effective care. The programs that utilize these value-based models include Medicare Advantage, Managed Medicaid, Medicare ACOs, Dual Eligible Pilot Programs and Medicare Value-Based Purchasing. We believe our experience in managing government-insured lives positions us to benefit from the expected growth of these programs.

Impact of Health Reform Law

We believe that the Health Reform Law, which has expanded healthcare coverage through the growth of Exchanges, private sector coverage and expanded Medicaid coverage, has reduced the level of uncompensated care we provide to uninsured individuals. We believe the benefits realized from expanded healthcare coverage under the Health Reform Law have generally been offset by the reductions required by the law in the growth in Medicare payments and the decreases in disproportionate share hospital (“DSH”) payments, which have adversely affected our government reimbursement.

Because of the many variables, including the law’s complexity, court challenges to the law, and possible reductions in funding by Congress and future reductions in Medicare and Medicaid reimbursement, we cannot predict the long-term effect of the Health Reform Law on our Company. Moreover, the 2016 federal elections, which resulted in the election of the Republican presidential nominee and Republican majorities in both houses of Congress, is likely to prompt renewed legislative efforts to significantly modify or repeal the Health Reform Law. While we are unable to predict the full impact of any significant modifications to the Health Reform Law on our acute care business and/or managed care business in light of the uncertainty regarding what legislative or other actions may be taken, if the Health Reform Law is repealed or significantly modified, such repeal or modification may have a materially adverse impact our business, strategies, prospects, operating results and/or financial condition.

Business Strategy

We believe our key business strengths position us as a provider-centric, payor-agnostic provider of broad and differentiated healthcare services, with flexibility for growth in new and existing markets. Our business strategy includes the following key components:

Focus on High Quality Care and Cost Effectiveness. We focus on operational excellence and cost-conscious behavior that allows us to provide high-quality patient care at affordable rates. We believe high-quality patient care may be achieved while maintaining cost efficiency. We believe that our quality and cost-efficiency initiatives favorably position us in a payment environment that is increasingly value- and performance-based.

We seek to leverage our corporate infrastructure and expense control expertise to achieve significant cost savings and operating efficiencies. Our corporate-wide supply purchase contracts and our revenue cycle management capabilities, billing systems and health information technologies allow our hospitals to benefit from economies of scale. We have also focused significant resources and expertise in managing employee productivity and labor-related costs at our hospitals, which helps to control costs and improve margins. We have also sought to integrate our acute care and managed care expertise through our Health Choice Preferred ACO networks and Health Choice MSO capabilities, which operate in conjunction with our hospitals and affiliated physicians to manage healthcare costs under value-based contracts with health plans.

 

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We believe that consistent delivery of high-quality care results in patient loyalty and long-term revenue growth and profitability. Our quality-of-care strategies include establishing best practices to benchmark our clinical performance and patient safety and satisfaction; investing in access points of care and our emergency rooms to improve patient access, flow, quality and timeliness of care; and deploying our information technology to promote patient care coordination and clinical efficiency.

To achieve our goal of achieving high-quality patient care at cost effective rates, we must attract and retain effective healthcare professionals. To this end, we believe that we must execute our comprehensive physician alignment strategy. This includes investing in the recruitment, employment and retention of highly competent physicians, nurses and other healthcare professionals. Outside of the employment context, we seek to attract high-quality physicians to practice at our hospitals through our Health Choice Preferred ACO networks, which bring local physicians and our facilities together under “narrow” networks that contract on a value-based basis with health plans. We also seek to make our facilities attractive to and convenient for local physicians by equipping our hospitals with advanced medical technology, computer systems and platforms and by enabling physicians to remotely access clinical data through our advanced information systems.

Leverage Our Managed Care and Population Health Management Expertise to Improve Patient Care, Create Payor Contracting Opportunities and Expand Health Choice’s Service Offerings. The U.S. healthcare system and the demand for healthcare services are evolving in ways that favor more coordinated healthcare delivery, focusing on population health management. Specifically, the Medicare and Medicaid programs, and commercial health insurers, are increasingly seeking to compensate healthcare providers based on quality outcomes and efficiency of care, rather than fixed fee schedules. These models include gain-sharing arrangements, various capitation models and other forms of risk-based reimbursement. We believe that effective population health management—which involves increased patient care coordination among physicians and hospitals, with a focus on wellness and disease management, and monitoring of overall health outcomes within populations—can lead to higher quality, more cost efficient healthcare.

The population health management expertise within Health Choice provides us with unique opportunities to improve care quality and to participate competitively in the emerging value-based payment landscape. Health Choice’s core competency lies in its medical management of Medicaid beneficiaries and “dual eligible” patients who receive both Medicare and Medicaid benefits. These groups have higher overall incidences of complex and chronic medical conditions than the population as whole. We have begun integrating the core competencies of our Health Choice assets in the hospital side of our business, which we believe will further enable us to manage the financial risks associated with our acute care hospitals entering into value-based relationships with governmental and commercial payors (as opposed to traditional fee-for-service arrangements). We believe that Health Choice’s medical management expertise provides growth opportunities that will further facilitate expansion beyond its core managed Medicaid business into a comprehensive managed care solutions organization. For example, Health Choice now provides administrative services for 98,000 lives to other commercial insurers, and operates an integrated acute and behavioral health care plan in northern Arizona, servicing 225,100 plan members.

Pursue a Flexible and Comprehensive Development Strategy. We continuously assess opportunities to strengthen and grow our hospitals through organic investment in our existing operations, transactional opportunities to expand our local and national presence through in-market and new market acquisitions, and strategic partnerships, all in an effort to identify underserved areas and expand our access points of care.

In existing markets, we seek acute care growth through the addition and expansion of attractive service lines such as primary care, orthopedics, oncology, cardiology and women’s health services, as well as acquisitions of physician clinics, outpatient care centers, urgent care centers and other access points of care to expand the geographical reach of our hospitals. For instance, in 2015, we acquired surgical hospitals in each of our Odessa and Port Arthur, Texas markets, which now operate as campuses of the main facilities. Additionally in 2015, we opened Mountain Point Medical Center, a new full-service, 40-bed hospital in Lehi, Utah, that functions as a campus of Jordan Valley Medical Center (“Jordan Valley”) and serves a fast-growing local population. In August 2016, we opened our new Jordan Valley Cancer Center, which provides radiation, medical and surgical oncology services in support of the community surrounding Jordan Valley. These acquisitions and new facilities improved our geographical footprint and patient service capabilities within our markets.

We also seek to explore the potential expansion of our Health Choice managed care solutions business, through both organic growth of our core business, new business lines such as our Utah Medicaid plan and strategic transactions, such as HCIC, our integrated acute and behavioral health plan that provides behavioral health benefits to 225,100 health plan members in northern Arizona.

Because Health Choice, in combination with our hospitals, gives us a broad and differentiated set of capabilities and assets, there are multiple ways for us to enter markets. We can enter new markets by acquiring new hospitals or opening, acquiring or partnering with existing health plans, or by any combination of these. For instance, our risk platform enables us to enter new markets to develop accountable care networks, launch health plans or provide MSO services, either in support of newly acquired provider assets or solely as a health insurer or MSO contracting with third-party payors and providers in the market. As a result, in addition to the acquisition or construction approaches pursued most often by pure acute care hospital systems, we have greater flexibility to enter new markets in a capital-efficient manner.

 

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Investments in Technology to Improve Patient Care and Clinical Integration. We believe that investment in technology drives improvement in clinical outcomes and quality of patient care. Since our inception, we have made significant investments to equip our hospitals with advanced clinical and health information technology. In October 2015, we entered into an agreement with Cerner Corporation to implement an integrated EHR and revenue cycle system across our acute care operations. We have made significant investments, and expect to continue to make significant investments, in this system through our 2019 fiscal year, as this system is implemented across our operations. We selected Cerner to provide this system after our incumbent clinical information technology vendor, McKesson Information Solutions LLC, announced its plan to stop development of its Horizon Clinicals system in early 2018. We believe that deploying our information technology where possible throughout our facilities and physician networks will position us to better track quality and to achieve clinical outcomes and costs savings, enhancing our competitiveness in a healthcare reimbursement landscape moving toward payment for performance. We believe that the enhancements in our information technology systems will improve real-time access to patient records and relevant clinical data to relevant physicians and facility personnel, allowing us to maximize clinical and financial efficiency.

Our Geographic Markets

The following includes a discussion of the acute care operations for certain of our markets and the geographic markets where Health Choice lines of business currently operate.

Salt Lake City, Utah

We operate five acute care hospital facilities with 692 licensed beds in the Salt Lake City area, which has been a very competitive environment. We believe that our hospitals in this market benefit from attractive locations and participate in a more favorable demographic and economic environment relative to other markets. For the year ended September 30, 2016, we generated 29.1% of our total acute care revenue in this market.

Our Salt Lake City market strategy focuses on high-quality patient care, disciplined capital deployment and the expansion of our footprint by developing a more extensive network of services, including a comprehensive physician alignment strategy and development of outpatient services and other patient access points around our hospitals.

In August 2016, we opened the Jordan Valley Cancer Center, a 24,000 square foot healthcare facility offering radiation, medical and surgical oncology services in support of the community surrounding Jordan Valley. We also acquired Riverwoods Surgery Center in Provo, Utah in November 2016, further expanding our geographic footprint in the Salt Lake City area.

In June 2015, we opened a new integrated inpatient and outpatient healthcare campus in Lehi, Utah, called Mountain Point Medical Center, as a provider-based campus of Jordan Valley. This healthcare campus includes 40 inpatient beds and full service outpatient capabilities in a 124,000 square foot hospital and an attached 60,000 square foot medical office building, which is occupied by primary care and multi-specialty physician groups practicing in the area. The campus provides a full range of services including inpatient intensive care, obstetrics and surgical services. The campus also provides cardiology services, including a cardiac catheterization lab. Additional outpatient services include emergency, imaging, lab and outpatient surgery. The campus has the capability to expand depending on community need and demand for services in the Lehi area. This new campus, in which we invested more than $80.0 million, serves eight cities in Northern Utah County and is in the fastest growing area within the state of Utah.

In recent years, we expanded our hospitals’ access points through, among other things, the acquisition of a hospital surgery center, the expansion of our emergency room capacity at several hospitals and the addition of new inpatient beds at Jordan Valley, Davis Hospital and Medical Center (“Davis”) and Salt Lake Regional Medical Center. We operate a free-standing emergency department and helped develop a medical office building in Roy, Utah, which has increased the emergency, primary care and specialty capacity of Davis. We also have made investments in a surgery center, urgent care clinics and on-site industrial medicine clinics within our Salt Lake City market.

We expanded our Health Choice business in Utah. Health Choice operates a managed Medicaid plan in Utah which, as of September 30, 2016, served 17,700 members. Additionally, Health Choice also has led the development of our local Health Choice Preferred ACO provider network that, working in conjunction with Health Choice’s MSO, enhances our hospitals’ abilities to coordinate care and contract with payors for 56,800 affiliated lives. This network and the related Health Choice Preferred physician association includes 1,349 physicians and represents part of our overall physician alignment strategy, which we also pursue through direct employment, professional services arrangements and other avenues. We believe that these physician alignment and related clinical integration efforts are laying the foundation for a high-quality, well-coordinated healthcare delivery network in the Salt Lake City area.

 

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Texas

We operate six acute care hospital facilities with 2,007 licensed beds that serve the areas of Houston, San Antonio, Odessa, Texarkana, Port Arthur and Beaumont, Texas. Additionally, we own a 79 bed acute care hospital facility in Hope, Arkansas, that is near our hospital in Texarkana. For the year ended September 30, 2016, we generated 41.8% of our total acute care revenue in this market.

Our strategic focus, throughout our Texas market, centers on integration of our hospitals and physician operations through developing a more extensive network of primary care physicians, including the expansion of our physician alignment strategies and extending the reach of our outpatient business, including both surgical and imaging services. We also seek to expand profitable product lines within our higher acuity service lines, including neurosurgery, cardiology and cardio-thoracic services and neonatology.

In the first quarter of fiscal year 2016, St. Joseph Medical Center (“SJMC”) acquired two radiation oncology centers, thereby expanding its footprint in the Houston area. These oncology clinics provide specialized treatments that are complimentary to the services offered by SJMC, and therefore help to expand the hospital’s community reach.

In 2015, we expanded the geographic footprint of ORMC through purchasing the assets of Basin Healthcare Center, a 14-bed surgical hospital located near ORMC’s main campus. Basin has been renamed Odessa Regional Medical Center South Campus, and its addition increases ORMC’s capacity to deliver high quality inpatient and outpatient services. Also in 2015, our hospital in Port Arthur, Texas, The Medical Center of Southeast Texas, acquired the assets of Victory Medical Center of Beaumont, a physician-founded 17-bed inpatient facility that opened in 2013. The Beaumont facility has been renamed The Medical Center of Southeast Texas Victory Campus and enhances our ability to provide accessible healthcare to the residents of Port Arthur, Beaumont and the surrounding communities.

Phoenix, Arizona

We operate three acute care hospital facilities and one behavioral health hospital facility, with a total of 589 licensed beds in the Phoenix area. Our strategic investments in this market have focused on capturing market share through expansion of various service lines and bed capacity. For the year ended September 30, 2016, we generated 19.5% of our total acute care revenue in this market.

Our physician alignment and access point strategy in our Arizona market focuses on enhancing our physician specialty and emergency room coverage to allow our hospitals to better meet community needs. We continue to grow our employed physician base in the Phoenix area and, additionally, we have leveraged Health Choice’s expertise to establish an accountable care provider network.

We also seek to make strategic capital investments in our Arizona hospitals and to adapt to our service lines to meet local market needs. In recent years, for example, we expanded our geropsychiatry services in the Phoenix market by adding beds for these services at both our St. Luke’s Medical Center in downtown Phoenix and Mountain Vista Medical Center in Mesa. As well, we are currently in the midst of a project to renovate and revitalize our Tempe St. Luke’s Hospital in Tempe by focusing on emergency services, general medicine and women’s services, which we believe will more effectively serve the needs of that community.

Health Choice bases its operations in Phoenix, Arizona, where it employs more than 700 managed care professionals and operates its core Health Choice Arizona managed Medicaid plan, along with its Duals plan and Health Insurance Exchange Plan. Our Phoenix-area Health Choice Preferred ACO network includes 528 aligned physicians and 56,800 affiliated lives, including those who participate in our network through our alliance with Phoenix Children’s Hospital. This network allows our Arizona hospitals and participating physicians to coordinate care and collaborate with respect to patient populations and to enter into value-based arrangements with commercial payors that reward effective population health management. Effective January 1, 2017, we are discontinuing our Arizona Exchange Plan, due to regulatory and financial uncertainty resulting from insufficient government funding as outlined in the original program details.

West Monroe, Louisiana

We operate Glenwood Regional Medical Center (“Glenwood”) with 278 licensed beds, in West Monroe, Louisiana, which benefits from a strong market position and opportunities for strategic growth of profitable product lines. For the year ended September 30, 2016, we generated 8.4% of our total acute care revenue in this market.

Since acquiring Glenwood in 2007, our focus on capital spending at this facility has included renovations and capacity expansion, with an emphasis on creating additional inpatient capacity with a 25-bed expansion, expanding emergency room coverage, growing the hospital’s cardiovascular program, expanding and renovating operating rooms and purchasing new diagnostic imaging equipment, automated laboratory systems and other equipment. We also have invested in the facility’s hospitalist program, expanded emergency room coverage and re-opened the inpatient psychiatric program. In 2016, we completed an expansion of our intensive care unit, and began work to renovate and further expand our emergency department in an effort to create additional capacity.

 

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To build on our capital investments in Glenwood and to serve our growing patient volume, we continue to seek opportunities to expand the hospital’s patient access points, including acquisitions, or new development, of other ancillary facilities around Glenwood. We believe our focus on providing high-quality patient care and our efforts to expand the reach of our physician network in this market will provide opportunities to capture additional market share and improve our relationships with managed care payors. In 2016, for example, we entered into a strategic affiliation agreement with Ochsner in New Orleans, which identified Glenwood as a northeast Louisiana partner in its state-wide network. The agreement provides for numerous elements, including co-branding, service line planning and development, physician recruiting, clinical integration and community physician alignment.

In connection with the Health Reform Law, Louisiana expanded Medicaid coverage effective July 1, 2016. This expanded coverage is expected to reduce the cost of uncompensated care provided by our Louisiana hospital, assuming that relevant provisions of the Health Reform Law are not otherwise significantly modified or repealed, as noted above.

Health Choice Geographic Markets

Health Choice’s related entities delivered healthcare services to 677,900 covered lives across three states as of September 30, 2016. Health Choice’s Phoenix-based managed Medicaid plan represents its core business, serving 259,100 members in Arizona’s Apache, Coconino, Gila, Maricopa, Mohave, Navajo, Pima and Pinal counties. Along with its managed Medicaid plan, Health Choice operates a Medicare Advantage Prescription Drug (“MAPD”) Special Needs Plan (“SNP”) that serves 9,500 members in the same Arizona counties. Our Health Choice Preferred ACO Network aims to organize our hospitals and local physicians and to serve as a contracting vehicle with commercial payors. Health Choice also operates a Phoenix-area Health Insurance Exchange plan, which serves 11,400 members, and which Health Choice is discontinuing as of January 1, 2017, due to the regulatory and financial uncertainty resulting from insufficient government funding as outlined in the original program details.

Our Northern Arizona joint venture manages the standalone behavioral health benefit for an estimated 225,100 northern Arizona Medicaid plan members, and acute and behavioral care on an integrated basis for 5,400 such members who are seriously mentally ill. We believe that in the future, states other than Arizona may adopt this model of integration of acute and behavioral health benefits under one managed care organization, such as our Northern Arizona joint venture.

In our Salt Lake City market, Health Choice operates a managed Medicaid plan under a contract with the state of Utah, serving 17,700 members. Health Choice, in conjunction with our Utah hospitals and local physicians, has also established an accountable care network, in the Salt Lake City area, which allows participating providers to contract with commercial health insurers.

Health Choice also offers MSO services to third party health plans and health systems, and currently provides these services for 98,000 members in the state of Florida through a contract with a large national insurer.

Hospital Operations

At each of our hospitals, we have implemented policies and procedures to enhance patient safety and quality of care, and to improve the hospital’s operating and financial performance. A hospital’s local management team is comprised of a chief executive officer, chief financial officer and chief nursing officer. Local management teams, in consultation with our corporate staff, develop annual operating plans setting forth goals for quality and patient satisfaction, revenue growth and operating profit strategies. These strategies may include the expansion of services offered by the hospital, market development to improve community access to care, the recruitment and employment of physicians, plans to enhance quality of care and improvements in operating efficiencies to reduce costs. The competence, skills and experience of the management team at each hospital is critical to the hospital’s successful execution of its operating plan. Our performance-based compensation program for each local management team is based upon the achievement of qualitative and quantitative goals in the annual operating plan. Our hospital management teams are advised by boards of trustees that include members of hospital medical staffs, and community leaders. Each board of trustees establishes policies concerning medical, professional and ethical practices, monitors such practices and is responsible for ensuring these practices conform to established standards.

Factors that affect demand for our services include:

 

    local economic conditions;

 

    the geographic location of our hospital facilities and other access points of care and their convenience for patients and physicians;

 

    our participation in managed care programs, including managed care contracts on the Exchanges;

 

    utilization management practices of managed care plans;

 

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    consolidation of managed care payors;

 

    strategic investment and improvements in healthcare access points;

 

    capital investment at our facilities;

 

    the quality of our medical staff;

 

    competition from other healthcare providers;

 

    the size of and growth in the local population; and

 

    improved treatment protocols because of advances in medical technology and pharmacology.

The ability of our hospitals to meet the healthcare needs of their communities is determined by factors including:

 

    level of physician support;

 

    availability of nurses and other healthcare professionals;

 

    quality, skills and compassion of our employees;

 

    scope, breadth and quality of our services; and

 

    physical capacity and level of technological advancement at our facilities.

We continually evaluate our services with the goal of improving quality of care, expanding our profitable lines of business and improving our business mix. We use our advanced information systems to perform detailed clinical process and care quality reviews, to review product line margin analyses, and to monitor the profitability of the services provided at our facilities. We employ these analyses to capitalize on price and volume trends through the expansion and improvement of certain services.

Health Choice Operations

Health Choice is the managed care risk platform through which we manage 677,900 covered lives as of September 30, 2016, under our multiple health plans, ACO networks, MSO services and other managed care solutions. With its headquarters and primary operations in Phoenix, Arizona, Health Choice employs more than 1,000 managed care professionals in Phoenix and Flagstaff, Arizona, Salt Lake City, Utah and Tampa, Florida. Health Choice’s senior management team operates out of Phoenix, Arizona with an additional east coast operations hub in Tampa, Florida and is supported by medical directors, case management and utilization management nurses, care coordinators, provider network professionals, medical economics analysts, actuaries, an internal compliance group and other administrative personnel. The Health Choice senior management team provides general oversight over the health plan products and management services that Health Choice offers. Health Choice’s business divisions, including its Arizona and Utah managed Medicaid plans, its integrated acute care and behavioral health joint venture, its east coast MSO office and accountable care network divisions, each have dedicated management teams who report to Health Choice’s senior executives.

Competition

Our facilities and related businesses operate in competitive environments. Several factors affect our competitive position, including:

 

    the local economies in which we operate;

 

    the level of tourism in our service areas;

 

    our managed care contracting relationships;

 

    the number, availability, quality and specialties of physicians, nurses and other healthcare professionals;

 

    the scope, breadth and quality of services;

 

    the reputation of our facilities and physicians;

 

    ability to develop, expand or participate in accountable care networks in certain markets;

 

    growth in hospital capacity and healthcare access points in the markets we serve;

 

    the physical condition of our facilities and medical equipment;

 

    the location of our facilities and availability of physician office space;

 

    federal and state restrictions;

 

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    the availability of parking or proximity to public transportation;

 

    accumulation, access and interpretation of publicly reported quality indicators;

 

    growth in outpatient service providers;

 

    the charges we can set for our services and the growing demand for transparency of such charges; and

 

    the geographic coverage of our hospitals in the regions in which we operate.

We face competition from established, tax-exempt healthcare companies and systems, investor-owned hospital companies, large tertiary care centers, specialty hospitals and outpatient service providers, such as surgery centers and imaging centers. In addition, some of our hospitals operate in regions with vertically integrated healthcare providers that include health plans, physician groups and facilities, which could affect our ability to obtain managed care contracts. We continue to encounter increased competition from specialty hospitals, free-standing emergency rooms and other outpatient service providers, not-for-profit healthcare providers and companies, like ours, that consolidate hospitals and healthcare companies in specific geographic markets.

Our competitiveness depends heavily on obtaining and maintaining contracts with managed care organizations, which seek to control healthcare costs through utilization policies and procedures. Most of our markets have experienced significant managed care penetration, along with increasing consolidation of major managed care plans. The revenue and operating results of our hospitals are affected by our ability to negotiate reasonable contracts with managed care plans. Health maintenance organizations (“HMOs”) and preferred provider organizations (“PPOs”) use managed care contracts to encourage patients to utilize certain hospitals for discounts from the hospitals’ established charges. Traditional health insurers also contain costs through similar contracts with hospitals.

Our managed care relationships also depend upon whether one of our hospitals is part of a local hospital network, and the scope and quality of services offered by the network compared to competing networks. We believe that our hospitals are better positioned for the transition to higher quality, more affordable networks being established by managed care organizations. On an ongoing basis, we evaluate circumstances in each geographic area in which we operate. We may position ourselves to compete in these managed care markets by forming our own, or joining with others to form, local hospital networks. Where strategically advantageous, we seek to participate in or form accountable care networks comprising hospitals and physicians that can deliver clinically integrated, coordinated care.

As we continue to focus on our physician alignment strategies, we face significant competition for skilled physicians in certain of our markets, as more providers are adopting a physician staffing model approach. Further, there is a general shortage of physicians across most specialties, particularly primary care. This increased competition has resulted in efforts by managed care organizations to align with certain provider networks in the markets in which we operate. While we anticipate that our physician alignment strategies, including provider network development efforts, will help us compete more effectively in our markets, we can provide no assurance regarding the success of our strategy.

We believe physician alignment promotes clinical integration, enhances quality of care and makes us more efficient and competitive in a healthcare environment trending toward value-based purchasing and pay-for-performance. To meet community needs and address healthcare coverage issues, we have made significant investments to align with physicians through various recruitment and employment strategies, as well as through alternative means of alignment such as our formation of provider networks in certain markets. We have formed our own ACO networks in certain markets that include both employed and non-affiliated physicians, providing the infrastructure through which we can contract more efficiently with commercial payors, position ourselves for value-based reimbursement and promote clinical integration. While we expect that employing physicians will provide relief on cost pressures associated with on-call coverage and other professional fees, we anticipate incurring additional labor and other start-up related costs as we continue the integration of recently employed physicians and their related support staff.

We also face risk from competition for outpatient business. We expect to mitigate this risk through continued focus on our physician alignment strategies, developing new access points of care, our commitment to capital investment in our hospitals, including expenditures to update technology and equipment, and our commitment to our quality of care initiatives that some competitors, such as individual physicians or physician groups, may not be equipped to implement.

The health insurance market and MSO markets are generally highly competitive. Historically, the managed care industry has been fragmented; however, the competitive landscape is subject to ongoing changes as a result of the Health Reform Law, business consolidations and new strategic alliances. Health Choice competes with a large number of national, regional and local managed Medicaid, Duals and MSO service providers, some of whom have more prominent national brands and greater capital resources than us.

 

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We compete for government contracts, renewals of government contracts, members and providers. State agencies consider many factors in awarding contracts to health plans. Among such factors are the health plan’s provider network, medical management, degree of member satisfaction, timeliness of claims payment and financial resources. Potential members typically choose a health plan based on a specific provider being a part of the network, the quality of care and services available, accessibility of services and reputation or name recognition of the health plan. We believe factors that providers consider in deciding whether to contract with a health plan include potential member volume, payment methods, timeliness and accuracy of claims payment, and administrative service capabilities. We face competition from other health insurers and MSOs in establishing relationships with state agencies, plan members and network providers.

Sources of Revenue

Acute Care Revenue

Acute care revenue is comprised of net patient revenue, which represents gross charges for our inpatient and outpatient services less contractual adjustments and discounts based upon negotiated rates. Contractual adjustments principally result from differences between the hospitals’ established charges and payment rates under Medicare, Medicaid and various managed care plans. Discounts and contractual adjustments also result from our uninsured discount and charity care programs. Acute care revenue also includes other revenue, consisting of medical office building rental income and other miscellaneous revenue.

 

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The following table provides the sources of our hospitals’ gross patient revenue by payor before discounts, contractual adjustments and the provision for bad debts:

 

     Year Ended September 30,  
     2016     2015     2014  

Medicare

     26.1     26.5     27.0

Managed Medicare

     15.8        15.3        15.1   

Medicaid and managed Medicaid

     21.3        21.3        21.2   

Managed care

     31.5        31.4        30.8   

Self-pay

     5.3        5.5        5.9   
  

 

 

   

 

 

   

 

 

 

Total

     100.0     100.0     100.0
  

 

 

   

 

 

   

 

 

 

A large percentage of our hospitals’ net patient revenue consists of fixed payments from discounted sources, including Medicare, Medicaid and commercial managed care organizations. Reimbursement for services provided to Medicare and Medicaid beneficiaries is often fixed regardless of the cost incurred or the level of services provided. Similarly, various commercial managed care companies with which we contract reimburse providers on a fixed payment basis regardless of the costs incurred or the level of services provided.

We receive payment for patient services primarily from:

 

    the federal government, primarily under the Medicare program;

 

    state Medicaid programs, including managed Medicaid plans;

 

    commercial managed care payors, including HMOs and PPOs, and managed Medicare plans; and

 

    individual patients and private insurers.

Our hospitals offer discounts from established charges to managed care plans if they are large group purchasers of healthcare services. We offer discounts to all uninsured patients receiving healthcare services who do not qualify for assistance under state Medicaid, other federal or state assistance plans or charity care. These discount programs limit our ability to increase net patient revenue in response to increasing costs. Patients are not responsible for any difference between established hospital charges and amounts reimbursed for such services under Medicare, Medicaid, HMOs, PPOs or private insurance plans. Patients are responsible for services not covered by these plans, in addition to deductibles or co-insurance features of their coverage. Collecting amounts due from patients is more difficult than collecting from governmental programs, managed care plans or private insurers. Increases in the population of uninsured individuals, and the acuity levels of such patients seeking care in our emergency rooms, changes in the states’ indigent and Medicaid eligibility requirements, continued efforts by employers to pass more out-of-pocket healthcare costs to employees through increased co-payments and deductibles and the effects of an uncertain, low-growth economic environment have historically resulted in increased levels of uncompensated care.

The following table provides the sources of our hospitals’ net patient revenue before the provision for bad debts by payor:

 

     Year Ended September 30,  
     2016     2015     2014  

Medicare

     18.8     19.6     20.4

Managed Medicare

     10.6        10.4        10.8   

Medicaid and managed Medicaid

     11.6        12.2        12.8   

Managed care

     43.8        42.7        40.9   

Self-pay

     15.2        15.1        15.1   
  

 

 

   

 

 

   

 

 

 

Total

     100.0     100.0     100.0
  

 

 

   

 

 

   

 

 

 

Medicare

Medicare is a federal program that provides hospital and medical insurance benefits to persons age 65 and over, some disabled persons and persons with Lou Gehrig’s disease and end-stage renal disease. All of our hospitals are certified as providers of Medicare services and must meet specific Medicare conditions of participation to remain eligible. Under the Medicare program, acute care

 

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hospitals receive reimbursement under a prospective payment system that pays fixed rates for inpatient and outpatient hospital services. Certain types of facilities are exempt or partially exempt from the prospective payment system methodology, including children’s hospitals, cancer hospitals and critical access hospitals. Hospitals and units exempt from the prospective payment system are reimbursed on a reasonable cost-based system, subject to cost limits.

In addition to the reimbursement adjustments and policies discussed below, beginning in 2013, the Budget Control Act of 2011 (“BCA”) imposed automatic spending reductions intended to reduce the federal deficit, including Medicare spending reductions of up to 2% per fiscal year, with a uniform percentage reduction across all Medicare programs. These automatic spending reductions have been extended through federal fiscal year 2025.

Inpatient Acute Care

The Medicare program reimburses general, acute care hospitals for inpatient services under a prospective payment system based on the patient’s assigned MS-DRG. The MS-DRG system classifies categories of illnesses according to the estimated intensity of hospital resources required to furnish care for each principal diagnosis. Fixed payment rates are assigned to MS-DRG rates based on a statistically normal distribution of severity. The MS-DRG payments consider no specific hospital’s actual costs but are adjusted for geographic area wage differentials. Inpatient capital costs for acute care hospitals are reimbursed on a prospective system based on diagnosis related group weights multiplied by geographically adjusted federal weights. When treatments for patients fall well outside the normal distribution, providers may receive additional payments known as outlier payments. For federal fiscal year 2017, CMS has established an outlier threshold of $23,570 per case.

The MS-DRG rates are adjusted each federal fiscal year, using the market basket index, which takes into account inflation experienced by hospitals and entities outside of the healthcare industry in purchasing goods and services. In past years, the percentage increases to the MS-DRG rates have been lower than the percentage increases in the costs of goods and services purchased by hospitals. Further, the Health Reform Law provides for reductions of 0.75% to the market basket update in federal fiscal years 2017 through 2019. It also requires annual reductions by a “productivity adjustment” equal to the projected average nationwide productivity gains over the preceding 10 years based on the U.S. Bureau of Labor Statistics 10-year moving average of changes in specified economy-wide productivity. In addition, CMS is required to reduce payments under the inpatient prospective payment system by a documentation and coding adjustment through federal fiscal year 2017. For federal fiscal year 2016, CMS issued a final rule that resulted in a net increase in operating payment rates of 0.9%. This increase reflected a 2.4% market basket increase, a multi-factor productivity adjustment of negative 0.5%, a 0.2% reduction as required by the Health Reform Law, and a prospective documentation and coding adjustment of negative 0.8%. For federal fiscal year 2017, CMS issued a final rule that results in a net increase in operating payments of 0.95% for hospitals that successfully participate in the Hospital Inpatient Quality Reporting Program and are meaningful users of EHR. This increase reflects a 2.7% market basket increase, a multi-factor productivity adjustment of negative 0.3%, a prospective reduction of 1.5% for documentation and coding, an additional reduction of 0.75% as required by the Health Reform Law. It also reflects a positive adjustment of approximately 0.8% to remove the effects of prior adjustments intended to offset the estimated increase in inpatient prospective payment system expenditures resulting from the Medicare program’s “two-midnight rule.”

Under the two-midnight rule, services provided to Medicare beneficiaries are only payable as inpatient hospital services when there is a reasonable expectation that the hospital care is medically necessary and will be required across two midnights, absent unusual circumstances. Hospital stays expected to need less than two midnights of hospital care are subject to medical review on a case-by-case basis. Quality Improvement Organizations (“QIOs”) are handling the reviews of short inpatient stays and will refer claim denials to the Medicare Administrative Contractors (“MACs”) for payment adjustments. Providers that exhibit persistent noncompliance with the two midnight rule may be referred to Recovery Audit Contractors (“RACs”).

Quality of care provided is becoming an increasingly important factor in Medicare reimbursement. Hospitals must submit data for certain patient care indicators to CMS to receive MS-DRG increases at the full market basket. Hospitals that do not participate will lose one-quarter of the percentage increase in their payment updates. In addition, the market basket update for any hospital that is not a meaningful EHR user will be reduced by three-fourths in federal fiscal year 2017 and later years. We monitor our compliance with the quality indicators and intend to submit the quality data required to receive the full market basket pricing update when appropriate.

In addition, as required by the Health Reform Law, CMS has implemented a value-based purchasing program for inpatient hospital services to reward hospitals that meet certain quality performance standards. CMS funds the payment pool for this program by reducing the inpatient prospective payment system payment amount for all discharges by 2% each federal fiscal year, as specified by the Health Reform Law. Hospitals are scored based on a weighted average of patient experience scores using the Hospital Consumer Assessment of Healthcare Providers and Systems survey and certain clinical measures. CMS scores each hospital based on achievement (relative to other hospitals) and improvement ranges (relative to the hospital’s own past performance) for each applicable measure. Hospitals that meet or exceed the quality performance standards set by CMS will receive greater Medicare reimbursement

 

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than they would have otherwise. Conversely, hospitals that do not achieve the necessary quality performance will receive reduced Medicare inpatient hospital payments. Under this program, for discharges in federal fiscal year 2017, CMS will make available an estimated $1.8 billion to hospitals based on their overall performance on a set of quality measures that have been linked to improved clinical processes of care and patient satisfaction.

Inpatient payments are also reduced each fiscal year if a hospital experiences “excess readmissions” within the 30-day period from the date of discharge for conditions specified by the Health Reform Law and CMS, including heart attack, heart failure, pneumonia and total knee arthroplasty. Hospitals with excess readmissions for the specified conditions receive reduced payments for all inpatient discharges, not just discharges relating to the conditions subject to the excess readmissions standard. Each hospital’s performance is publicly reported by CMS.

Reimbursement is also reduced based on a facility’s rate of hospital acquired conditions (“HACs”). A HAC is a condition acquired by a patient while admitted as an inpatient in a hospital, such as a surgical site infection. Medicare does not pay hospitals additional amounts to treat HACs. Currently, there are 14 categories of conditions on the list of HACs and, separately, three National Coverage Determinations that prohibit Medicare reimbursement for erroneous surgical procedures. CMS may revise the list of conditions from time to time. The Health Reform Law tied HAC rates to a facility’s overall reimbursement. Hospitals that rank in the worst 25% nationally for HAC rates across all hospitals in the previous year receive a 1% reduction in total Medicare payments.

Outpatient

CMS reimburses hospital outpatient services and certain Medicare Part B services furnished to hospital inpatients that have no Part A coverage on a prospective payment system basis. CMS uses fee schedules to pay for physical, occupational and speech therapies, durable medical equipment, clinical diagnostic laboratory services and nonimplantable orthotics and prosthetics.

All services paid under the prospective payment system for hospital outpatient services are classified into groups called ambulatory payment classifications (“APCs”). A payment rate is established for each APC, as services in each APC are similar clinically and in terms of the resources they require. The APC payment rates are updated each calendar year based on the market basket, which is required by the Health Reform Law to be reduced by 0.75% for each of 2017, 2018, and 2019. The Health Reform Law also provides for annual reductions to the market basket update based on changes in economy-wide productivity. For calendar year 2016, CMS decreased payments for hospital outpatient services by an estimated 0.4%. The change was based on a market basket increase of 2.4%, a negative 0.5% multifactor productivity adjustment and a negative 0.2% adjustment required by the Health Reform Law, along with other policy changes, including a 2.0% reduction to address what CMS views as inflated payments in past calendar years for laboratory tests packaged with payments for hospital outpatient services. For calendar year 2017, CMS has finalized payment adjustments and policy updates that it estimates will result in a 1.7% increase in payments for hospital outpatient services. This reflects a market basket increase of 2.7%, a negative 0.3% adjustment for multifactor productivity, and the 0.75% reduction required by the Health Reform Law annually for calendar years 2017 through 2019.

CMS requires hospitals to submit quality data regarding certain measures relating to outpatient care in each calendar year to receive the full market basket increase under the outpatient prospective payment system in the following calendar year. Hospitals that fail to submit such data will receive the market basket update minus two percentage points for the outpatient prospective payment system.

Rehabilitation

Inpatient rehabilitation hospitals and designated units are reimbursed under a prospective payment system. Under this prospective payment system, patients are classified into case mix groups based upon impairment, age, co-morbidities and functional capability. Inpatient rehabilitation facilities are paid a predetermined amount per discharge that reflects the patient’s case mix group and is adjusted for area wage levels, low-income patients, rural areas and high-cost outliers. The Health Reform Law provides for a 0.75% reduction to the market basket update for fiscal years 2017 through 2019. It also requires annual reductions to the market based update based on changes in economy-wide productivity. For federal fiscal year 2016, CMS updated inpatient rehabilitation rates by 1.8%, which reflected an inpatient rehabilitation-specific market basket estimate of 2.4%, a negative 0.5% productivity adjustment and a 0.2% reduction required by the Health Reform Law, along with an additional 0.1% increase to aggregate payments due to updating the outlier threshold. For federal fiscal year 2017, CMS has issued a final rule increasing inpatient rehabilitation rates by an estimated 1.9%, which reflects an inpatient rehabilitation-specific market basket estimate of 2.7%, a negative 0.3% multifactor productivity adjustment, and the 0.75% reduction required by the Health Reform Law annually for federal fiscal years 2017 through 2019.

Each inpatient rehabilitation facility must report certain quality measures to CMS or receive a two percentage point reduction to the market basket update. For federal fiscal year 2017, seven quality measures must be reported. CMS has finalized new quality measures to be implemented in federal fiscal years 2018 and 2020.

 

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To qualify for classification as an inpatient rehabilitation facility, at least 60% of the facility’s inpatient population during the most recent 12-month cost reporting period must have required intensive rehabilitation services for one or more of 13 specified conditions. Inpatient rehabilitation facilities must meet additional coverage criteria, including patient selection and care requirements relating to pre-admission screenings, post-admission evaluations, ongoing coordination of care and involvement of rehabilitation physicians. As of September 30, 2016, we operate nine inpatient rehabilitation units within our hospitals.

Psychiatric

Inpatient psychiatric facilities are paid based on a prospective payment system. Under this prospective payment system, inpatient psychiatric facilities receive a federal per diem base rate that is based on the sum of the average routine operating, ancillary and capital costs for each patient day of psychiatric care in an inpatient psychiatric facility. The federal per diem base rate is then adjusted for budget neutrality, such that total payments under the prospective payment system are projected to be equal to the total estimated payments that would have been made to inpatient psychiatric facilities under the previous cost-based system of payment. This federal per diem base rate is further adjusted to reflect certain patient and facility characteristics, including patient age, certain diagnostic related groups, facility wage index adjustment, and facility rural location. Inpatient psychiatric facilities also receive additional outlier payments for cases in which estimated costs for the case exceed an adjusted threshold amount plus the total adjusted payment amount for the stay. The Health Reform Law provides for a reduction of 0.75% to the base rate for rate years 2017 through 2019, in addition to an annual reduction to the base rate that is set according to economy-wide productivity changes.

For federal fiscal year 2016, CMS increased inpatient psychiatric payment rates by 1.5%, which included a market basket update of 2.4%, reduced by a 0.5% productivity adjustment and a reduction of 0.2% as required by the Health Reform Law, along with other payment adjustments. For federal fiscal year 2017, CMS has issued a final rule updating inpatient psychiatric payment rates by 2.2%, which reflects a market basket increase of 2.8%, a negative 0.3% productivity adjustment, and a reduction of 0.2% as required by the Health Reform Law. The Health Reform Law provides for additional reductions to the psychiatric prospective payment system market basket update of 0.75% per year in federal fiscal years 2017 through 2019. As of September 30, 2016, we operate one behavioral health hospital facility and eleven specially designated psychiatric units subject to these rules.

Physician services reimbursement

Physician services are reimbursed under the physician fee schedule system, under which CMS has assigned a national relative value unit (“RVU”) to most medical procedures and services that reflects the resources required by a physician to provide the services relative to all other services. Each RVU is calculated based on work required in time and intensity of effort for the service, practice expense (overhead) attributable to the service and malpractice insurance expense attributable to the service. These three elements are each modified by a geographic adjustment factor to account for local practice costs and then aggregated. Historically, the payment amount for each service was determined using the sustainable growth rate (“SGR”). However, in April 2015, the Medicare Access and Children’s Health Insurance Program (“CHIP”) Reauthorization Act of 2015 (“MACRA”) repealed the SGR physician payment methodology and replaced it with the Quality Payment Program (“QPP”), which is intended to reward high-quality patient care. MACRA also provides for a 0.5% update for each calendar year through 2019.

In October 2016, HHS issued a final rule implementing the QPP. Beginning in 2017, physicians must choose to participate in the QPP through one of two tracks. The Advanced Alternative Payment Model (“APM”) track makes available incentive payments for participation in specific innovative payment models approved by CMS. Providers may earn a 5% Medicare incentive payment and will be exempt from reporting requirements and payment adjustments imposed under the Merit-Based Incentive Payment System (“MIPS”) if the provider has sufficient participation (based on percentage of patients or payments) in an APM. Under the MIPS track, physicians will receive performance-based payment incentives or payment reductions based on their performance with respect to clinical quality, resource use, clinical improvement activities and meaningful use of EHRs. MIPS will consolidate components of three existing programs: the Physician Quality Reporting System, the Physician Value-Based Payment Modifier, and the Medicare EHR Incentive Program. Providers must begin collecting performance data for the QPP between January 1 and October 2, 2017. Medicare payments in 2019 will be subject to a positive or negative adjustment of up to 4% of the provider’s Medicare payments-based on the data submitted from 2017 and the QPP track selected. As the QPP evolves, CMS expects to transition increasing financial risk to providers.

Ambulatory surgery centers

CMS reimburses ambulatory surgery centers using a predetermined fee schedule. Reimbursements for ambulatory surgery center overhead costs are limited to no more than the overhead costs paid to hospital outpatient departments under the Medicare hospital outpatient prospective payment system. All surgical procedures, other than those that pose a significant safety risk or generally require an overnight stay, are payable as ambulatory surgery center procedures. From time to time, CMS considers expanding the services that may be performed in ambulatory surgery centers, which may result in more Medicare procedures that historically have been performed in hospitals, such as ours, being moved to ambulatory surgery centers, potentially reducing surgical volume in our hospitals.

 

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The Health Reform Law provides for annual reductions to the payment system for ambulatory surgery center services, based on changes in economy-wide productivity. For calendar year 2016, CMS increased ambulatory surgery center payment rates by 0.3%, reflecting a Consumer Price Index for urban consumers (“CPI-U”) update of 0.8% and a negative 0.5% productivity adjustment. For calendar year 2017, CMS has issued a final rule that increases ambulatory surgery center payment rates by 1.9%, based on a CPI-U update of 2.2% and a negative 0.3% productivity adjustment as required by the Health Reform Law. In addition, CMS has established a quality reporting program for ambulatory surgery centers under which those that fail to report on required quality measures receive a two percentage point reduction in reimbursement.

Managed Medicare

Managed Medicare plans, commonly known as Medicare Advantage, are contractual arrangements between CMS and private health plans to provide Medicare Part A, Part B and Part D benefits to beneficiaries who enroll in such plans. The Medicare program allows beneficiaries to choose enrollment in certain Medicare Advantage plans, which may be structured as HMOs, PPOs, or private fee-for-service plans. Nationally, approximately 31% of Medicare beneficiaries have elected to enroll in Medicare Advantage plans.

Enrollment in Medicare Advantage plans has grown, and is expected to continue to grow, despite reductions in payments to Medicare Advantage plans imposed by the Health Reform Law, which were intended to bring payments closer to the average costs of traditional Medicare beneficiaries. CMS has indicated that, for the majority of beneficiaries in calendar year 2017, Medicare Advantage premium rates will either remain stable or decrease slightly.

Medicaid

Medicaid programs are jointly funded by federal and state governments and are administered by states under an approved plan that provides hospital and other healthcare benefits to qualifying individuals who cannot afford care. All of our hospitals are certified as providers of Medicaid services. State Medicaid programs may use a prospective payment system, cost-based payment system or other payment methodology for hospital services. However, Medicaid reimbursement is often less than a hospital’s cost of services.

The federal government and many states from time to time consider altering the level of Medicaid funding or expanding Medicaid benefits in a manner that could adversely affect future levels of Medicaid reimbursement received by our hospitals. In recent years, the states in which we operate have experienced budget constraints because of increased costs and lower than expected tax collections, and many states have experienced or projected shortfalls in their budgets. Health and human services programs, including Medicaid and similar programs, represent a significant portion of state budgets. The states in which we operate responded to these budget concerns by decreasing funding for healthcare programs or making structural changes that resulted in a reduction to Medicaid hospital revenues. Additional Medicaid spending cuts or other program changes may be implemented in the states in which we operate. However, the Health Reform Law generally requires states to at least maintain the Medicaid eligibility standards established prior to the enactment of the law for children until October 1, 2019. The Health Reform Law also includes provisions allowing states to significantly expand their Medicaid program coverage. However, states that elect not to implement the law’s Medicaid expansion provisions may do so without the loss of existing federal Medicaid funding. As a result, a number of state governors and legislatures, including Texas, have chosen not to participate in the expanded Medicaid program. It is unclear how many states will ultimately implement the Medicaid expansion, particularly following the 2016 federal elections.

The Health Reform Law prohibits the use of federal funds under the Medicaid program to reimburse providers for medical assistance provided to treat certain provider-preventable conditions. Each state Medicaid program must deny payments to providers to treat healthcare-acquired conditions and provider-preventable conditions designated by CMS and any other provider-preventable conditions designated by the state.

Private supplemental Medicaid reimbursement programs

Certain of our acute care hospitals receive supplemental Medicaid reimbursement, including reimbursement from programs for participating private hospitals that enter into indigent care affiliation agreements with public hospitals or county governments in the state of Texas. Under the CMS-approved programs, affiliated hospitals, including our Texas hospitals, have expanded the community healthcare safety net by providing indigent healthcare services. Participation in indigent care affiliation agreements by our Texas hospitals has resulted in an increase in acute care revenue by the hospitals’ entitlement to supplemental Medicaid inpatient reimbursement. Under a five-year Medicaid waiver approved by CMS in 2011 and extended through December 31, 2017, Texas continues to receive supplemental Medicaid reimbursement while expanding its managed Medicaid programs.

Supplemental payment programs are being reviewed by certain other state agencies, and some states have made or may make waiver requests to CMS to replace their existing supplemental payment programs. These reviews and waiver requests will cause restructuring of such supplemental payment programs and could cause the payments to be reduced or eliminated.

 

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Managed Medicaid

Managed Medicaid programs represent arrangements in which states contract with one or more entities for patient enrollment, care management and claims adjudication. The states rarely give up program responsibilities for financing, eligibility criteria and core benefit plan design. Our hospitals contract directly with the designated entities, which usually are managed care organizations. These programs are state-specific.

As state governments seek to control the cost of their Medicaid programs, enrollment in managed Medicaid plans, including states in which we operate, has increased in recent years. For example, under the five-year Medicaid waiver approved by CMS in 2011 and extended through December 31, 2017, the Texas legislature and the Texas Health and Human Services Commission (“THHSC”) expanded Medicaid managed care enrollment in the state. The waiver allows Texas to expand its Medicaid managed care program while preserving hospital funding, provides incentive payments for healthcare improvements and directs more funding to hospitals that serve large numbers of uninsured patients. Texas is seeking a longer-term extension of the waiver and is working to develop a proposal for CMS that integrates its Delivery System Reform Incentive Payment pool into Medicaid managed care. There may be additional expansion of managed Medicaid plans in the states in which we operate, and economic conditions or budgetary pressures may cause reductions in premium payments to these plans.

Disproportionate share hospital payments

Besides making payments for services provided directly to beneficiaries, Medicare makes additional payments to hospitals that treat a disproportionately large number of low-income patients (Medicaid and Medicare patients eligible to receive Supplemental Security Income). DSH payments are determined annually based on certain statistical information required by the U.S. Department of Health and Human Services (the “Department”) and are calculated as a percentage addition to MS-DRG payments. The Health Reform Law provides for certain reductions to both the Medicare and Medicaid DSH payment systems.

Under the Health Reform Law, beginning in federal fiscal year 2014, Medicare DSH payments are reduced to 25% of the amount they would have been absent the law. The remaining 75% is effectively pooled, and this pool is reduced further each year by a formula that reflects reductions in the national level of uninsured who are under age 65. Thus, the greater the level of coverage for the previously uninsured, the more the Medicare DSH payment pool is reduced. Each hospital is paid, out of the reduced DSH payment pool, an amount allocated based upon its estimated cost of providing uncompensated care.

The federal government distributes federal Medicaid DSH funds to each state based on a statutory formula, and the states then distribute the DSH funding among hospitals that qualify based on state-specific criteria. The Health Reform Law provides for reductions to the Medicaid DSH hospital program in federal fiscal years 2016 through 2020. However, several laws have been enacted since the passage of the Health Reform Law that have adjusted the amounts of and timeline for the Medicaid DSH reductions. As a result, the reductions are set to occur in federal fiscal years 2018 through 2025 in the following amounts: 2018 ($2.0 billion); 2019 ($3.0 billion); 2020 ($4.0 billion); 2021 ($5.0 billion); 2022 ($6.0 billion); 2023 ($7.0 billion); 2024 ($8.0 billion); and 2025 ($8.0 billion). CMS is expected to allocate the cuts among the states based on the volume of Medicaid inpatients and levels of uncompensated care in each state. States largely retain the ability to manage the reduced allotments and to allocate these cuts among providers within the state. The majority of our Medicaid DSH is recognized by our Texas hospital operations.

Annual Cost Reports

All hospitals participating in the Medicare and Medicaid programs, whether paid on a reasonable cost basis or under a prospective payment system, must meet specific financial reporting requirements. Federal regulations require submission of annual cost reports identifying medical costs and expenses associated with the services provided by each hospital to Medicare beneficiaries and Medicaid recipients. These annual cost reports are subject to routine audits, which may cause adjustments to the amounts ultimately determined to be due to us under these reimbursement programs. The audit process may take several years to reach the final determination of allowable amounts under the programs. Providers also have the right of appeal, and it is common to contest issues raised in audits of prior years’ reports.

Cost reports filed by our facilities remain open for three years after the notice of program reimbursement date. If any of our facilities are found to have violated federal or state laws relating to preparing and filing of Medicare or Medicaid cost reports, whether prior to or after our ownership of these facilities, we and our facilities could be subject to substantial monetary fines, civil and criminal penalties and exclusion from participation in the Medicare and Medicaid programs.

Medicare Integrity Efforts

CMS contracts with third parties to promote the integrity of the Medicare program, including managed Medicare, through review of quality concerns and detection and correction of improper payments. QIOs are groups of physicians and other healthcare

 

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quality experts that work on behalf of CMS to ensure that Medicare pays only for goods and services that are reasonable and necessary and that are provided in the most appropriate setting. RACs conduct post-payment reviews of Medicare providers and suppliers by employing data analysis techniques to identify those Medicare claims most likely to contain overpayments, and are paid on a contingency fee basis. CMS reduced the number of claims that RACs may audit by limiting the volume of records that RACs may request from hospitals based on each provider’s claim denial rate for the previous year.

As required by the Health Reform Law, each state has established a RAC program to audit Medicaid claims or has sought an exemption from CMS. States may coordinate with Medicaid RACs regarding recoupment of overpayments and refer suspected fraud and abuse to appropriate law enforcement agencies. In addition, under the Medicaid Integrity Program, CMS employs private contractors, referred to as MICs, to perform reviews and post-payment audits of Medicaid claims and identify overpayments. The Health Reform Law increased federal funding for the Medicaid Integrity Program. Besides MICs, several other contractors and state Medicaid agencies have increased their review activities.

Currently, there are significant delays in the assignment of new Medicare appeals to administrative law judges. According to the Office of Medicare Hearings and Appeals, the average processing time in the third quarter of fiscal year 2016 was over two and a half years. To ease the backlog, CMS will make available an administrative settlement process for disputed claims, offering to pay 66% of the net allowable amount in exchange for a hospital’s withdrawal of all medical claims appealed. When CMS last made this process available in 2014, we accepted the settlement offer.

Managed Care

Managed care payors, including HMOs and PPOs, are organizations that provide insurance coverage and a network of healthcare providers to members for a fixed monthly premium. To control costs, these organizations typically contract with hospitals and other providers for discounted prices, review medical services to ensure that no unnecessary services are provided, increasingly implement quality standards, including refusing to pay for serious adverse events, and market providers within their networks to health plan members. A significant percentage of our overall payor mix is commercial managed care. We generally receive lower payments from commercial managed care payors than from traditional commercial/indemnity insurers for similar services.

Commercial Insurance

Our hospitals provide services to a decreasing number of individuals covered by traditional private healthcare insurance as managed care plans grow in prominence. Private insurance carriers make direct payments to hospitals or, sometimes, reimburse their policy holders, based upon negotiated discounts from the particular hospital’s established charges and the particular coverage provided in the insurance policy.

Commercial insurers are continuing efforts to limit the payments for hospital services by adopting discounted payment mechanisms, including prospective payment or diagnosis related group-based payment systems, for more inpatient and outpatient services. In addition, commercial insurers increasingly are implementing quality standards, including refusing to pay for serious adverse events, similar to Medicare. If these efforts succeed, hospitals may receive reduced levels of reimbursement.

Charity Care

In the ordinary course of business, we provide care without charge to patients financially unable to pay for the healthcare services they receive. Because we do not pursue collection of amounts determined to qualify as charity care, they are not reported in acute care revenue. We record revenue deductions for patient accounts that meet our guidelines for charity care. We provide charity care to patients with income levels below 200% of the federal poverty level (“FPL”). At all of our hospitals, a sliding scale of reduced rates is offered to all uninsured patients who are not covered through federal, state or private insurance, with incomes between 200% and 400% of the FPL.

Uninsured

In the ordinary course of business, we provide care to patients who do not have insurance coverage to pay for the healthcare services they receive, nor do they qualify for charity care, or other federal, state or county indigent care programs. These patients include those for whom we are required to provide treatment under the federal Emergency Medical Treatment and Labor Act (“EMTALA”), which imposes requirements upon physicians, hospitals and other facilities to provide certain emergency care regardless of a patient’s ability to pay for his or her care. We provide discounts for these patients to eliminate some of this financial burden. These patients often do not have the financial resources to fully reimburse our hospitals for the discounted services provided. While we typically pursue collection of these account balances, the patient’s lack of financial resources can cause reduced collection rates and increased bad debts.

 

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Accountable Care Organizations

Pursuant to the Health Reform Law, the Department established Medicare Shared Savings Programs (“MSSPs”), which seek to promote accountability and coordination of care through the creation of Medicare ACOs. The program allows certain providers, including hospitals, physicians and other designated professionals, to voluntarily form Medicare ACOs and work together along with other Medicare ACO participants to invest in infrastructure and redesign delivery processes to achieve high quality and efficient delivery of services. The program is intended to produce savings as a result of improved quality and operational efficiency. Medicare ACOs that achieve quality performance standards established by the Department will be eligible to share in a portion of the amounts saved by the Medicare program. As authorized by the Health Reform Law, certain waivers are available from fraud and abuse laws for Medicare ACOs. As of January 2015, CMS has approved over 400 to participate as Medicare ACOs. We have applied for Medicare ACO status in certain markets. We are also pursuing similar initiatives with commercial insurers, with a focus on building clinically integrated high performance provider networks intended to compete in an environment where commercial insurers increasingly are implementing pay for performance and value-based purchasing reimbursement models similar to those contemplated by the Health Reform Law.

Bundled Payment Pilot Programs

The Health Reform Law created the Center for Medicare and Medicaid Innovation (the “CMS Innovation Center”) with responsibility for establishing demonstration projects and other initiatives in order to identify, develop, test and encourage the adoption of new methods of delivering and paying for healthcare that create savings under the Medicare and Medicaid programs, while improving quality of care. One initiative announced by the CMS Innovation Center is the BPCI initiative, a five-year voluntary, national pilot program on payment bundling for Medicare services. Under the BPCI initiative, organizations may enter into payment arrangements that include financial and performance accountability for episodes of care, models that are intended to lead to higher quality, more coordinated care at a lower cost to the Medicare program.

Another bundled payment initiative of the CMS Innovation Center is the Comprehensive Care for Joint Replacement model, which began in April 2016. Hospitals located in markets selected by CMS, including three of our facilities, are required to participate in this alternative payment model for knee and hip replacements. Participating hospitals will be evaluated against quality standards and Medicare spending targets established by CMS for each episode of care. An episode of care begins with a patient’s hospital admission and includes all related care by the hospital and other providers within 90 days of discharge. Depending on whether overall CMS spending per episode exceeds or falls below the target and whether quality standards are met, hospitals may receive supplemental Medicare payments or owe repayments to CMS.

The Health Reform Law also provides for a bundled payment demonstration project for Medicaid services, but CMS has not yet implemented this project. The Department will select up to eight states to participate based on the potential to lower costs under the Medicaid program while improving care. State programs may target particular categories of beneficiaries, selected diagnoses or geographic regions of the state. The selected state programs will provide one payment for both hospital and physician services provided to Medicaid patients for certain episodes of inpatient care.

Premium, Service and Other Revenue

The following table provides the sources of Health Choice’s premium, service and other revenue by major product line:

 

     Year Ended September 30,  
     2016     2015     2014  

Medicaid and Medicaid MSO

     88.3     85.7     86.7

MAPD SNP

     9.8        13.0        13.1   

Other

     1.9        1.3        0.2   
  

 

 

   

 

 

   

 

 

 

Total

     100.0     100.0     100.0
  

 

 

   

 

 

   

 

 

 

 

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Premium revenue is generated through capitated contracts, under which Health Choice provides healthcare services to enrollees for fixed periodic payments, based upon negotiated per capita member rates, and certain supplemental payments from the state of Arizona’s Medicaid agency, or Arizona Health Care Cost Containment System (“AHCCCS”), the state of Utah’s Medicaid agency and CMS. All capitation payments received by Health Choice are recognized as revenue in the month that members are eligible for healthcare services.

Medicaid Health Plans

Health Choice’s primary source of revenue is derived from contracts with state Medicaid programs in Arizona and Utah to provide specified health services to qualified Medicaid enrollees through contracted healthcare providers.

Effective October 1, 2013, Health Choice entered into a contract with AHCCCS with an initial term of three years, and includes two one-year renewal options at the discretion of AHCCCS. The contract has been renewed through fiscal year 2017. The contract is terminable without cause on 90 days written notice or for cause upon written notice if the Company fails to comply with any term or condition of the contract or fails to take corrective action as required to comply with the terms of the contract. Additionally, AHCCCS can terminate the contract in the event of the unavailability of state or federal funding.

In our 2014 fiscal year, Health Choice’s enrollment grew significantly as a result of Arizona’s expansion of its Medicaid program under the Health Reform Law, which includes increased eligibility for adults, children and pregnant women, and the restoration of eligibility to childless adults that were previously eliminated. The expansion of the state’s Medicaid program, effective January 1, 2014, under the Health Reform Law is expected to result in the addition of approximately 350,000 people to its Medicaid rolls over the next few years. This increase in enrolled members and premium revenue followed a period of several years in which AHCCCS tightened Medicaid eligibility standards in Arizona and decreased capitation rates paid to managed Medicaid contractors, reflecting state government budgetary pressures and a struggling state economy. If additional changes to the Arizona Medicaid program are implemented, our revenue and earnings could be significantly impacted.

AHCCCS has implemented a tiered profit sharing plan on managed Medicaid plans, thereby limiting the amount of profit that may be retained by health plans serving the Medicaid population. These changes implemented by AHCCCS followed a movement by the agency to a risk-based or severity-adjusted payment methodology for all health plans, under which capitation rates for each health plan and geographic service area are adjusted annually based on the severity of treatment episodes experienced by each plan’s membership compared to the average over a specified 12-month period. AHCCCS’ changes in its payment structure have placed limits on Health Choice’s profitability.

Medicare Advantage Prescription Drug Special Needs Plan

Health Choice provides coverage as a MAPD SNP provider pursuant to a contract with CMS. The SNP allows Health Choice to offer Medicare and Part D drug benefit coverage for new and existing dual eligible members (i.e., those that are eligible for Medicare and Medicaid). The contract with CMS includes successive one-year renewal options at the discretion of CMS and is terminable without cause on 90 days written notice or for cause upon written notice if Health Choice fails to comply with any term or condition of the contract or fails to take corrective action as required to comply with the terms of the contract.

Healthcare Exchange Insurance Plan

Effective October 1, 2013, Health Choice began offering insurance plans on the Arizona state insurance exchange through Health Choice Insurance Company, a wholly-owned subsidiary of Health Choice. This enables us to enroll members in our Exchange plan as they move between the Arizona state insurance exchange and Medicaid eligibility under AHCCCS. Effective January 1, 2017, Health Choice will be exiting the Arizona marketplace exchange business.

Management and Administrative Services

Health Choice provides management and administrative services to its affiliated Health Choice Preferred ACO networks and through contracts with third party health plans. These services include member services, claims adjudication, provider network services, prior authorization, utilization management, clinical care coordination, case management, disease management and quality improvement programs. Revenue under these contracts are generated through performing these services in exchange for a contracted service fee and/or payments tied to incentives intended to produce high clinical quality and effective medical cost management.

 

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Accountable Care Networks

Health Choice has continued to lead our provider network development efforts in Arizona, Utah and other markets through its Health Choice Preferred ACO network operations. These networks serve as contracting vehicles that allow our hospitals and affiliated network physicians to enter into risk and other performance-based contracts with third-party payors.

Government Regulation and Other Factors

A framework of complex federal and state laws, rules and regulations governs the healthcare industry and, for many provisions, there is little history of regulatory or judicial interpretation upon which to rely. The Health Reform Law significantly increases this complexity. Because we operate in a heavily regulated industry subject to shifts in political and regulatory dynamics, we devote significant time and resources to regulatory compliance, including compliance with those laws and regulations described below.

Healthcare Reform

The Health Reform Law changed how healthcare services are covered, delivered and reimbursed through expanded coverage of uninsured individuals, reduced growth in Medicare program spending, reductions in Medicare and Medicaid DSH payments and the establishment of programs where reimbursement is tied to clinical integration and quality of care. In addition, the Health Reform Law reformed certain aspects of health insurance, continues to expand efforts to tie Medicare and Medicaid payments to performance and quality and contains provisions intended to strengthen fraud and abuse enforcement. As noted above, the 2016 federal elections increase the likelihood that legislation will be adopted that significantly modifies or repeals the Health Reform Law.

Expanded Coverage

Based on estimates issued in March 2016, the Health Reform Law is expected to expand coverage to 24 million previously uninsured individuals by 2026. This increased coverage is expected to occur through a combination of public program expansion and private sector health insurance and other reforms.

Medicaid expansion. The primary public program coverage expansion is occurring through changes in Medicaid, and to a lesser extent, expansion of CHIP. The most significant changes expand the categories of individuals eligible for Medicaid coverage and permit individuals with relatively higher incomes to qualify. Since January 1, 2014, the Health Reform Law requires all state Medicaid programs to provide, and the federal government to subsidize, Medicaid coverage to virtually all adults under 65 years old with incomes at or under 133% of the FPL. However, states may opt out of the expansion without losing existing federal Medicaid funding. For those states that expand Medicaid coverage, the Health Reform Law also requires those states to apply a “5% income disregard” to the Medicaid eligibility standard, so that Medicaid eligibility will effectively be extended to those with incomes up to 138% of the FPL. A number of state governors and legislatures, including in Texas, have chosen not to participate in the expanded Medicaid program at this time; however, these states could choose to implement the expansion at a later date.

As Medicaid is a joint federal and state program, the federal government provides states with “matching funds” in a defined percentage, known as the federal medical assistance percentage (“FMAP”). Beginning in 2014, states began receiving an enhanced FMAP for the individuals enrolled in Medicaid pursuant to the Medicaid expansion provisions of the Health Reform Law. The FMAP percentage is as follows: 95% for 2017; 94% in 2018; 93% in 2019; and 90% in 2020 and thereafter.

The Health Reform Law also provides that the federal government will subsidize states that create non-Medicaid plans for residents whose incomes are greater than 133% of the FPL but do not exceed 200% of the FPL. Approved state plans will be eligible to receive federal funding. The amount of that funding per individual will be equal to 95% of subsidies that would have been provided for that individual had he or she enrolled in a health plan offered through one of the Exchanges, as discussed below.

Historically, states often have attempted to reduce Medicaid spending by limiting benefits and tightening Medicaid eligibility requirements. For states that do not participate in Medicaid expansion, the maximum income level required for individuals and families to qualify for Medicaid varies widely from state to state. However, the Health Reform Law requires states to at least maintain the Medicaid eligibility standards established prior to the enactment of the law for children until October 1, 2019.

Private sector expansion. The expansion of health coverage through the private sector as a result of the Health Reform Law is occurring through requirements applicable to health insurers, employers and individuals. Each health plan must keep its annual non-medical costs lower than 15% of premium revenue for the group market and lower than 20% in the small group and individual markets or rebate its enrollees the amount spent in excess of the percentage. In addition, health insurers are not permitted to deny coverage to children based upon a pre-existing condition and must allow dependent care coverage for children up to 26 years old. Health insurance companies are prohibited from imposing annual coverage limits, dropping coverage, excluding persons based upon pre-existing conditions or denying coverage for any individual who is willing to pay the premiums for such coverage.

 

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Larger employers are required to provide health insurance benefits to their full-time employees. Employers with 50 or more employees that do not offer health insurance are subject to a penalty if an employee obtains government-subsidized coverage through an Exchange. The employer penalties range from approximately $2,000 to $3,000 per employee per year, subject to certain thresholds and conditions.

The Health Reform Law uses various means to induce individuals who do not have health insurance to obtain coverage. As of January 1, 2014, individuals are required to maintain health insurance for a minimum defined set of benefits or pay a tax penalty. The Internal Revenue Service (“IRS”), in consultation with the Department, is responsible for enforcing the tax penalty, although the Health Reform Law limits the availability of certain IRS enforcement mechanisms. In addition, for individuals and families below 400% of the FPL, the cost of obtaining health insurance will be subsidized by the federal government. Those with lower incomes are eligible to receive greater subsidies.

To facilitate the purchase of health insurance by individuals and small employers, the Health Reform Law mandates that each state establish or participate in an Exchange or default to a federally operated Exchange. Based on CBO estimates issued in March 2016, approximately 18 million nonelderly individuals will obtain their health insurance coverage through an Exchange by 2026. This amount will include individuals who were previously uninsured and individuals who have switched from their prior insurance coverage to a plan obtained through the Exchange. However, there is uncertainty regarding the stability of the Exchanges, as several health insurers have indicated they will reduce or cease participation in the 2017 plan year because of unsustainable financial losses.

The Health Reform Law requires that the Exchanges be designed to make the process of evaluating, comparing and acquiring coverage simple for consumers. For example, each state’s Exchange must maintain an internet website through which consumers may access health plan ratings that are assigned by the state based on quality and price, view governmental health program eligibility requirements and calculate the actual cost of health coverage. Health insurers participating in the Exchange must offer a set of minimum benefits to be defined by the Department and may offer more benefits. Health insurers must offer at least two, and up to five, levels of plans that vary by the percentage of medical expenses that must be paid by the enrollee. These levels are referred to as platinum, gold, silver, bronze and catastrophic plans, with gold and silver being the two mandatory levels of plans. Each level of plan must require the enrollee to share the following percentages of medical expenses up to the deductible/co-payment limit: platinum, 10%; gold, 20%; silver, 30%; bronze, 40%; and catastrophic, 100%. Health insurers may establish varying deductible/co-payment levels, up to the statutory maximum. The health insurers must cover 100% of the amount of medical expenses in excess of the deductible/co-payment limit. For example, an individual making 100% to 200% of the FPL will have co-payments and deductibles reduced to about one-third of the amount payable by those with the same plan with incomes at or above 400% of the FPL.

Payments for Hospitals and Ambulatory Surgery Centers

Payment Reductions and Quality-based Payments. The Health Reform Law provides for Medicare, Medicaid and other federal healthcare program spending reductions between 2010 and 2019 and a permanent annual productivity adjustment that began in 2012. In July 2012, the CBO estimated that, between 2013 and 2022, the Health Reform Law reductions would include $415 billion in Medicare fee-for-service market basket and productivity reimbursement reductions, the majority of which will come from hospitals. The CBO estimate included an additional $56 billion in reductions in Medicare and Medicaid DSH funding. The Health Reform Law also establishes or expands a number of programs designed to promote value-based purchasing and to link payments to quality and efficiency. These items are discussed above in the section entitled “Sources of Revenue—Acute Care Revenue.”

Accountable care organizations. Pursuant to the Health Reform Law, the Department established the MSSP to facilitate coordination and cooperation among providers to improve the quality of care for Medicare fee-for-service beneficiaries and reduce unnecessary costs. Eligible providers, hospitals, and suppliers may participate in the MSSP by creating or participating in an ACO. To drive improvements in quality and operational efficiency, the MSSP rewards ACOs that decrease their growth in healthcare costs while meeting performance standards, as discussed above in the section entitled “Sources of Revenue—Acute Care Revenue.”

Bundled payment pilot programs. The CMS Innovation Center, established under the Health Reform Law, is responsible for testing innovative payment and service delivery models to reduce Medicare and Medicaid program expenditures while preserving or enhancing quality of care. The BPCI initiative, discussed above in the section entitled “Sources of Revenue—Acute Care Revenue”, for example, is comprised of four models of care that link payments for the multiple services a beneficiary receives during an episode of care. Organizations enter into payment arrangements that include financial and performance accountability, which may lead to higher quality and more coordinated care at a lower cost to the Medicare program.

Medicare managed care. Under the Medicare Advantage (“MA”) program, the federal government contracts with private health plans to provide inpatient and outpatient benefits to beneficiaries who enroll in such plans. Effective in 2014, the Health Reform Law requires Medicare Advantage plans to keep annual administrative costs lower than 15% of annual premium revenue. The Health Reform Law provides for additional reductions to Medicare Advantage plans, as discussed above in the section entitled “Sources of Revenue—Acute Care Revenue.”

 

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Physician-owned hospitals. The Health Reform Law effectively prohibits the formation of physician-owned hospitals that participate in Medicare or Medicaid after December 31, 2010. While the Health Reform Law grandfathers existing physician-owned hospitals, including our facilities that have physician ownership, it does not allow these hospitals to increase the percentage of physician ownership and significantly restricts our ability to add beds, operating rooms and procedure rooms at such physician-owned facilities.

The Health Reform Law also imposes additional disclosure requirements on physician-owned hospitals. For example, a grandfathered physician-owned hospital is required to submit periodic reports listing each investor in the hospital, including all physician owners. In addition, grandfathered physician-owned hospitals must have procedures in place that require each referring physician owner to disclose to patients, with enough notice for the patient to make a meaningful decision regarding receipt of care, the physician’s ownership interest and, if applicable, any ownership interest held by the treating physician. A grandfathered physician-owned hospital also must disclose on its website and in any public advertising the fact that it has physician ownership. The Health Reform Law requires the Department to audit grandfathered physician-owned hospitals’ compliance with these requirements.

Program Integrity and Fraud and Abuse

The Health Reform Law changes healthcare fraud and abuse laws, provides additional enforcement tools to the government, increases cooperation between agencies by establishing mechanisms for sharing information and enhances criminal and administrative penalties for non-compliance. The Health Reform Law: (1) provides $350 million in increased federal funding over 10 years to fight healthcare fraud, waste and abuse; (2) expands the RAC program to include MA plans and Medicaid; (3) authorizes the Department, in consultation with the Office of the Inspector General (“OIG”), to suspend Medicare and Medicaid payments to a provider of services or a supplier pending an investigation of a credible allegation of fraud; (4) provides Medicare contractors with additional flexibility to conduct random prepayment reviews; and (5) tightens the requirements for returning overpayments made by governmental health programs and expands the federal False Claims Act (“FCA”) liability to include failure to report and return an overpayment within 60 days of identifying the overpayment or by the date a corresponding cost report is due, whichever is later.

Impact of Health Reform Law on Our Company

The expansion of health insurance coverage under the Health Reform Law may cause a material increase in the number of patients using our facilities who have either private or public program coverage. In addition, a disproportionately large percentage of the new Medicaid coverage is likely to be in states that have relatively low income eligibility requirements. Further, the Health Reform Law provides for a value-based purchasing program, the establishment of Medicare ACOs and bundled payment pilot programs, which will create possible sources of additional revenue.

It is difficult to predict the ongoing impact of the Health Reform Law, because of uncertainty surrounding several material factors, including:

 

    the potential that the Health Reform Law is repealed or significantly modified in light of the 2016 federal elections;

 

    how many states will implement the Medicaid expansion and under what terms;

 

    the possibility of enactment of additional federal or state healthcare reforms;

 

    uncertainty regarding new or pending court challenges to elements of the Health Reform Law;

 

    the success and financial sustainability of the Exchanges, which may be impacted by whether a sufficient number of payors participate.

 

    how many previously uninsured individuals will obtain coverage because of the Health Reform Law (based on the CBO March 2016 estimates, by 2026, the Health Reform Law will expand coverage to 24 million additional individuals);

 

    what percentage of the newly insured patients will be covered under the Medicaid program and what percentage will be covered by private health insurers;

 

    the extent to which states will enroll new Medicaid participants in managed care programs;

 

    the pace at which insurance coverage expands, including the pace of different types of coverage expansion;

 

    the change in the volume of inpatient and outpatient hospital services sought by and provided to previously uninsured individuals;

 

    the potential that adverse selection and high acuity levels associated with newly insured individuals may negatively impact the operations of Health Choice;

 

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    the rate paid to hospitals by private payors and state governments for newly covered individuals, and individuals with existing coverage, including those covered through health plans offered through the Exchanges and those covered under the Medicaid program;

 

    the effect of the value-based purchasing trends, such as bundled payments or coordination of care programs, on our hospitals’ revenue and the effects of other quality programs implemented;

 

    the percentage of individuals in the Exchanges who select high deductible or restricted network plans, since health insurers offering those kinds of products have traditionally sought to pay lower rates to hospitals;

 

    the extent to which employers will drop existing coverage of employees and their dependents, potentially resulting in those individuals purchasing coverage through the Exchange or enrolling in Medicaid;

 

    uncertainty regarding future EHR incentives;

 

    whether the net effect of the Health Reform Law, including the prohibition on excluding individuals based on pre-existing conditions, the requirement to keep medical costs lower than a specified percentage of premium revenue, other health insurance reforms and the annual fee applied to all health insurers, will put pressure on the profitability of health insurers, which might cause them to reduce payments to hospitals regarding both newly insured individuals and their existing business.

 

    the effect of future reductions in Medicare and Medicaid spending and reimbursement rates on the overall revenues we will generate from governmental healthcare programs;

 

    the size of the Health Reform Law’s annual productivity adjustment to the market basket in future years;

 

    the Medicare DSH reductions, and the allocation to our hospitals of the Medicaid DSH reductions;

 

    the potential losses in revenues resulting from the Health Reform Law’s quality initiatives;

 

    how successful ACOs will be at coordinating care and reducing costs; and

 

    whether our revenues from private supplemental Medicaid reimbursement programs will be adversely affected because there may be fewer indigent, non-Medicaid patients for whom we provide services under these programs.

Licensure, Certification and Accreditation

Healthcare facility construction and operation is subject to extensive government regulation at the federal, state and local levels. Under these regulations, hospitals must meet requirements to be certified as hospitals and qualified to participate in government programs, including the Medicare and Medicaid programs. The requirements imposed include those relating to the adequacy of medical care, equipment, personnel, operating policies and procedures, fire prevention, rate-setting and compliance with building codes and environmental protection laws. Our facilities also are subject to periodic inspection by governmental and other authorities to assure continued compliance with the standards necessary for licensing and accreditation. We believe that all of our operating healthcare facilities are properly licensed under state healthcare laws, but we cannot assure you that government agencies or other entities enforcing licensure requirements would find our facilities in compliance with such requirements. Failure to meet these requirements may result in loss of license or the ability to participate in government programs as well as civil and criminal penalties. All of our operating hospitals are certified under the Medicare program and are accredited by either Det Norske Veritas (“DNV”) or The Joint Commission, the effect of which is to permit the facilities to participate in the Medicare and Medicaid programs. If any facility loses its accreditation, the facility would be subject to state surveys, potentially be subject to increased scrutiny by CMS and likely lose payment from non-government payors. We intend to conduct our operations in compliance with current applicable federal, state, local and independent review body regulations and standards, but we cannot assure you that government agencies or other entities enforcing such requirements would find our facilities in compliance with such requirements. Licensure, certification, or accreditation requirements also may require notification or approval if certain transfers or changes in ownership or organization occur. Requirements for licensure, certification and accreditation are subject to change and, to remain qualified, we may need to change our facilities, equipment, personnel and services.

Utilization Review

Federal law contains numerous provisions designed to ensure that services rendered by hospitals to Medicare and Medicaid patients meet professionally recognized standards and are medically necessary and that claims for reimbursement are properly filed. These provisions require that a sampling of admissions of Medicare and Medicaid patients be reviewed by quality improvement organizations that analyze the appropriateness of Medicare and Medicaid patient admissions and discharges, quality of care, validity of diagnosis-related group classifications and appropriateness of cases of extraordinary length of stay or cost. Quality improvement organizations may deny payment for services provided, assess fines and recommend to the Department that a provider not in substantial compliance with the standards of the quality improvement organization be excluded from participation in the Medicare program. Most non-governmental managed care organizations also require utilization review.

 

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Federal and State Fraud and Abuse Provisions

Participation in any federal healthcare program, like Medicare, is regulated heavily by statute and regulation. If a hospital provider fails to substantially comply with the numerous conditions of participation in the Medicare or Medicaid program or performs specific prohibited acts, the hospital’s participation in the Medicare and Medicaid programs may be terminated or civil or criminal penalties may be imposed upon it under provisions of the Social Security Act and other statutes.

Among these statutes is a section of the Social Security Act, known as the federal anti-kickback statute. This law prohibits providers and others from soliciting, receiving, offering or paying, directly or indirectly, any remuneration intending to generate referrals or orders for services or items covered by a federal healthcare program. Courts have interpreted this law broadly and held that it violates the anti-kickback statute if just one purpose of the remuneration is to generate referrals, even if there are other lawful purposes. Knowledge of the law or intent to violate the law is not required to establish a violation of the anti-kickback statute.

The OIG has published safe harbor regulations that outline categories of activities deemed protected from prosecution under the anti-kickback statute. There are safe harbors for various arrangements and activities, including: investment interests, space rental, equipment rental, practitioner recruitment, personal services and management contracts, sale of practice, referral services, warranties, discounts, employees, group purchasing organizations, waiver of beneficiary co-insurance and deductible amounts, managed care arrangements, obstetrical malpractice insurance subsidies, investments in group practices, ambulatory surgery centers, and referral agreements for specialty services.

The fact that certain conduct or a certain business arrangement does not fall within a safe harbor does not automatically render the conduct or business arrangement illegal under the anti-kickback statute. The conduct or business arrangement, however, risks increased scrutiny by government enforcement authorities.

The OIG, among other regulatory agencies, identifies and engages in enforcement actions regarding fraud, abuse and waste. The OIG carries out this mission through a nationwide program of audits, investigations and inspections. To provide guidance to healthcare providers, the OIG has from time to time issued “fraud alerts” that, although they do not have the force of law, identify features of a transaction that may indicate that the transaction could violate the anti-kickback statute or other federal healthcare laws. The OIG has identified several incentive arrangements as potential violations, including:

 

    payment of any incentive by the hospital when a physician refers a patient to the hospital;

 

    use of free or significantly discounted office space or equipment for physicians in facilities usually located close to the hospital;

 

    provision of free or significantly discounted billing, nursing, or other staff services;

 

    free training for a physician’s office staff, including management and laboratory techniques;

 

    guarantees that provide that, if the physician’s income fails to reach a predetermined level, the hospital will pay any portion of the remainder;

 

    low-interest or interest-free loans, or loans that may be forgiven if a physician refers patients to the hospital;

 

    payment of the costs of a physician’s travel and expenses for conferences or a physician’s continuing education courses;

 

    coverage on the hospital’s group health insurance plans at an inappropriately low cost to the physician;

 

    rental of space in physician offices, at other than fair market value terms, by persons or entities to which physicians refer;

 

    payment for services that require few substantive duties by the physician, or payment for services over the fair market value of the services rendered;

 

    “gainsharing,” the practice of giving physicians a share of any reduction in a hospital’s costs for patient care attributable in part to the physician’s efforts; or

 

    physician-owned entities (often referred to as physician-owned distributorships or PODs) that derive revenue from selling, or arranging for the sale of implantable medical devices ordered by their physician-owners for use on procedures that physician-owners perform on their own patients at hospitals or ambulatory surgery centers.

Besides issuing fraud alerts, the OIG from time to time issues compliance program guidance for certain types of healthcare providers. In its hospital compliance guidance, the OIG identifies areas of potential risk of liability under federal fraud and abuse statutes and regulations. These areas of risk include compensation arrangements with physicians, recruitment arrangements with physicians and joint venture relationships with physicians. The OIG recommends structuring arrangements to fit squarely within a safe harbor.

 

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We have a variety of financial relationships with physicians who refer patients to our hospitals. Physicians have an ownership interest in nine of our full service acute care hospitals. We also have other joint venture relationships with physicians and contracts with physicians providing for a variety of financial arrangements, including employment contracts, leases and professional service agreements. We provide financial incentives to recruit physicians to relocate to communities served by our hospitals, including minimum cash collections guarantees and forgiveness of repayment obligations. Although we have established policies and procedures to help ensure that our arrangements with physicians comply with current law and interpretations, we cannot assure you that regulatory authorities that enforce these laws will not determine that some violate the anti-kickback statute or other applicable laws. Violation of the anti-kickback statute is a felony, and such a determination could subject us to liabilities under the Social Security Act, including criminal penalties of imprisonment or fines, civil penalties up to $73,588 per violation, damages up to three times the total improper payment to the referral source and exclusion from participation in Medicare, Medicaid or other federal healthcare programs, any of which could have a material adverse effect on our business, financial condition or results of operations.

The Social Security Act also imposes criminal and civil penalties for submitting false claims to Medicare and Medicaid. False claims include, but are not limited to, billing for services not rendered, misrepresenting actual services rendered to obtain higher reimbursement and cost report fraud. Also prohibited is the payment of inducements to Medicare or Medicaid beneficiaries to influence those beneficiaries to order or receive services from a particular provider or practitioner. Further, the Social Security Act contains civil penalties for conduct including improper coding and billing for unnecessary goods and services. Civil penalties may also be imposed for failing to report and return an overpayment within 60 days of identifying the overpayment or by the date a corresponding cost report is due, whichever is later. To avoid liability, providers must carefully and accurately code claims for reimbursement, and accurately prepare cost reports.

Some of these provisions, including the federal Civil Monetary Penalties Law, require a lower burden of proof than other fraud and abuse laws, including the federal anti-kickback statute. Civil monetary penalties of up to $73,588 per act may be imposed under the federal Civil Monetary Penalty Law, in addition to penalties of up to three times the remuneration offered, paid, solicited or received. Beginning in 2017, the civil monetary penalties will be updated annually based on changes to the consumer price index. In addition, a violator may be subject to exclusion from federal and state healthcare programs. Exclusion may extend to any investors, officers and managing employees associated with business entities that have committed healthcare fraud. Federal and state governments increasingly use the federal Civil Monetary Penalty Law, especially where they believe they cannot meet the higher burden of proof requirements under the federal anti-kickback statute. Providers are also subject to several criminal provisions for healthcare fraud offenses that apply to all health benefit programs.

The Social Security Act also includes a provision commonly known as the “Stark Law.” This law prohibits physicians from referring Medicare patients to entities with which they or any of their immediate family members have a financial relationship for the provision of certain designated health services that are reimbursable by Medicare or Medicaid, including inpatient and outpatient hospital services. The law also prohibits the entity from billing the Medicare program for any items or services that stem from a prohibited referral and requires the entity to refund amounts received for items or services provided pursuant to the prohibited referral on a timely basis. Failure to refund amounts received as a result of a prohibited referral on a timely basis may constitute a false or fraudulent claim and may result in civil penalties and additional penalties under the FCA. Sanctions for violating the Stark Law also include denial of payment (and obligation to repay amounts improperly received) and civil monetary penalties up to $23,863 per item or service improperly billed and exclusion from the federal healthcare programs. The statute also provides for a penalty of up to $159,089 for a scheme intended to circumvent the Stark Law prohibitions. Beginning in 2017, these civil monetary penalties will be updated annually based on changes to the consumer price index. There are several exceptions to the Stark Law, including an exception for a physician’s ownership interest in an entire hospital, although the Health Reform Law significantly restricts this exception. There also are exceptions for many of the customary financial arrangements between physicians and providers, including employment contracts, leases, professional services agreements and recruitment agreements. Unlike safe harbors under the anti-kickback statute, with which compliance is voluntary, an arrangement must comply with every requirement of the Stark Law exception or the arrangement violates the Stark Law. Further, intent does not have to be proven to establish a violation of the Stark Law.

CMS has issued final regulations implementing the Stark Law that help clarify the exceptions to the Stark Law, it is unclear how the government will interpret many for enforcement purposes. We cannot assure you that the arrangements entered into by us and our hospitals will be found to comply with the Stark Law, as it ultimately may be implemented or interpreted.

Historically, the Stark Law has contained an exception, commonly referred to as the “whole-hospital” exception, allowing physicians to own an interest in an entire hospital, as opposed to an interest in a hospital department. However, the Health Reform Law significantly narrows the Stark Law’s whole-hospital exception. Specifically, the whole-hospital exception is available only to hospitals that had physician ownership in place as of March 23, 2010, and a Medicare provider agreement effective as of

 

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December 31, 2010. The Health Reform Law and implementing regulations issued by CMS prevent the formation of new physician-owned hospitals that participate in Medicare or Medicaid. While the amended whole-hospital exception grandfathers certain existing physician-owned hospitals, including nine of ours, it prohibits a grandfathered hospital from increasing its aggregate percentage of physician ownership beyond the aggregate level in place as of March 23, 2010. In 2015, CMS issued a final rule that changes the methodology for calculating the baseline level of ownership effective January 1, 2017. A grandfathered physician-owned hospital may not increase its aggregate number of operating rooms, procedure rooms, and beds for which it is licensed beyond the number as of March 23, 2010, subject to limited exceptions. A grandfathered physician-owned hospital must comply with several additional requirements, including not conditioning any physician ownership directly or indirectly on the owner making or influencing referrals, not offering any ownership interests to physician owners on more favorable terms than those offered to non-physicians and not providing any guarantee to physician owners to purchase other business interests related to the hospital. Further, a grandfathered hospital cannot have been converted from an ambulatory surgery center to a hospital.

The whole-hospital exception, as amended, also contains additional disclosure requirements. For example, a grandfathered physician-owned hospital is required to submit periodic reports listing each investor in the hospital, including all physician owners. Although CMS has delayed the collection of annual reporting data until further notice, the agency recently released a new form for the annual disclosures. In addition, grandfathered physician-owned hospitals must have procedures in place that require each referring physician owner to disclose to patients, with enough notice for the patient to make a meaningful decision regarding receipt of care, the physician’s ownership interest and, if applicable, any ownership interest held by the treating physician. A grandfathered physician-owned hospital also must disclose on its website and in any public advertising the fact that it has physician ownership. The Health Reform Law requires the Department to audit grandfathered physician-owned hospitals’ compliance with these requirements.

Besides the restrictions and disclosure requirements applicable to physician-owned hospitals in the Health Reform Law, CMS regulations require physician-owned hospitals and their physician owners to disclose certain ownership information to patients. Physician-owned hospitals that receive referrals from physician owners must disclose in writing to patients that such hospitals are owned by physicians and that patients may receive a list of the hospitals’ physician investors upon request. A physician-owned hospital must require all physician owners who are members of the hospital’s medical staff to agree, as a condition of continued medical staff membership or admitting privileges, to disclose in writing to all patients whom they refer to the hospital their (or an immediate family member’s) ownership interest in the hospital. A hospital is physician-owned if any physician, or an immediate family member of a physician, holds debt, stock or other types of investment in the hospital or in any owner of the hospital, excluding physician ownership through publicly traded securities that meet certain conditions. If a hospital fails to comply with these regulations, the hospital could lose its Medicare provider agreement and be prevented from participating in Medicare.

Evolving interpretations of current, or the adoption of new, federal or state laws or regulations could affect many of the arrangements entered into by each of our hospitals. In addition, law enforcement authorities, including the OIG, the courts and Congress are increasing scrutiny of arrangements between healthcare providers and potential referral sources to ensure that the arrangements are not designed as a mechanism to improperly pay for patient referrals or other business. Investigators also have demonstrated a willingness to look behind the formalities of a business transaction to determine the underlying purpose of payments between healthcare providers and potential referral sources.

Many of the states in which we operate also have adopted laws that prohibit payments to physicians for referrals similar to the federal anti-kickback statute or that otherwise prohibit fraud and abuse activities. Many states also have passed self-referral legislation similar to the Stark Law, prohibiting the referral of patients to entities with which the physician has a financial relationship. Often these state laws are broad in scope and may apply regardless of the source of payment for care. These statutes typically provide for criminal and civil penalties, and loss of licensure. Little precedent exists for the interpretation or enforcement of these state laws.

Our operations could be adversely affected by the failure of our arrangements to comply with the anti-kickback statute, the Stark Law, billing laws and regulations, current state laws or other legislation or regulations in these areas adopted. We cannot predict whether other legislation or regulations at the federal or state level if any will be adopted, what form such legislation or regulations may take or how they may affect our operations. We are continuing to enter into new financial arrangements with physicians and other providers in a manner structured to comply materially with these laws. We cannot assure you, however, that governmental officials responsible for enforcing these laws or whistleblowers will not assert that we violate them or that such statutes or regulations ultimately will be interpreted by the courts in a manner consistent with our interpretation.

The Federal False Claims Act and Similar State Laws

Another trend affecting the healthcare industry is the increased use of the FCA and actions being brought by individuals on the government’s behalf under the FCA’s “qui tam” or whistleblower provisions. Whistleblower provisions allow private individuals to sue on behalf of the government alleging that the defendant has defrauded the federal government. For example, the FCA is implicated by the submission of false claims to Medicare, Medicaid and other federal healthcare programs. The FCA also applies to payments

 

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involving federal funds in connection with the Exchanges. If the government intervenes and prevails, the party filing the initial complaint may share in any settlement or judgment. If the government does not intervene, the whistleblower plaintiff may pursue the action independently and may receive a larger share of any settlement or judgment. When a private party brings a qui tam action under the FCA, the defendant will not know the lawsuit until the government commences its own investigation or makes a determination whether it will intervene. Further, every entity that receives at least $5 million annually in Medicaid payments must have written policies for all employees, contractors or agents, providing detailed information about false claims, false statements and whistleblower protections under certain federal laws, including the FCA, and similar state laws.

When a defendant is determined by a court of law to be liable under the FCA, the defendant must pay three times the actual damages sustained by the government, plus mandatory civil penalties of between $10,781 and $21,563 for each separate false claim. These civil monetary penalties will increase annually, beginning in 2017, based on updates to the consumer price index. Settlements entered into prior to litigation usually involve a less severe calculation of damages. There are many potential bases for liability under the FCA, including knowingly and improperly avoiding repayment of an overpayment received from the government and the knowing failure to report and return an overpayment within 60 days of identifying the overpayment or by the date a corresponding cost report is due, whichever is later. Overpayments are deemed to have been “identified” when a provider has, or should have, through reasonable diligence, determined that a reimbursement overpayment was received and has quantified such overpayment. Liability often arises when an entity knowingly submits a false claim for reimbursement to the federal government. The FCA broadly defines the term “knowingly.” Although simple negligence will not give rise to liability under the FCA, submitting a claim with reckless disregard to its truth or falsity can constitute “knowingly” submitting a false claim and result in liability. The Health Reform Law provides that submission of a claim for an item or service generated in violation of the anti-kickback statute constitutes a false or fraudulent claim under the FCA. Sometimes, whistleblowers, the federal government and courts have claimed that providers that allegedly have violated other statutes, such as the Stark Law, have submitted false claims under the FCA.

Several states, including states in which we operate, have adopted their own false claims provisions and their own whistleblower provisions whereby a private party may file a civil lawsuit in state court. The Deficit Reduction Act of 2005 (“DEFRA”) creates an incentive for states to enact false claims laws that are comparable to the FCA. From time to time, companies in the healthcare industry, including ours, may be subject to actions under the FCA or similar state laws.

Corporate Practice of Medicine/Fee Splitting

Certain of the states in which we operate have laws that prohibit unlicensed persons or business entities, including corporations, from employing physicians or laws that prohibit certain direct or indirect payments or fee-splitting arrangements between physicians and unlicensed persons or business entities. Possible sanctions for violations of these restrictions include loss of a physician’s license, civil and criminal penalties and rescission of business arrangements that may violate these restrictions. These statutes vary from state to state, are often vague and seldom have been interpreted by the courts or regulatory agencies. Although we exercise care to structure our arrangements with healthcare providers to comply with relevant state laws, we cannot assure you that governmental officials responsible for enforcing these laws will not assert that we, or transactions in which we are involved, violate such laws, or that such laws ultimately will be interpreted by the courts in a manner consistent with our interpretations.

Health Insurance Portability and Accountability Act (“HIPAA”) Administrative Simplification and Privacy and Security Requirements

The HIPAA administrative simplification provisions are intended to encourage electronic commerce in the healthcare industry. These provisions require the use of uniform electronic data transmission standards for healthcare claims and payment transactions submitted or received electronically. HIPAA also requires that each provider use a National Provider Identifier. In addition, the Health Reform Law requires the Department to adopt standards for additional electronic transactions and to establish operating rules to promote uniformity in the implementation of each standardized electronic transaction. The Department has established operating rules for healthcare electronic funds transfers and remittance advice transactions. Further, all healthcare providers and plans covered by HIPAA were required to transition, by October 1, 2015, to updated standard code sets to report certain diagnoses and procedures, known as ICD-10 code sets.

As required by HIPAA, the Department has issued privacy and security regulations that extensively regulate the use and disclosure of individually identifiable health information (known as protected health information or “PHI”) and require covered entities, including healthcare providers, to implement administrative, physical and technical safeguards to protect the security of PHI. Entities that handle PHI on behalf of covered entities (known as “business associates”) or of other business associates must comply with most provisions of the HIPAA privacy and security regulations and are subject to civil and criminal penalties for violations to these regulations. A covered entity may be subject to penalties as a result of a business associate violating HIPAA, if the business associate is found to be an agent of the covered entity.

Covered entities must report breaches of unsecured PHI to affected individuals without unreasonable delay, but not to exceed 60 days of discovery of the breach by the covered entity or its agents. Notification must also be made to the Department and, in certain situations involving large breaches, to the media. All non-permitted uses or disclosures of unsecured PHI are presumed to be breaches unless the covered entity or business associate establishes that there is a low probability the information has been compromised.

 

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The privacy and security regulations have and will continue to impose significant costs on our facilities in order to comply with these standards. Violations of the HIPAA privacy and security regulations may result in civil and criminal penalties. Further, the Department is required to perform compliance audits, which may result in increased enforcement activity. In addition, state attorneys general may bring civil actions seeking either injunction or damages in response to violations of HIPAA privacy and security regulations that threaten the privacy of state residents. The Department is required to impose penalties for violations resulting from willful neglect.

There are numerous other laws and legislative and regulatory initiatives at the federal and state levels addressing privacy and security concerns. Our facilities remain subject to any federal or state privacy-related laws that are more restrictive than the privacy regulations issued under HIPAA. These laws vary, may impose additional obligations and could impose additional penalties. For example, various state laws and regulations may require us to notify affected individuals in the event of a data breach involving individually identifiable information (even if no health-related information is involved). In addition, the Federal Trade Commission (“FTC”) uses its consumer protection authority to initiate enforcement actions in response to data breaches.

The Emergency Medical Treatment and Labor Act

The federal EMTALA was adopted by Congress in response to reports of a widespread hospital emergency room practice of “patient dumping.” At the time of the enactment, patient dumping was considered to have occurred when a hospital capable of providing the needed care sent a patient to another facility or turned the patient away based on such patient’s inability to pay for his or her care. The law imposes requirements upon physicians, hospitals and other facilities that provide emergency medical services. Such requirements pertain to what care must be provided to anyone who comes to such facilities seeking care before they may be transferred to another facility or otherwise denied care. The government broadly interprets the law to cover situations in which individuals do not present to a hospital’s emergency department, but present for emergency examination or treatment to the hospital’s campus or to a hospital-based clinic that treats emergency medical conditions or are transported in a hospital-owned ambulance, subject to certain exceptions. At least one court has interpreted the law also to apply to a hospital notified of a patient’s pending arrival in a non-hospital owned ambulance. Sanctions for violations of this statute include termination of a hospital’s Medicare provider agreement, exclusion of a physician from participation in Medicare and Medicaid programs and civil monetary penalties. In addition, the law creates private civil remedies that enable an individual who suffers personal harm because of a violation of the law, and a medical facility that suffers a financial loss because of another participating hospital’s violation of the law, to sue the offending hospital for damages and equitable relief. We can give no assurance that governmental officials responsible for enforcing the law, individuals or other medical facilities will not assert from time to time that our facilities violate this statute.

Conversion Legislation

Many states have enacted or are considering enacting laws affecting the conversion or sale of not-for-profit hospitals. These laws include provisions relating to attorney general approval, advance notification and community involvement. In addition, attorneys general in states without conversion legislation may exercise authority over these transactions based upon existing law. In many states, there has been an increased interest in the oversight of not-for-profit conversions. The adoption of conversion legislation and the increased review of not-for-profit hospital conversions may increase the cost and difficulty or prevent the completion of transactions with or acquisitions of not-for-profit organizations in various states.

Healthcare Industry Investigations

Significant media and public attention has focused in recent years on the hospital industry, which has led to increasing scrutiny of the industry by government investigators and private parties pursuing civil lawsuits. In addition, government agencies and their agents, including MACs, may conduct audits of our healthcare operations. Private payors may conduct similar audits, and we also perform internal audits and monitoring.

Our substantial Medicare, Medicaid and other governmental billings may result in heightened scrutiny of our operations. We continue to monitor all aspects of our business and have developed a compliance program to assist us in gaining comfort that our business practices follow both legal principles and current industry standards. However, because the law is complex and constantly evolving, we cannot assure you that government investigations will not result in interpretations inconsistent with industry practices, including ours. In public statements surrounding current investigations, governmental authorities have taken positions on several issues, including some for which little official interpretation previously has been available, that appear to be inconsistent with practices that have been common within the industry and that previously have not been challenged in this manner. In some cases, government investigations that have in the past been conducted under the civil provisions of federal law may now be conducted as criminal investigations.

 

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Federal and state government agencies have increased their focus on and coordination of civil and criminal enforcement efforts throughout the healthcare industry. The Health Reform Law allocates $350 million of additional federal funding through 2020 to fight healthcare fraud, waste and abuse. The OIG and the United States Department of Justice (“DOJ”) have, from time to time, established national enforcement initiatives, focusing on specific providers, billing practices, or other suspected areas of abuse. Many current healthcare investigations are based on national initiatives in which federal agencies target an entire segment of the healthcare industry. In addition to national enforcement initiatives, federal and state investigations have addressed to several issues associated with healthcare operations, including: hospital charges and collection practices for uninsured and indigent patients; cost reporting and billing practices; hospitals with high Medicare outlier payments; recruitment arrangements with physicians; and financial arrangements with referral sources. The federal government has indicated that it plans to expand its use of civil monetary penalties and Medicare program exclusions to focus on those in the healthcare industry who accept kickbacks or present false claims, in addition to the federal government’s continuing efforts to focus on the companies that offer or pay kickbacks.

Prior to our acquisition, several of our hospitals were contacted in relation to certain government investigations targeted at an entire segment of the healthcare industry. Although we claim that, under the acquisition agreements, the prior owners of these hospitals retained any liability resulting from these government investigations, we cannot assure you that the prior owners’ resolution or failure to resolve these matters, if any resolution was deemed necessary, will not have a material adverse effect on our operations.

Certificates of Need

In some states, the construction of new facilities, acquisition of existing facilities or addition of new beds or services might have to be reviewed by state regulatory agencies under a certificate of need program. Certificate of need laws require state agency determination of public need and approval prior to the addition of beds or services or other capital expenditures. Failure to obtain necessary state approval can cause the inability to expand facilities, add services and complete an acquisition or change ownership. Further, violation may cause the imposition of civil sanctions or the revocation of a facility’s license. We currently do not operate any of our hospital operations in any state that we believe has materially restrictive certificate of need laws.

Insurance Industry Regulations

The federal and state governments in the United States continue to enact and seriously consider many broad-based legislative and regulatory proposals that could materially impact various aspects of our business.

The Health Reform Law

The Health Reform Law mandates broad changes affecting insured and self-insured health benefit plans that impact our current business model, including our relationship with current and future customers, producers and healthcare providers, products, services, processes and technology. Because individuals seeking to purchase health insurance coverage on the exchanges are guaranteed to be issued a policy, the Health Reform Law provides three programs designed to reduce the risk for participating health insurance companies:

 

    a three-year (2014-2016) reinsurance program for non-grandfathered individual business sold either on or off the public exchanges that began in 2014. This program is designed to provide reimbursement for high cost individual customers and will be funded by the per-customer reinsurance fee assessed against insurers and self-insured group health plans;

 

    a three-year (2014-2016) risk corridor program put in place to limit insurer gains and losses and protect against inaccurate rate setting at the outset of the new program; and

 

    a permanent risk adjustment program that will transfer funds from lower risk to higher risk plans based on the relative health risk scores of plan participants.

We have implemented the provisions of the Health Reform Law that are currently in effect and we continue our implementation planning for those provisions that take effect in the future. Management continues to closely monitor the implementation of the Health Reform Law, and intends to continue to closely monitor the potential impacts of any legislative efforts to significantly modify or repeal the Health Reform Law following the 2016 federal elections, and is actively engaged with regulators and policymakers with respect to rule-making.

Health Choice Considerations

Health Choice is subject to state and federal laws and regulations, and CMS, AHCCCS and the state Medicaid agency in Utah may audit Health Choice to determine the Plan’s compliance with such standards. Health Choice must file periodic reports demonstrating satisfaction of certain financial viability standards with CMS, the Utah Department of Insurance, the National Association of Insurance Commissioners (“NAIC”), the state Medicaid agency in Utah and AHCCCS. Health Choice must provide its enrollees with certain mandated benefits and must meet certain quality assurance and improvement requirements. Health Choice must also comply with the electronic transactions regulations and privacy and security standards of HIPAA.

 

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The federal anti-kickback statute prohibits the payment, solicitation, offering or receipt of any form of remuneration in return for the referral of federal healthcare program patients or any item or service reimbursed, in whole or in part, by any federal healthcare program. Similar anti-kickback statutes have been adopted in Arizona and Utah, which apply regardless of the source of reimbursement. The Department has adopted safe harbor regulations specifying the following relationships and activities deemed not to violate the federal anti-kickback statute that specifically relate to managed care:

 

    waivers by HMOs of Medicare and Medicaid beneficiaries’ obligation to pay cost-sharing amounts or to provide other incentives to attract Medicare and Medicaid enrollees;

 

    certain discounts offered to prepaid health plans by contracting providers;

 

    certain price reductions offered to eligible managed care organizations; and

 

    certain price reductions offered by contractors with substantial financial risk to managed care organizations.

We believe the incentives offered by Health Choice to its Medicaid and Medicare enrollees and the discounts it receives from contracting healthcare providers satisfy the safe harbor regulations. However, failure to satisfy each criterion of the safe harbor does not mean that the arrangement constitutes a violation of the law; rather the safe harbor regulations provide that the arrangement must be analyzed on the basis of its facts and circumstances. We believe that Health Choice’s arrangements comply materially with the federal anti-kickback statute and similar Arizona and Utah statutes.

Licensing

Our risk platform and third-party payor subsidiaries must be licensed by the jurisdictions in which they conduct business. These subsidiaries are subject to numerous state, federal and international regulations related to their business operations, including, but not limited to:

 

    the form and content of customer contracts including benefit mandates (including special requirements for small groups);

 

    premium rates and medical loss ratios;

 

    the content of agreements with participating providers of covered services;

 

    producer appointment and compensation;

 

    claims processing and appeals;

 

    underwriting practices;

 

    reinsurance arrangements;

 

    unfair trade and claim practices;

 

    protecting the privacy and confidentiality of the information received from customers;

 

    risk sharing arrangements with providers;

 

    reimbursement or payment levels for Medicare services;

 

    advertising; and

 

    the operation of consumer-directed plans (including health savings accounts, health reimbursement accounts, flexible spending accounts and debit cards).

Our operations, accounts and other books and records are subject to examination at regular intervals by regulatory agencies, including state insurance and health and welfare departments, state boards of pharmacy and CMS to assess compliance with applicable laws and regulations.

Solvency and Capital Requirements

Many states have adopted some form of the NAIC model solvency-related laws and risk-based capital rules (“RBC rules”) for life and health insurance companies. The RBC rules recommend a minimum level of capital depending on the types and quality of investments held, the types of business written and the types of liabilities incurred. If the ratio of the insurer’s adjusted surplus to its risk-based capital falls below statutory required minimums, the insurer could be subject to regulatory actions ranging from increased scrutiny to conservatorship.

 

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Marketing, Advertising and Products

In most states, our HMO subsidiaries are required to certify compliance with applicable advertising regulations on an annual basis. Our HMO subsidiaries are also required in most states to file and secure regulatory approval of products prior to the marketing, advertising, and sale of such products.

Medicare and Medicaid Regulations

Several of our subsidiaries engage in businesses that are subject to federal (and state) Medicare and Medicaid regulations.

Our right to obtain payment (and the determination of the amount of such payments), enroll and retain members and expand into new service areas is subject to compliance with CMS’ and state Medicaid administrators’ numerous and complex regulations and requirements that are frequently modified and subject to administrative discretion. The marketing and sales activities (including those of third-party brokers and agents) are also heavily regulated by CMS and other governmental agencies, including applicable state departments of insurance. We expect to continue to allocate significant resources to our compliance, ethics and fraud, waste and abuse monitoring programs to comply with the laws and regulations governing the Medicare and Medicaid programs.

Health Insurance Portability and Accountability Act Regulations

HIPAA imposes requirements on health insurers, HMOs, health plans, healthcare providers and clearinghouses. Health insurers and HMOs are further subject to regulations related to guaranteed issuance (for groups with 50 or fewer lives), guaranteed renewal, and portability of health insurance.

HIPAA also imposes minimum standards for the privacy and security of PHI. HIPAA’s privacy and security requirements were expanded by the Health Information Technology for Economic and Clinical Health Act (“HITECH”), which enhanced penalties for HIPAA violations and requires regulated entities to provide notification to various parties in the event of a breach of unsecured PHI. Regulations pursuant to HITECH continue to be promulgated and are monitored and implemented as they are finalized.

Holding Company Laws

Our managed care entities are subject to state laws regulating subsidiaries of insurance holding companies. Under such laws, certain dividends, distributions and other transactions between a managed care subsidiary and its affiliates may require notification to, or approval by, one or more state insurance commissioners.

Environmental Matters

We are subject to various federal, state and local environmental laws and regulations, including those relating to the protection of human health and the environment. The principal environmental requirements applicable to our operations relate to:

 

    the proper handling and disposal of solid waste, medical and pharmaceutical waste, hazardous waste, universal waste and low-level radioactive medical waste;

 

    the proper use, storage and handling of mercury, radioactive materials and other hazardous materials;

 

    registration and licensing of radiological equipment;

 

    underground and above-ground storage tanks;

 

    management of hydraulic fluid or oil associated with elevators, chiller units or other equipment;

 

    management of asbestos-containing materials or lead-based paint present or likely to be present at some locations;

 

    air emission permits and standards for boilers or other equipment; and

 

    wastewater discharge permits or requirements.

We do not expect our obligations under these or other applicable environmental laws and requirements to have a material effect on us. In our operations, we also may identify other conditions at our facilities, such as water intrusion or the presence of mold or fungus, which warrant action, and we can incur additional costs to address those conditions. Under various environmental laws, we

 

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also may be required to investigate, clean up or contribute to the cost of cleaning up substances or wastes that have been released into the environment either at properties owned or operated by us or our predecessors or at other properties to which substances or wastes from our operations were sent for off-site treatment or disposal. These obligations may be imposed without regard to fault, and liability for environmental remediation can be substantial. While we cannot predict whether or to what extent we might be held responsible for such cleanup costs in the future, as of the date of this Report, we have not identified any environmental cleanup costs or liabilities that would be expected to have a material effect on us.

Professional and General Liability Insurance

As is typical in the healthcare industry, we are subject to claims and legal actions by patients in the ordinary course of business. To cover these claims, we maintain professional malpractice liability insurance and general liability insurance in amounts we believe to be sufficient for our operations, including our employed physicians, although some claims may exceed the coverage in effect. We also maintain umbrella coverage.

For our fiscal year 2016, our self-insured retention for professional and general liability coverage remains unchanged at $7.0 million for the first claim and $5.0 million for each additional claim, with an excess aggregate limit of $55.0 million, and maximum coverage under our insurance policies of $75.0 million. Our self-insurance reserves for estimated claims incurred but not yet reported is based upon estimates determined by third-party actuaries. Funding for the self-insured retention of such claims is derived from operating cash flows. We cannot assure you this insurance will continue to be available at reasonable prices that will allow us to maintain adequate levels of coverage. We also cannot assure you that our cash flow will be adequate to provide for professional and general liability claims.

Our Information Systems

We use a common information systems platform across all of our hospitals. In October 2015, we entered into an agreement with Cerner Corporation to implement an integrated EHR and revenue cycle system across our acute care operations. We expect to make significant investments in this new system through our 2019 fiscal year, as it is implemented across our operations. We currently use McKesson’s clinical, patient accounting, laboratory, radiology and decision support software and Lawson’s financial application and enterprise resource planning software. We use other vendors for specialized information systems needs for our decision support, emergency and radiology departments.

Our information systems are essential to the following areas of our business operations, among others:

 

    patient accounting, including billing and collection of net patient revenue;

 

    financial, accounting, reporting and payroll;

 

    coding and compliance;

 

    laboratory, radiology and pharmacy systems;

 

    EHRs;

 

    materials and asset management;

 

    negotiating, pricing and administering our managed care contracts; and

 

    monitoring quality of care and collecting data on quality measures for full Medicare payment updates.

Utilizing a common information systems platform across all our hospitals allows us to:

 

    enhance patient safety, automate medication administration and increase staff time available for direct patient care;

 

    optimize staffing levels according to patient volumes, acuity and seasonal needs at each facility;

 

    perform product line analyses;

 

    continue to meet or exceed quality of care indicators;

 

    monitor registration, billing, collections, managed care contract compliance and all other aspects of our revenue cycle;

 

    control supply costs by complying with our group purchasing organization contract; and

 

    monitor financial results.

 

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The cost of maintaining our information systems has increased significantly in recent years, partially due to the impact of implementing and demonstrating meaningful use of certified EHR technology. Information systems maintenance expense was $15.5 million, $12.2 million and $15.9 million for the years ended September 30, 2016, 2015 and 2014, respectively.

HITECH included approximately $26.0 billion in funding for various healthcare information technology (“IT”) initiatives, including Medicare and Medicaid incentives for eligible hospitals and professionals to adopt and meaningfully use certified EHR technology (“EHR Incentive Programs”). Eligible providers that fail to demonstrate meaningful use of certified EHR technology are subject to reduced payments from Medicare, beginning in 2015. Implementation of the EHR Incentive Programs has been divided into three stages with increasing requirements for participation. Stage 1 required providers to meet meaningful use objectives specified by CMS, which included electronically capturing health information in structured format, tracking key clinical conditions for coordination of care purposes, implementing clinical decision support tools to facilitate disease and medication management, using EHRs to engage patients and families, and reporting clinical quality measures and public health information. Our hospitals, and several physician clinics, substantially met the Stage 1 requirements in fiscal year 2012. Stage 2 introduced several new meaningful use measures, and imposed stricter requirements on certain existing Stage 1 measures. As of the date of this Report, all of our hospitals have met the Stage 2 meaningful use criteria. On October 16, 2015, CMS established new standards for continued participation in the EHR Incentive Programs for 2015 through 2017, replacing the then-current criteria with “Modified Stage 2” criteria. CMS also specified the Stage 3 criteria for continued participation in the EHR Incentive Programs. The Stage 3 criteria will be optional in 2017 and mandatory in 2018. Though we expect to continue to incur certain non-productive and other operating costs, and additional investments in hardware and software, we believe our historical investments in advanced clinical and other information systems, and quality of care programs, provides a solid platform to build upon for timely compliance with the healthcare IT initiatives and requirements of HITECH. During the years ended September 30, 2016, 2015 and 2014, we recognized income from the EHR Incentive Programs totaling $2.2 million, $6.9 million and $14.4 million, respectively.

Our Health Choice managed care risk platform relies on certain information systems and applications for its for day-to-day business functions. We use such systems to optimize coordination of plan member care, adjudication of claims and provider reimbursement, utilization and disease management, among other things. Additionally, our call centers rely on specialized telephone systems to receive, route and monitor calls and to provide our service representatives access to the information they need to serve our members and providers. Our infrastructure and capabilities enable our MSO to provide care management, population health and administrative services in existing and new geographic markets. In some scenarios depending upon client need, we may rely on the interface of our Heath Choice systems with the information systems of our MSO clients. We believe our capacity to interface our operations and systems with our clients’ information systems in an effective manner differentiates us from many of our MSO competitors.

Employees and Medical Staff

As of September 30, 2016, we had approximately 13,700 employees, including 3,000 part-time employees. We consider our employee relations to be good. We recruit and retain nurses and medical support personnel by creating a desirable, professional work environment, providing competitive wages, benefits and long-term incentives, and providing career development and other training programs. To supplement our current employee base, we have expanded our relationship with local colleges and universities, including our sponsorship of nursing scholarship programs, in our markets.

Our hospitals are staffed by licensed physicians admitted to the medical staff of our individual hospitals. Any licensed physician may apply to be admitted to the medical staff of any of our hospitals, but admission to the staff must be approved by each hospital’s medical staff and the governing board of the hospital under established credentialing criteria. To meet community needs in certain markets in which we operate, we have implemented a strategy of employing physicians, with an emphasis on those practicing within primary care and other certain specialties. While this strategy follows industry trends, we cannot be assured of the long-term success of such a strategy, which includes related integration of physician practice management.

Our Health Choice operations are staffed by more than 1,000 managed care professionals, with integrated operations in three locations. These professionals include various medical specialists that oversee the proper adjudication and administration of health services, such as medical directors, pharmacists, dental consultants, care coordinators and care navigators. Additionally, to provide optimal patient care, we employ administrative personnel such as claims examiners, claims adjudicators and database engineers.

Compliance Program

Our compliance program is designed to ensure that we maintain high standards of conduct in the operation of our business and implement policies and procedures so employees act in compliance with all applicable laws, regulations and Company policies. We believe that the organizational structure of our compliance satisfies the seven elements of an effective compliance program published by the OIG. Our compliance program includes a compliance committee of our Board of Directors, a corporate management

 

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compliance committee and local management compliance committees at each of our hospitals. These committees have the oversight responsibility for the effective development and implementation of our program. Our Vice President of Ethics and Business Practices, who reports directly to our Chief Executive Officer and to the compliance committee of our Board of Directors, serves as Chief Compliance Officer and is charged with direct responsibility for the development and implementation of our compliance program. Other features of our compliance program include the designation of a Regional Compliance Officer for each of our hospitals, periodic ethics and compliance training and effectiveness reviews, and the development and implementation of policies and procedures, including a mechanism for employees to report, without fear of retaliation, any suspected legal or ethical violations.

Available Information

We file periodic and current reports and other information with the SEC. All filings made by IASIS with the SEC may be copied and read at the SEC’s Public Reference Room at 100 F Street NE, Washington, DC 20549. Information on the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. The SEC also maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC, as IASIS does. The website address of the SEC is http://www.sec.gov.

Additionally, a copy of our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and any amendments to the aforementioned filings, are available on our website, www.iasishealthcare.com, free of charge as soon as reasonably practicable after we electronically file such reports or amendments with, or furnish them to, the SEC. The filings can be found in the SEC filings section of our website. Reference to our website does not constitute incorporation by reference of the information contained on the website and should not be considered part of this Report. All of the aforementioned materials may also be obtained free of charge by contacting us at our principal offices located at 117 Seaboard Lane, Building E, Franklin, TN 37067 or by calling (615) 844-2747.

Item 1A.   Risk Factors.

You should carefully consider the following risks and the other information included in this Report, including “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our financial statements and Notes. We have presented the below risks as “Risks related to our acute care operations and company generally,” “Risks related to our managed care operations,” and “Risks related to our capital structure.” Any of these risks could materially and adversely affect our business, financial condition or results of operations, and the factors that we identify as risks to a particular segment of our business could materially affect another segment of our business or our Company generally. The risks described below are not the only risks we face. Additional risks and uncertainties not currently known to us or those we currently view to be immaterial also may materially and adversely affect our business, financial condition or results of operations.

Risks Related to Our Acute Care Operations and Company Generally

Changes in governmental healthcare programs may reduce our revenues.

Governmental healthcare programs, principally Medicare and Medicaid, including managed Medicare and managed Medicaid, accounted for 41.0%, 42.2% and 44.0% of our hospitals’ net patient revenue before the provision for bad debts for the years ended September 30, 2016, 2015 and 2014, respectively. However, in recent years legislative and regulatory changes have limited, and sometimes reduced, the levels of payments that our hospitals receive for various services under Medicare, Medicaid and other federal healthcare programs. The BCA and later legislation require automatic spending reductions of $1.2 trillion for federal fiscal years 2013 through 2025, minus any deficit reductions enacted by Congress and debt service costs. However, the percentage reduction for Medicare may not be more than 2% for a fiscal year, with a uniform percentage reduction across all Medicare programs. These automatic spending reductions are commonly referred to as “sequestration.” Sequestration began in 2013, with CMS imposing a 2% reduction on Medicare claims. We cannot predict what other deficit reduction initiatives may be proposed by the President or the Congress or whether the President and the Congress will restructure or suspend sequestration or enact greater spending reductions.

The Health Reform Law also provides for material reductions in the growth of Medicare program spending, including reductions in Medicare market basket updates and Medicare DSH funding. Further, from time to time, CMS revises the reimbursement systems used to reimburse healthcare providers and the requirements for coverage of services, including changes to the MS-DRG system and national and local coverage decisions, which may result in reduced Medicare payments. Sometimes, commercial third-party payors and other payors, such as some state Medicaid programs, rely on all or portions of the Medicare MS-DRG system to determine payment rates, and therefore, adjustments that negatively affect Medicare payments also may negatively affect payments from Medicaid programs or commercial third-party payors and other payors.

 

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In addition, from time to time, state legislatures consider measures to reform healthcare programs and coverage within their respective states. Because of economic conditions and other factors, several states are experiencing budget problems and have adopted or are considering legislation designed to reduce their Medicaid expenditures, including enrolling Medicaid recipients in managed care programs, reducing the number of Medicaid beneficiaries by implementing more stringent eligibility requirements and imposing additional taxes or assessments on hospitals to help finance or expand states’ Medicaid systems. The states in which we operate have decreased funding for healthcare programs or made other structural changes resulting in a reduction in Medicaid hospital rates in recent years. Additional Medicaid spending cuts may be implemented in the states in which we operate, including reductions in supplemental Medicaid reimbursement programs.

Beginning in 2014, the Health Reform Law provided for significant expansion of the Medicaid program, but the Department may not penalize states that do not implement the Medicaid expansion provisions by withholding existing federal Medicaid funding. As a result, a number of states have opted not to implement the expansion, including Texas. Our Texas hospitals participate in private supplemental Medicaid reimbursement programs that are structured to expand the community safety net by providing indigent healthcare services and result in additional revenues for participating hospitals. Although CMS approved the Medicaid waiver that allows Texas to continue receiving supplemental Medicaid reimbursement while expanding its managed Medicaid program, this waiver expires December 31, 2017. We cannot predict whether the Texas private supplemental Medicaid reimbursement programs will continue or guarantee that revenues recognized from the programs will not decrease. We also cannot predict the impact of the 2016 federal elections on Medicaid expansion or other aspects of the Health Reform Law.

We believe that hospital operating margins across the country, including ours, have been and may continue to be under pressure because of limited pricing flexibility and growth in operating expenses in excess of the increase in payments under Medicare and other governmental programs. Current or future healthcare reform efforts, changes to or repeal of the Health Reform Law, additional changes in laws or regulations regarding government health programs, changes to structure and reimbursement rates of governmental health programs or other changes in the administration of government health programs could have a material adverse effect on our financial position and results of operations.

We cannot predict with certainty the long-term impact of the Health Reform Law, which represents a significant change to the healthcare industry.

The Health Reform Law represents a significant change across the healthcare industry. As currently structured, the Health Reform Law has decreased the number of uninsured individuals by expanding coverage to additional individuals through public program expansion and private sector health insurance reforms. The Health Reform Law expands eligibility under existing Medicaid programs and subsidizes states that create non-Medicaid plans for certain residents that do not qualify for Medicaid. States have opted, and may continue to opt, not to implement the expansion. Several state governors and legislatures, including Texas, have chosen not to participate in the expanded Medicaid program; however, these states could implement the expansion at a later date. Further, the Health Reform Law requires states to establish or participate in Exchanges or default to a federally-operated Exchange to facilitate the purchase of health insurance by individuals and small businesses. Through the “individual mandate,” the Health Reform Law imposes financial penalties on individuals who fail to carry insurance coverage. In addition, the employer mandate requires companies with 50 or more employees to provide health insurance or pay fines. The Health Reform Law also establishes a number of health insurance market reforms, including a ban on lifetime limits and pre-existing condition exclusions, new benefit mandates, and increased dependent coverage.

Although the expansion of health insurance coverage has positively impacted our revenues from providing care to certain previously uninsured individuals, we believe that the Health Reform Law could adversely affect our business and results of operations due to provisions of the Health Reform Law that are intended to reduce Medicare and Medicaid healthcare costs. Among other things, in order to fund the expansion of coverage to the uninsured population, the Health Reform Law reduces market basket updates, reduces Medicare and Medicaid DSH funding, and expands efforts to tie payments to quality and clinical integration. Any decrease in payment rates or an increase in rates that is below our increase in costs may adversely affect our results of operations. The Health Reform Law also provides additional resources to combat fraud, waste, and abuse, including expansion of the RAC program to identify and recoup improper Medicare payments. Further, the Health Reform Law required the states to establish state Medicaid RAC programs. These initiatives may result in increased costs for us to appeal or refund any alleged overpayments.

The Health Reform Law contains additional provisions intended to promote value-based purchasing. The Department has established a value-based purchasing system for hospitals that provides incentive payments to hospitals that meet or exceed certain quality performance standards, and such system is funded through decreases in the inpatient prospective payment system market basket updates to all hospitals. Further, hospitals with excess readmissions for conditions designated by the Department receive

 

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reduced payments for all inpatient discharges, not just discharges relating to the conditions subject to the excess readmissions standard. The Health Reform Law also prohibits the use of federal funds under the Medicaid program to reimburse providers for medical assistance provided to treat HACs and other provider-preventable conditions. In addition, as of federal fiscal year 2016, hospitals that fall into the worst 25% of national risk-adjusted HAC rates for all hospitals in the previous year receive a 1% reduction in their total Medicare payments.

The Health Reform Law has changed how healthcare services are covered, delivered, and reimbursed. However, many variables continue to impact the effect of the Health Reform Law, including the law’s complexity, possible amendment or repeal of the law, court challenges to the law, the possibility of further technical issues with operating the federal and state Exchanges, uncertainty regarding continued participation of a sufficient number of health insurers offering individual coverage through the Exchanges, uncertainty regarding the success of Exchanges enrolling uninsured individuals, possible reductions in funding by Congress and future reductions in Medicare and Medicaid reimbursement, and uncertainty as to the extent to which states will choose to participate in the expanded Medicaid program. Moreover, the outcome of the 2016 federal elections is expected to increase the likelihood of repeal or significant changes to the Health Reform Law. Because of these many variables, we are unable to predict with certainty the net effect on our operations of the expected increases in insured individuals using our facilities, the reductions in government healthcare spending, and numerous other provisions in the Health Reform Law that may affect us.

Our business may be adversely impacted if the Health Reform Law is repealed in its entirety or if provisions beneficial to our acute care operations business or our managed care operations business are repealed or significantly modified as a result of the 2016 federal elections.

The Health Reform Law remains subject to efforts to repeal or modify the law. The 2016 federal elections, which resulted in the election of the Republican presidential nominee and Republican majorities in both houses of Congress, is likely to prompt renewed legislative efforts to significantly modify or repeal the Health Reform Law, is likely to impact how the executive branch implements the law, and may impact how the federal government responds to lawsuits challenging the Health Reform Law. In this regard, the President-elect has signaled his intent to significantly change healthcare laws, including significantly modifying or repealing the Health Reform Law. While we are unable to predict the full impact of any modification of the Health Reform Law or its implementation on our acute care operations business and/or managed care operations business in light of the uncertainty regarding what legislative or other actions may be taken, if the Health Reform Law is repealed or significantly modified, such repeal or modification may have a materially adverse impact our business, strategies, prospects, operating results or financial condition.

If we experience a shift in payor mix from commercial managed care payors to self-pay and Medicaid, our revenue and results of operations could be adversely affected.

Reimbursement from self-pay and Medicaid programs is generally lower than traditional commercial managed care products. In the several years prior to fiscal 2014, we experienced a shift in our patient volumes and revenue from commercial and managed care payors to self-pay and Medicaid, including managed Medicaid. This shift resulted in pressure on pricing and operating margins from expending the same resources to provide patient care, but for less reimbursement. This shift also reflected elevated unemployment levels and the resulting increases in states’ Medicaid rolls and the uninsured population. In addition, certain states have implemented measures to reduce enrollment in Medicaid, which have increased the number of uninsured patients seeking care at our hospitals. More recently, we have seen a reduction in the levels of our self-pay payor mix, which reflects improvement in the U.S. economy and decline in unemployment rate, and adoption of Medicaid expansion under the Health Reform Law in certain of our markets, including Arizona and Louisiana. However, we can provide no assurance that our payor mix will continue to improve, especially in light of potential efforts to significantly modify or repeal the Health Reform Law following the 2016 federal election. Increased enrollment in Exchange plans or Medicaid plans may cause lower reimbursement rates relative to traditional employer-sponsored health insurance plans for the healthcare services provided by our hospitals and employed physicians. Further, Exchange-insured persons may pay higher deductibles, which may cause them to delay their medical treatment. Certain Exchange plans may also include limits on an enrollee’s overall benefit coverage as well as higher deductibles and other out-of-pocket costs that are the responsibility of such Exchange insured-persons, which, if unpaid, would result in higher levels of bad debt.

Utilization behavior of the insured population has changed because of the increasing prevalence of higher deductible and co-insurance plans implemented by employers, which has resulted in the deferral of elective and non-emergent procedures by individuals with high co-payments. We may be adversely affected by the growth in patient responsibility accounts because of increased adoption of plan structures, including health savings accounts, which shift greater responsibility for care to individuals through greater exclusions and higher co-payment and deductible amounts. Patient responsibility accounts may continue to increase even with expanded health plan coverage because of increases in plan exclusions and co-payment and deductible amounts. If we experience certain shifts in our patient volumes, our revenue and results of operations may be adversely affected.

 

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If government-sponsored reimbursement and supplemental payment programs withhold payments due to our hospitals for services rendered, our cash flows, revenues and profitability of our operations could be adversely affected.

Our Texas hospitals participate in private supplemental Medicaid reimbursement programs structured to expand the community safety net by providing indigent healthcare services and result in additional revenues for participating hospitals. Although CMS approved an extension of the Medicaid waiver through December 31, 2017 allowing Texas to continue receiving supplemental Medicaid reimbursement while expanding its managed Medicaid program, we cannot predict whether the Texas private supplemental Medicaid reimbursement programs will continue or guarantee that revenues recognized from the programs will not decrease, which may negatively affect our cash flows and profitability.

If we are unable to retain and negotiate reasonable contracts with managed care plans or if insured patients switch from traditional commercial insurance plans to Exchange plans, then our net revenue may be reduced.

Our ability to obtain reasonable contracts with HMOs, PPOs and other managed care plans significantly affects the revenue and operating results of our hospitals. Net patient revenue, before the provision for bad debts, derived from HMOs, PPOs and other managed care plans accounted for 43.8%, 42.7% and 40.9% of our hospitals’ net patient revenue for the years ended September 30, 2016, 2015 and 2014, respectively. Our hospitals have more than 250 managed care contracts with no one payor contract representing more than 10.0% of our net patient revenue. Typically, we negotiate our managed care contracts annually as they come up for renewal at various times during the year. Further, many are terminable by either party on relatively short notice. Our future success will depend, in part, on our ability to retain and renew our managed care contracts and enter into new managed care contracts on terms favorable to us. Other healthcare providers, including some with larger and more integrated health systems, provider networks, greater geographic coverage or a wider range of services, may affect our ability to enter into managed care contracts or negotiate increases in our reimbursement and other favorable terms and conditions. Some of our competitors may negotiate exclusivity provisions with managed care plans or otherwise restrict the ability of managed care companies to contract with us. In one region in which we operate, the largest healthcare provider organization controls one of the largest payor organizations and operates it primarily as a closed network. The patients enrolled in this integrated health system are largely unavailable to us.

Also, some employed individuals may move from commercial insurance coverage with higher reimbursement rates for our services and lower co-pays and deductibles for the insured employee to Exchange insurance plans that may provide lower reimbursement for our services, higher co-pays and deductibles for the insured employee or even exclusion of our hospitals and employed-physicians from coverage under certain Exchange plans. If we cannot retain and negotiate favorable contracts with managed care plans or experience reductions in payment increases or amounts received from non-governmental payors or a shift in business from commercial insurance payors to Exchange plans, then our revenues may be reduced.

Consolidation among managed care organizations may reduce our ability to negotiate favorable contracts with such payors.

In recent years, the managed care segment of the healthcare industry has become more concentrated, as health insurers become less numerous and grow larger in size, due to an increasing number of mergers, acquisitions and other business consolidations. For instance, in 2015, two national-scale managed care mergers were announced: Anthem’s acquisition of Cigna and Aetna’s acquisition of Humana. Each of these announced transactions has been the subject of anti-trust regulatory review, and neither transaction has yet been consummated. The hospital segment of the healthcare industry is less concentrated and more fragmented than the managed care segment. However, local hospitals and hospital systems without significant bargaining power often face difficult contract negotiations with HMOs and other third party payors and therefore are incented to consolidate. Continued consolidation among managed care organizations with respect to bargaining power may reduce our hospitals’ rates and contract terms.

If we experience growth in volume and revenue related to uncompensated care, our financial condition or results of operations could be adversely affected.

Like others in the hospital industry, from time to time we have experienced high levels of uncompensated care, including charity care and bad debts. These levels are driven by the number of uninsured and under-insured patients seeking care at our hospitals, the acuity levels at which these patients present for treatment, primarily resulting from economic pressures and their related decisions to defer care, increasing healthcare costs and other factors beyond our control, such as increases for co-payments and deductibles as employers continue to pass more of these costs on to their employees. In addition, in periods of high unemployment, we believe that our hospitals may continue to experience high levels of or possibly growth in bad debts and charity care.

 

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Over time, the Health Reform Law, as currently structured, is expected to continue to decrease the number of uninsured individuals through expanding Medicaid and incentivizing employers to offer, and requiring individuals to carry, health insurance or be subject to penalties. However, several state governors and legislatures, including Texas, have chosen not to participate in the expanded Medicaid program, the results of which have adversely affected our operations in those markets compared to states that have elected to expand their Medicaid programs. Further, the outcome of the 2016 federal elections increase the likelihood of legislative action being taken to repeal or significantly modify the Health Reform Law.

It is difficult to predict with certainty the full impact of the Health Reform Law due to the law’s complexity, continued delays or exceptions to employer mandates, possible amendments to or repeal of the law, court challenges to the law, uncertainty regarding the stability of the Exchanges and their long-term success enrolling uninsured individuals, possible reductions in funding by Congress, future reductions in Medicare and Medicaid reimbursement and uncertainty surrounding state participation in the law’s expanded Medicaid program. We may continue to provide charity care to the uninsured, including those who choose not to comply with the insurance requirements currently in effect and undocumented aliens not permitted to enroll in an Exchange or government healthcare program.

Although we continue to seek ways of improving point of service collection efforts and implementing payment plans with our patients, if we experience growth in self-pay volume and revenue, including increased acuity levels for uninsured patients and continued increases in co-payments and deductibles for insured patients, our results of operations could be adversely affected. Further, our ability to improve collections from self-pay patients may be limited by regulatory and investigatory initiatives, including private lawsuits directed at hospital charges and collection practices for uninsured and underinsured patients.

Industry trends towards value-based purchasing, care coordination and “narrow networks” of healthcare providers may present our Company with operational, financial and competitive challenges.

There is a trend in the healthcare industry towards value-based purchasing of healthcare services. These value-based purchasing programs include both public reporting of quality data and preventable adverse events tied to the quality and efficiency of care provided by facilities. Governmental programs, including Medicare and Medicaid, require hospitals to report certain quality data to receive full reimbursement updates. In addition, Medicare does not reimburse for care related to certain preventable adverse events (called “never events”). Many large commercial payors require hospitals to report quality data, and several commercial payors do not reimburse hospitals for certain preventable adverse events. The Health Reform Law, as currently structured, contains several provisions intended to promote value-based purchasing under Medicare and Medicaid. We expect value-based purchasing programs, including programs that condition reimbursement on patient outcome measures, to become more common and to involve a higher percentage of reimbursement amounts. While we believe we are adapting our business strategies to compete in a value-based reimbursement environment, we cannot predict how this trend will affect our results of operations, and it could negatively affect our revenues.

Integrated ACOs and other kinds of “narrow” provider networks or organizations may exclude our hospitals, employed-physicians and other affiliated providers from their plans’ networks of healthcare providers. These contracting networks often organize hospitals, physicians and ancillary healthcare providers into narrow networks involving a smaller number of healthcare providers than does a network that allows all providers to participate, a so-called “open panel” network of providers, in exchange for which the “narrow network” may, if appropriately structured, achieve lower cost and/or higher quality in a way that benefits patients, employers, providers and payors. For instance, in some of the regions in which our hospitals operate, we face competition from large, not-for-profit healthcare systems with vertically integrated healthcare providers including health plans, physician groups and facilities, which affect our ability to obtain managed care contracts with their affiliated health insurance plans. Similarly, ACOs commonly require physicians and other providers to participate exclusively in their organization. If our affiliated providers are excluded from such networks, or we are unable to recruit sufficient providers to our own networks, our business will face competitive disadvantages.

If controls imposed by Medicare, Medicaid and other third-party payors to reduce admissions and length of stay affect our inpatient volumes, our financial condition or results of operations could be adversely affected.

Controls imposed by Medicare, Medicaid and commercial third-party payors designed to reduce admissions and lengths of stay, commonly referred to as “utilization reviews,” have affected and are expected to continue to affect our facilities. Utilization review entails the review of the admission and course of treatment of a patient by managed care plans. Inpatient utilization, average lengths of stay and occupancy rates continue to be negatively affected by payor-required preadmission authorization and utilization review and by payor pressures to maximize outpatient and alternative healthcare delivery services for less acutely ill patients. Efforts to impose more stringent cost controls and reductions are expected to continue. For example, the Health Reform Law potentially expands the use of prepayment review by MACs by eliminating statutory restrictions on their use.

 

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There has been increased scrutiny of a hospital’s “Medicare Observation Rate” from government enforcement agencies and industry observers. A low rate may raise suspicions that a hospital is inappropriately admitting patients that could be cared for in an observation setting. The industry may be subject to increased scrutiny and litigation risk, including government investigations and qui tam suits, related to inpatient admission decisions and the Medicare Observation Rate. The CMS policy known as the “two midnight rule” provides guidance for practitioners admitting patients and contractors conducting payment reviews on when it is appropriate to admit individuals as hospital inpatients. Under the two midnight rule, services provided to Medicare beneficiaries are only payable as inpatient hospital services when there is a reasonable expectation that the hospital care is medically necessary and will be required across two midnights, absent unusual circumstances.

If we are unable to attract and retain quality medical professionals, our financial condition or results of operations could be adversely affected.

The success of our hospitals depends on the following factors, among others:

 

    the number and quality of the physicians on the medical staffs of our hospitals;

 

    the competency of those physicians and our facilities to meet their communities’ needs for healthcare services in a convenient, high quality and high value manner;

 

    the referral patterns of those physicians; and

 

    maintaining good relations with those physicians.

Our efforts to attract and retain physicians are affected by our managed care contracting relationships, national shortages in some specialties, the adequacy of our support personnel, the condition of our facilities and medical equipment, the availability of suitable medical office space and federal and state laws and regulations prohibiting financial relationships that may have the effect of inducing patient referrals.

To meet varying community needs for healthcare services in certain markets in which we operate, and to better coordinate patient care, we have implemented a strategy to employ physicians, which has expanded our employed physician base. The execution of a physician employment strategy includes an increased cost at our Company for salaries, wages and benefits; increases in malpractice insurance coverage costs; increased rent expense; risks of unsuccessful physician integration and difficulties associated with physician practice management. While we believe this strategy follows industry trends, we cannot be assured of the long-term success of our physician employment strategy.

We also compete with other healthcare providers in recruiting and retaining qualified management and staff to run the day-to-day operations of our hospitals, including administrators, nurses, technicians and non-physician healthcare professionals. It is more difficult to recruit physicians and nurses to some of our markets, compared to other of our markets or other competing markets, depending on the community need, area of practice and the recruited physician’s or nurse’s personal considerations. Our failure to recruit and retain such management personnel and skilled professionals could adversely affect our financial condition and results of operations.

Our hospitals face competition for staffing, especially because of the shortage of nurses, which has in the past and may in the future increase our labor costs and materially reduce our profitability.

We compete with other healthcare providers in recruiting and retaining qualified management and staff personnel responsible for the day-to-day operations of each of our hospitals, physician practices and our managed care operations, including most significantly nurses and other non-physician healthcare professionals. While the national nursing shortage has abated somewhat, certain portions of our markets have limited nursing resources. In the healthcare industry, including in our markets, the shortage of nurses and other medical support personnel is a significant operating issue. This shortage has caused us in the past and may require us in the future to increase wages and benefits to recruit and retain nurses and other medical support personnel or to hire more expensive temporary personnel. Frequently in the past, we have voluntarily raised, and expect to continue to raise, wages for our nurses and other medical support personnel.

If our labor costs continue to increase, we may not be able to achieve higher payor reimbursement levels or reduce other operating expenses in a manner sufficient to offset these increased labor costs. Because substantially all of our net patient revenues are based on reimbursement rates fixed or negotiated no less frequently than annually, our ability to pass along periodic increased labor costs is materially constrained. Our failure to recruit and retain qualified management, nurses and other medical support personnel, or to control our labor costs, could have a material adverse effect on our profitability.

Our hospitals face competition from other hospitals and healthcare providers that could negatively affect patient volume.

The hospital industry is highly competitive. Our hospitals face competition for patients from other hospitals in our markets, large vertically integrated providers, large tertiary care centers and outpatient service providers that provide similar services to those provided by our hospitals. Other than our small 15-bed critical access hospital in Woodland Park, Colorado, none of our other hospitals are sole community providers, and all are in geographic areas in which at least one other hospital provides services

 

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comparable to those offered by our hospitals. Some of the hospitals that compete with ours are owned by governmental agencies or not-for-profit corporations supported by endowments and charitable contributions and can finance capital expenditures and operations on a tax-exempt basis. In addition, the number of freestanding specialty hospitals, outpatient surgery centers, emergency departments, urgent care centers and outpatient diagnostic centers has increased significantly in the areas in which we operate. We also face competition from competitors implementing physician alignment strategies, such as employing physicians, acquiring physician practice groups and participating in ACOs or other clinical integration models. Some of our competitors also have greater geographic coverage, offer a wider range of services or invest more capital or other resources than we do. In addition, competitors that operate non-hospital facilities or hospitals not owned by physicians are not subject to the same federal restrictions on expansion as our physician-owned hospitals. If our competitors can achieve greater geographic coverage, improve access and convenience to physicians and patients, recruit physicians to provide competing services at their facilities, expand or improve their services or obtain more favorable managed care contracts, we may experience a decline in patient volume.

CMS publicizes performance data relating to quality measures and data on patient satisfaction surveys that hospitals are required to submit to CMS. Federal law provides for the expansion of the number of quality measures that we are required to make publicly available. Further, hospitals must annually establish, update and make public a list of their standard charges for items and services or their policies for allowing the public to view a list of such charges in response to an inquiry. If any of our hospitals should achieve poor results (or results that are lower than our competitors) on these quality criteria, or if our standard charges are higher than those published by our competitors, our patient volumes could decline. The required reporting of additional quality measures and other trends toward clinical transparency and value-based purchasing of healthcare services may have an adverse impact on our competitive position and patient volume.

A health pandemic could negatively affect our business.

If a pandemic, or other widespread health crisis were to occur in our markets, our business could be adversely affected. Such a crisis could diminish the public trust in healthcare facilities, especially hospitals treating (or that have treated) patients affected by the pandemic. If any of our facilities treat patients from such a health crisis, others might cancel elective procedures or fail to seek needed care at our facilities. Further, a health pandemic might adversely affect our business by disrupting or delaying production and delivery of materials and products in the supply chain or by causing staffing shortages in our facilities. Although we have infection control and disaster plans in place, and we manage our hospital facilities pursuant to infectious disease protocols, the impact of a pandemic on our business could be materially adverse.

A failure of our information systems, or increased costs associated with upgrading and operating such systems, could adversely affect our ability to properly manage our operations.

We rely on our advanced information systems and our ability to successfully use these systems in our operations. These systems are essential to the following areas of our business operations, among others:

 

    patient accounting, including billing and collection of net patient revenue;

 

    financial, accounting, reporting and payroll;

 

    coding and compliance;

 

    laboratory, radiology and pharmacy systems;

 

    EHRs;

 

    materials and asset management;

 

    negotiating, pricing and administering managed care contracts; and

 

    monitoring quality of care and collecting data on quality measures for full Medicare payment updates.

If we fail to operate these systems effectively, we may experience delays in collection of net patient revenue and may not properly manage our operations or oversee compliance with laws or regulations. In the event of a failure to our EHRs and other systems affecting patient care, our ability to treat patients may be negatively impacted. Moreover, if we fail to continue to demonstrate meaningful use of certified EHR technology, we will be subject to reduced payments from Medicare (in addition to any on-going statutory reductions). Furthermore, because the information technology landscape changes frequently, our systems require upgrades and replacement as new technologies are introduced, old technologies are no longer supported and physician and patient needs evolve requiring greater emphasis on integration of clinical, revenue and patient accounting systems. In this context, we may face significant financial costs, cash flow disruptions and operational difficulties as we from time to time change our information technology platforms, as well as operational difficulties in installing such new technology into our hospitals and operating it effectively. Such difficulties could affect our ability to properly manage our operations and adversely affect our cash flows.

 

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Our inability to effectively replace information technology systems used by our hospitals, or the costs and operational risks associated with such replacements and upgrades, could adversely affect our operations and financial results.

Healthcare information technology continues to evolve at a rapid pace. In order to remain competitive and to provide high quality clinical care, our Company invests heavily in numerous information technology systems used by our hospitals and other lines of business. These information technology systems relate to clinical care, quality review, communications among providers, the storage of health records, billing and collections and many other business functions.

In October 2015, we entered into an agreement with Cerner Corporation (“Cerner”) to implement an integrated EHR and revenue cycle system across our acute care operations. We have made significant investments in this system, and expect to continue to make significant investments in this system through our 2019 fiscal year, as it is implemented across our operations.

We will continue to incur substantial costs to transition from our existing McKesson clinical information technology platform to Cerner’s, as well as with respect to the installation of Cerner’s revenue cycle management products. In addition to these costs, the technology transition and upgrade will entail significant management and staff personnel time and a complicated phase-in process, where difficulties in installing, customizing and training personnel in new technology can frequently occur. The replacement of any information technology system upon which we rely may be financially and administratively burdensome to us in this way and can constrain our ability to pursue other opportunities requiring significant capital and management resources. If our implementation of replacement technology systems is inefficient, delayed or ineffective, we may experience disruptions or delays in our cash flows and day-to-day caregiver processes, experience disruptions or errors related to using, accessing and sharing of patient care information and declines in patient and/or hospital employee satisfaction. Because the healthcare information technology business and our business’ and patients’ needs continuously evolve, we cannot assure you that we will not incur such financial and administrative difficulties. Moreover, if we fail to demonstrate meaningful use of certified EHR technology either through Horizon Clinicals or our replacement Cerner platform, we will be subject to reduced payments from Medicare (in addition to any ongoing statutory reductions).

We are required to comply with laws governing the transmission, security and privacy of health information.

The HIPAA administrative simplification provisions require the use of uniform electronic data transmission standards for healthcare claims and payment transactions submitted or received electronically. In addition, as required by HIPAA, the Department has issued privacy and security regulations that extensively regulate the use and disclosure of PHI and require covered entities, including healthcare providers and health plans, and vendors known as “business associates,” to implement administrative, physical and technical safeguards to protect the security of PHI. Covered entities must report breaches of unsecured PHI without unreasonable delay to affected individuals, the Department and, in the case of larger breaches, the media. The privacy, security and breach notification regulations have imposed, and will continue to impose, significant compliance costs on our operations.

Violations of the HIPAA privacy and security regulations may result in criminal penalties and in civil penalties of up to $55,010 per violation, to a maximum of $1,650,300 in a calendar year for violations of the same requirement. A covered entity may be subject to penalties as a result of a business associate violating HIPAA, if the business associate is found to be an agent of the covered entity. The Department is required to perform compliance audits, and state attorneys general may enforce the HIPAA privacy and security regulations in response to violations that threaten the privacy of state residents.

There are numerous other laws and legislative and regulatory initiatives at the federal and state levels addressing privacy and security concerns. These laws vary and may impose additional obligations or penalties. For example, various state laws and regulations may require us to notify affected individuals in the event of a data breach involving individually identifiable information (even if no health-related information is involved). In addition, the FTC uses its consumer protection authority to initiate enforcement actions in response to data breaches. To the extent we fail to comply with one or more federal and/or state privacy and security requirements or if we are found to be responsible for the non-compliance of our vendors, we could be subject to substantial fines or penalties, as well as third-party claims which could have a material adverse effect on our financial position, results of operations and cash flows.

A breach of our information system’s cybersecurity precautions may cause loss of protected health information, adversely affect our ability to properly manage our operations, cause us to incur remediation costs, increase our operating expenses and result in litigation and negative publicity.

Aspects of our business operations give rise to material cybersecurity risks and the potential costs and consequences associated with such risks. Additionally, we outsource functions that may also have material cybersecurity risks. Certain risks related to cyber incidents may remain undetected for an extended period. If we incur a security breach, the policy provides coverage for information security and privacy liability, regulatory defense and penalties, website media content liability, notification services and privacy breach response services.

 

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The objectives of cyber-attacks vary widely and may include theft of PHI, financial assets, intellectual property, or other sensitive information belonging to us, our customers or our business partners. Cyber-attacks also may be directed at disrupting our operations or the operations of our business partners. If we fall victim to cyber-attacks, we may incur substantial costs and suffer other negative consequences, which may include, but are not limited to, remediation costs that may include liability for stolen assets or information and repairing system damage that may have been caused, including incentives offered to customers or other business partners in an effort to maintain the business relationships after an attack; increased cybersecurity protection costs that may include organizational changes, deploying additional personnel and protection technologies, training employees, and engaging third party experts and consultants; lost revenues resulting from unauthorized use of proprietary information or the failure to retain or attract customers following an attack; litigation; and reputational damage adversely affecting customer or investor confidence. Furthermore, breaches of unsecured PHI or other personal information caused by cyber-attacks will trigger notification requirements under HIPAA and state laws, and could result in civil and criminal penalties, which could have a material adverse effect on our business.

If we fail to continually enhance our hospitals with the most recent technological advances in diagnostic and surgical equipment, our ability to maintain and expand our markets may be adversely affected.

Technological advances regarding CTs, MRIs and PET equipment, and other equipment used in our facilities, are continually evolving. To compete with other healthcare providers, we must constantly evaluate our equipment needs and upgrade equipment because of technological improvements. If we fail to remain current with the technological advancements of the medical community, our volumes and revenue may be negatively affected. Further, technological advances, including regarding both medical equipment and pharmaceuticals, may cure disease or alter the processes used for the diagnosis or treatment of certain illnesses or diseases which could increase competition for our healthcare services, reduce our patient volumes, reduce our revenues and have a material adverse effect on our profitability.

If we fail to effectively and timely implement EHR systems, our operations could be adversely affected.

As required by HITECH, the Department has adopted an incentive payment program for eligible hospitals and healthcare professionals that implement certified EHR technology and use it consistently with “meaningful use” requirements. If our hospitals and employed or contracted professionals do not meet the Medicare or Medicaid EHR incentive program requirements, we will not receive Medicare or Medicaid incentive payments to offset some of the costs of implementing the EHR systems. Further, beginning in 2015, eligible hospitals and physicians that failed to demonstrate meaningful use of certified EHR technology were subject to reduced payments from Medicare. Failure to implement EHR systems effectively and in a timely manner could have a material adverse effect on our financial position and results of operations.

If we fail to comply with extensive laws and governmental regulations, we could suffer penalties, be required to alter financial arrangements with our referral sources, including referral source investors in some of our hospitals, be required to significantly change our operations or be subject to significant liabilities.

The healthcare industry, including our Company, must comply with extensive and complex statutes and regulations at the federal, state and local government levels relating to:

 

    billing and coding for services and proper handling of overpayments;

 

    classification of level of care provided, including proper classification of emergency treatment, inpatient admissions, observation status and outpatient care;

 

    relationships with physicians and other referral sources or recipients, including financial arrangements and ownership interests involving physicians and other referral sources or recipients, such as physicians holding ownership interests in hospitals;

 

    necessity and adequacy of medical care;

 

    quality of medical equipment and services;

 

    qualifications of medical and support personnel;

 

    confidentiality, maintenance, data breach, identity theft and security issues associated with health related and personal information and medical records;

 

    screening, stabilization and transfer of individuals who have emergency medical conditions;

 

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    licensure and certification;

 

    hospital rate or budget review;

 

    preparation and filing of cost reports;

 

    activities regarding competitors;

 

    operating policies and procedures;

 

    provider-based reimbursement, including complying with requirements allowing multiple locations of a hospital to be billed under the hospital’s Medicare provider number;

 

    incentive payments for the adoption and meaningful use of certified EHR technology; and

 

    disclosures to patients, including disclosure of any physician ownership in a hospital.

Some of these statutes and regulations are relatively new and subject to ongoing interpretation by regulatory agencies. Further, regulatory and enforcement agencies may interpret existing laws and regulations in new or expansive ways that we are unable to predict. Thus, we do not always have the benefit of significant regulatory or judicial interpretation of these laws and regulations. Because these laws and regulations are so complex, hospital companies face a risk of inadvertent violations. Different interpretations or enforcement of these laws and regulations could subject our current or past practices to allegations of impropriety or illegality or could require us to change our facilities, equipment, personnel, services, capital expenditure programs and operating expenses.

If we fail to comply with applicable laws and regulations, we could be subjected to liabilities, including:

 

    criminal penalties;

 

    civil penalties, including the loss of our licenses to operate one or more of our facilities; and

 

    exclusion of one or more of our facilities from participation in the Medicare, Medicaid and other federal and state healthcare programs.

As required by the Bipartisan Budget Act of 2015, civil monetary penalties increased significantly in 2016. Beginning in 2017, the penalty amounts will be adjusted based on updates to the consumer price index.

The Health Reform Law imposes significant restrictions on hospitals that have physician owners.

Some of our hospitals have physician ownership pursuant to an exception to the Stark Law known as the “whole-hospital exception.” The Health Reform Law significantly narrows this exception to apply only to hospitals that had physician ownership in place as of March 23, 2010, and a Medicare provider agreement effective as of December 31, 2010. While the amended whole-hospital exception grandfathers certain existing physician-owned hospitals, including nine of ours, it prohibits a grandfathered hospital from increasing its percentage of physician ownership beyond the aggregate level that was in place as of March 23, 2010. Subject to limited exceptions, a grandfathered physician-owned hospital may not increase its aggregate number of operating rooms, procedure rooms, and beds for which it is licensed beyond the number in place as of March 23, 2010. A grandfathered physician-owned hospital must comply with a number of additional requirements, including not conditioning any physician ownership directly or indirectly on the owner making or influencing referrals, not offering any ownership interests to physician owners on more favorable terms than those offered to non-physicians and not providing any guarantee to physician owners to purchase other business interests related to the hospital. Further, a grandfathered hospital cannot have been converted from an ambulatory surgery center to a hospital.

The whole-hospital exception, as amended, also contains additional disclosure requirements. For example, a grandfathered physician-owned hospital is required to submit an annual report to the Department listing each investor in the hospital, including all physician owners. CMS has delayed the collection of annual reporting data until further notice. In addition, grandfathered physician-owned hospitals must have procedures in place that require each referring physician owner to disclose to patients, with enough notice for the patient to make a meaningful decision regarding receipt of care, the physician’s ownership interest and, if applicable, any ownership interest held by the treating physician. A grandfathered physician-owned hospital also must disclose on its website and in any public advertising the fact that it has physician ownership. The Health Reform Law requires the Department to audit grandfathered physician-owned hospitals’ compliance with these requirements.

In light of the Health Reform Law’s restrictions on the whole-hospital exception and limited interpretive guidance, it may be difficult for us to determine how the exception will apply to specific situations, including the ones discussed above, that may arise with our hospitals. If any of our hospitals, including the ones discussed above, fail to comply with the amended whole-hospital exception, those hospitals could be found to be in violation of the Stark Law, and we could incur significant financial or other penalties.

 

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Providers in the healthcare industry have been the subject of federal and state investigations, and we may become subject to additional investigations that could subject us to significant liabilities or penalties.

Both federal and state government agencies have increased their focus on and coordination of civil and criminal enforcement efforts in the healthcare area. There are numerous ongoing investigations of hospital companies and their executives and managers. The OIG and the DOJ have, from time to time, established national enforcement initiatives that focus on specific billing practices or other suspected areas of abuse. Further, under the FCA, private parties may bring “qui tam” whistleblower lawsuits against companies that submit false claims for payments to, or improperly retain overpayments from, the government. Some states have adopted similar state whistleblower and false claims provisions.

Federal and state investigations relate to a wide variety of routine healthcare operations, including:

 

    cost reporting and billing practices;

 

    financial arrangements with referral sources;

 

    physician recruitment activities;

 

    physician joint ventures; and

 

    hospital charges and collection practices for self-pay patients.

We engage in many of these and other activities that could be the subject of governmental investigations or inquiries from time to time. We have significant Medicare and Medicaid billings, we have numerous financial arrangements with physicians who are referral sources to our hospitals and we have nine hospitals as of September 30, 2016 that have physician investors. In addition, our executives and managers, many of whom have worked at other healthcare companies that are or may become the subject of federal and state investigations and private litigation, may be included in governmental investigations or named as defendants in private litigation. Any additional investigations of us, our executives or our managers could cause significant liabilities or penalties to us and adverse publicity.

In addition, governmental agencies and their agents, such as MACs, fiscal intermediaries and carriers, and the OIG, CMS and state Medicaid programs, conduct audits of our healthcare operations. Private payors may conduct similar audits, and we also perform internal audits and monitoring. Depending on the conduct found in such audits and whether the underlying conduct could be considered systemic, resolving these audits could have a material adverse effect on our financial position, results of operations and cash flows.

CMS has implemented a nationwide RAC program under which it engages private contractors to conduct post-payment reviews to detect and correct improper payments in the Medicare program. The contractors receive a contingency fee based on corrected, improper payments. The Health Reform Law expanded the RAC program’s scope to include other Medicare programs, including managed Medicare, effective December 31, 2010.

In addition, through DEFRA, Congress has expanded the federal government’s involvement in fighting fraud, waste and abuse in the Medicaid program by creating the Medicaid Integrity Program. Under this program, CMS engages private contractors, referred to as MICs, to perform post-payment audits of Medicaid claims and identify overpayments. In addition, the Health Reform Law expanded the RAC program’s scope to include Medicaid claims. In addition to MICs and RACs, several other contractors and state Medicaid agencies have increased their review activities.

Any such audit or investigation could have a material adverse effect on our financial position, results of operations and cash flows.

We face risks associated with federal and state antitrust laws applicable to the management and operation of our provider-sponsored networks.

Federal and state antitrust laws prohibit unreasonable restraints of trade, including price fixing and market allocations among competitors. Joint contracting among competitors may constitute price fixing, and may therefore be illegal, unless the contracting parties are under common governance, the contracting parties are involved in a legitimate joint venture to which joint contracting is ancillary, joint contracting is obtained through a “messenger” or there is sufficient clinical integration or substantial financial risk sharing. Violation of antitrust laws can result in civil penalties and/or criminal prosecution. The FTC has issued certain guidance regarding joint contracting among healthcare providers, including examples of financial arrangements that constitute sufficient risk sharing, and clinical integration that is sufficient, to permit joint provider contracting.

 

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Our acute care hospitals have collaborated with Health Choice, through its accountable care networking business, to build networks consisting of our hospitals, some of our hospitals’ medical staffs and our employed physicians and independent physicians and facilities. These so-called “narrow networks” can provide managed services to patients in contract with select payors, with the goal of achieving clinical integration and associated efficiencies among such providers, to improve population health, improve patients’ experience of care and control healthcare costs.

Our aggregation of providers into single networks, our joint contracting policies and procedure and our financial arrangements with third party payors through these networks are structured to comply with all federal and state antitrust laws. However, we can provide no assurance we will meet all the requirements under applicable antitrust law regarding operation of our provider networks. Failure to comply with various federal and state antitrust laws and regulations could result in investigations or litigation, with potential penalties or damages, and limitations on our ability to expand that could adversely affect our business, cash flows, financial condition and results of operations.

We are subject to risks associated with outsourcing functions to third parties.

To improve operating margins, productivity and efficiency, we outsource selected nonclinical business functions to third parties. We take steps to monitor and regulate the performance of independent third parties to whom we have delegated selected functions which may include revenue cycle management, patient access, billing, cash collections, payment compliance and other support services. Arrangements with third party service providers may make our operations vulnerable if vendors fail to satisfy their obligations to us because of their performance, changes in their own operations, financial condition, or other matters outside of our control. Our use of third party providers also may require changes to our existing operations and the adoption of new procedures and processes for retaining and managing these providers, and redistributing responsibilities to realize the potential productivity and operational efficiencies. Effective management, development and implementation of our outsourcing strategies are important to our business and strategy. If there are delays or difficulties in enhancing business processes or our third party providers do not perform as anticipated, we may not fully realize on a timely basis the anticipated economic and other benefits of the outsourcing projects or other relationships we enter into with key vendors, which could cause substantial costs, divert management’s attention from other strategic activities, negatively affect employee morale or create other operational or financial problems for us. Terminating or transitioning arrangements with key vendors could cause additional costs and a risk of operational delays, potential errors and possible control issues because of the termination or during the transition phase.

Regional economic downturns or other material changes in the economic condition in the markets in which we operate could cause our overall business results to suffer.

During periods of economic volatility or downturns, which may give rise to decreased consumer spending and high levels of unemployment or underemployment, governmental entities often experience budgetary constraints because of increased costs and lower than expected tax collections. These budgetary constraints have resulted in decreased spending for health and human service programs, including Medicare, Medicaid and similar programs, which represent significant payor sources for our hospitals. Many states, including states in which we operate, have decreased funding for state healthcare programs or made other structural changes resulting in a reduction in Medicaid spending. Additional Medicaid spending cuts may be implemented in the states in which we operate. Other risks we face from general economic downturns include patient decisions to postpone or cancel elective and non-emergent healthcare procedures, increases in the uninsured population and further difficulties in our collection of patient co-payment and deductible receivables.

Our acute care and managed care business segments operate in various regions across the country. For the fiscal year ended September 30, 2016, our total revenue was generated in the following geographic areas:

 

Phoenix, Arizona

     48.5

Six cities in Texas, including Houston and San Antonio

     25.5

Salt Lake City, Utah

     19.5

Other

     6.5

Our business is not as geographically diversified as some competing multi-facility healthcare companies and, therefore, is subject to greater market risks. Any material change in the current demographic, economic, competitive or regulatory conditions in any of the regions in which we operate could materially adversely affect our overall business results because of the significance of our operations in each of these regions to our overall operating performance.

 

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We may not achieve our acute care acquisition and growth strategies and we may have difficulty acquiring non-profit hospitals due to regulatory barriers and scrutiny.

Part of our business strategy has been expansion by acquiring hospitals and ambulatory care and other facilities in our existing markets and in new markets and by entering into partnerships or affiliations with other healthcare service providers. The competition to acquire these facilities is significant, including competition from healthcare companies with financial resources greater than us. There is no guarantee we can successfully integrate acquired hospitals and ambulatory care facilities, which limits our ability to complete future acquisitions.

In addition, we may not acquire additional hospitals on satisfactory terms and future acquisitions may be on less than favorable terms. We may have difficulty obtaining financing for future acquisitions on satisfactory terms. We invest capital in our existing facilities to develop new services or expand or renovate our facilities to generate new, or sustain existing, revenues from our operations. We may finance these capital commitments or development programs through operating cash flows or additional debt proceeds. Many states, including some where we have hospitals and others where we may attempt to acquire hospitals, have adopted legislation regarding the sale or other disposition of hospitals operated by non-profit entities. In other states that do not have such legislation, the attorneys general have demonstrated an interest in these transactions under their general obligations to protect charitable assets from waste. These legislative and administrative efforts focus primarily on the valuation of the assets divested and the use of the sale proceeds by the non-profit seller. These review and approval processes can add time to the consummation of an acquisition of a non-profit hospital, and future actions on the state level could seriously delay or even prevent future acquisitions of non-profit hospitals. As a condition to approving an acquisition, the attorney general of the state in which the hospital is located may require us to maintain services, such as emergency departments, or to continue to provide certain levels of charity care, which may affect our decision to acquire, or the terms upon which we acquire, these hospitals.

Difficulties in integrating acquired businesses may disrupt our ongoing operations.

We may, from time to time, evaluate strategic opportunities such as joint ventures and acquisitions that may be material, including the acquisition of healthcare systems, individual hospitals, outpatient clinics, physician groups and other ancillary healthcare businesses. Integrating acquired hospitals, physician practices or other business operations may require a disproportionate amount of management’s time and attention, potentially distracting management from its other day-to-day responsibilities. In addition, poor integration of acquired businesses could cause interruptions to our business activities, including those of the acquired facilities, and could cause potential loss of key employees or customers of acquired companies. We may not realize all or any of the anticipated benefits of an acquisition and we may incur significant costs related to the acquisitions or integration of these facilities. In addition, we may acquire hospitals and other businesses that have unknown or contingent liabilities, including liabilities for failure to comply with healthcare laws and regulations. Although we seek indemnification from prospective sellers covering these matters, we may have material liabilities for past activities of acquired hospitals.

We may be subject to liabilities because of claims brought against our hospitals, physician practices, outpatient facilities or other business operations.

Plaintiffs frequently sue hospitals and other healthcare providers, alleging malpractice, product liability or other legal theories. Many involve large claims and significant defense costs. Certain other hospital companies have been subject to class-action claims with respect to their billing practices for uninsured patients or lawsuits alleging inappropriate classification of claims, for billing, between observation and inpatient status.

We maintain professional malpractice liability insurance and general liability insurance in amounts we believe are sufficient to cover claims arising out of the operations of our facilities. Some of the claims could exceed the coverage in effect, and coverage of particular claims or damages could be denied.

The volatility of professional liability insurance and, sometimes, the lack of availability of such insurance coverage for physicians with privileges at our hospitals increase our risk of vicarious liability where both our hospital and the uninsured or underinsured physician are named as co-defendants. We are subject to self-insured risk and may be required to fund claims out of our operating cash flow. We cannot assure you that we can continue to obtain insurance coverage or that such insurance coverage, if it is available, will be available on acceptable terms.

As of September 30, 2016, our self-insured retention for professional and general liability coverage is $7.0 million for the first claim and $5.0 million per claim for each additional claim, with an excess aggregate limit of $55.0 million, and maximum coverage under our insurance policies is $75.0 million.

 

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In addition, physicians’ professional liability insurance costs in certain markets have dramatically increased to where some physicians are choosing to retire early or leave those markets. If physician professional liability insurance costs continue to escalate in markets in which we operate, some physicians may choose not to practice at our facilities, which could reduce our patient volumes and revenues. Our hospitals also may incur a greater percentage of the amounts paid to claimants if physicians cannot obtain adequate malpractice coverage since we are often sued in the same malpractice suits brought against physicians on our medical staffs who are not employed by us.

As part of our broader physician alignment strategies, we expect to continue to employ additional physicians, which could result in a significant increase in our professional and general liability risks and related costs in future periods.

Certain of our hospital leases contain terms and obligations that could expose us to lease termination or non-renewal, or other unfavorable leasing implications, which could materially and adversely affect our business, financial condition and results of operations.

We lease certain of our hospital properties. Some of these hospital leases can be subject to early termination if we violate certain provisions or covenants in the leases. Additionally, some of our hospital leases are with the same landlord and contain cross-default provisions that would allow that landlord to terminate all leases with us if we violate certain defined provisions related to a single lease with them. If we cannot renew or extend our existing leases, or purchase the hospitals subject to such leases, at or prior to the end of the existing lease terms, if the terms of lease renewal options are unfavorable or unacceptable to us, or if any landlord terminates a lease because of our breach of the lease, our business, financial condition and results of operations could be materially and adversely affected.

We depend on key personnel, and losing one or more of our senior management team or local management personnel could have a material adverse effect on our business.

Our business strongly depends upon the services and management experience of our senior management team and local management personnel. We depend on the ability of these senior management team members and key employees to manage growth successfully and on our ability to attract and retain skilled employees. Moreover, we do not maintain key man life insurance policies on any of our officers, including our senior corporate executives. If any of our executive officers or other members of senior management resign or otherwise cannot serve, our management expertise and ability to deliver healthcare services efficiently and to execute our business strategy could be diminished, and our business could be materially and adversely affected.

In addition, we manage our staffing carefully to enhance efficiency and control our salaries, wages and benefits. Historically, our hospitals have not overstaffed or had deep ranks of employees for succession planning but, rather, have maintained an efficient, small group of experienced personnel to manage our day-to-day business operations. If we fail to attract and retain managers at our hospitals and related facilities, our operations could be materially and adversely affected.

We may be subject to unionization, work stoppages, slowdowns or increased labor costs.

None of our employees are represented by a union. However, our employees have the right under the National Labor Relations Act to form or affiliate with a union. If some or all of our workforce were to become unionized and the terms of the collective bargaining agreement differed significantly from our current compensation agreements, it could increase our costs and adversely affect our profitability. Participation by our workforce in labor unions could put us at increased risk of labor strikes and disruption of our services.

Our hospitals are subject to compliance and other responsibilities and costs under environmental laws that could lead to material expenditures or liability.

We are subject to various federal, state and local environmental laws and regulations, including those relating to the protection of human health and the environment. We could incur substantial costs to maintain compliance with, and/or address liabilities arising under, these laws and regulations. We could become the subject of future enforcement or other legal proceedings, which could lead to damage claims, fines or criminal penalties if we are found to have liability under these laws and regulations. We also may be subject to requirements related to the investigation or remediation of substances or wastes released into the environment at properties owned or operated by us or our predecessors or at other properties where substances or wastes were sent for off-site treatment or disposal. These remediation requirements may be imposed without regard to fault, and liability for environmental remediation can be substantial.

 

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To our knowledge, we have not been and are not the subject of any investigations relating to noncompliance with or liability under environmental laws and regulations. We maintain insurance coverage for third-party liability related to the storage tanks at our facilities, which consists of several separate insurance policies, each providing for at least $2.0 million per claim and $5.0 million in the aggregate.

If the fair value of our reporting units declines, a material non-cash charge to earnings from an impairment of our goodwill may result.

At September 30, 2016, we had $767.7 million of goodwill recorded in our audited, consolidated financial statements. We expect to recover the carrying value of this goodwill through our future cash flows. On an annual basis, we evaluate, based on the fair value of our reporting units, whether the carrying value of our goodwill is impaired. An additional review is required when events or changes in circumstances indicate that such carrying value may not be recoverable. The testing of goodwill for impairment requires us to make significant estimates about our future performance and cash flows, as well as other assumptions related to our cost of capital and other factors impacting our fair value models. These estimates can be affected by various factors, including changes in economic, industry or other market assumptions, regulatory and legal factors, and changes in our business operations, changes in these factors, or changes in our actual performance compared with our estimates of future projections, could affect our calculation of the fair value of our reporting units, which could result in an impairment charge to goodwill.

As of September 30, 2016, the annual goodwill evaluation indicated an impairment of goodwill in our acute care Arizona reporting unit, and a non-cash charge of $54.0 million was recorded to write-off all goodwill related to that reporting unit. In addition, we determined that our Texas reporting unit was at risk for future impairment because its estimated fair value exceeded its carrying value by less than 15%. The estimated fair value of our acute care Texas reporting unit has been impacted by events and circumstances that have occurred at a Houston hospital during fiscal 2016. Additionally, revenue at certain of our Texas hospitals was negatively impacted by a decline in crude oil prices that occurred in fiscal years 2015 and 2016. We view the impact of these events on the estimated fair value of our acute care Texas reporting unit to be temporary in nature.

There can be no assurance that there will not be impairment charges in subsequent periods as a result of our future impairment reviews. To the extent that future impairment charges occur, it would have a material impact on our financial results.

A failure to maintain adequate internal controls over our financial and management systems may cause errors in our financial reporting.

The Sarbanes-Oxley Act of 2002 requires, among other things, that we maintain effective internal control over financial reporting. In particular, we must perform system and process evaluation and testing of our internal controls over financial reporting to allow management to report on our internal controls over financial reporting as required by Section 404 of the Sarbanes-Oxley Act of 2002.

While we have concluded that our internal control over financial reporting was effective as of September 30, 2016, as indicated in the Report of Management on Internal Control over Financial Reporting included in this Report, if we are unable to maintain effective internal control over financial reporting or we identify additional material weaknesses in the future, this may cause us to be unable to report our financial information on a timely basis or cause errors in our financial reporting and thereby subject us to adverse regulatory consequences, including sanctions by the SEC, or otherwise materially adversely affect our business, financial condition and results of operations.

Risks Related to our Managed Care Operations

Our revenue and profitability could be adversely affected by the loss of, or changes in, Health Choice’s contracts with the State of Arizona, a failure to control medical costs at Health Choice and other factors related to Health Choice.

Effective October 1, 2013, Health Choice entered into a contract with AHCCCS, Arizona’s Medicaid agency. The contract has a current term that expires on September 30, 2017 and includes one additional one-year renewal option that can be exercised at the discretion of AHCCCS. The contract is terminable without cause on 90 days written notice or for cause upon written notice if Health Choice fails to comply with any term or condition or fails to take corrective action as required to comply with the terms of the contract. AHCCCS can also terminate our contract upon unavailability of state or federal funding. If our existing contract with AHCCCS is terminated, our financial condition, cash flows and results of operations would be materially adversely affected. The contract allows Health Choice to serve Medicaid members in the following Arizona counties: Apache, Coconino, Gila, Maricopa, Mohave, Navajo, Pima and Pinal. For the years ended September 30, 2016, 2015 and 2014, Health Choice’s contract with AHCCCS contributed 25.0%, 25.6% and 23.6%, respectively, to our consolidated total revenue.

In response to state budgetary issues in Arizona during recent years, AHCCCS has worked to control its costs, through cuts in provider reimbursement and capitation premiums, targeted reductions in Medicaid eligible beneficiaries, the imposition of a tiered profit sharing plan and implementing a risk-based or severity-adjusted payment methodology for all health plans. Capitation rates for each health plan and geographic service area are adjusted annually based on the severity of treatment episodes experienced by each plan’s membership compared to the average over a specified 12-month period. Adjustments are calculated using diagnosis codes and

 

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procedural information from medical and pharmacy claims data, in addition to member demographic information. Each year, capitation rates are risk adjusted prospectively approximately six months into the contract year and then retroactively back to the start of the contract year. AHCCCS has implemented a tiered profit sharing plan, which is administered through an annual reconciliation process with all participating managed Medicaid health plans and will limit our net profit margins. If AHCCCS continues to reduce capitation premium rates, implements further eligibility restrictions or makes further alterations to the payment structure of its contracts, our results of operations and cash flows may be materially adversely affected.

Health Choice experienced significant enrollment growth following its award of a new contract in late 2013 and the governor of Arizona’s signing into law the state’s expansion of its Medicaid program under the Health Reform Law in 2013, which resulted in increased eligibility for adults, children and pregnant women, and the restoration of eligibility to childless adults whose eligibility was previously frozen. However, the state’s Medicaid expansion plan, which became effective on January 1, 2014, also contains a roll back provision that takes effect if the federally matched portion is reduced by 80% from its current levels. If additional changes to the Arizona Medicaid program are implemented, our revenue and earnings could be significantly impacted.

Further, while the Arizona legislature approved an expansion of Medicaid in 2013 which became effective on January 1, 2014, a lawsuit filed by several state lawmakers has challenged the legality of a provider fee assessed to all providers and used to help pay for Arizona’s Medicaid expansion. On August 26, 2015, the Arizona State Superior Court upheld the legality of the provider fee, thus preserving the existing funding for Medicaid expansion in Arizona. The plaintiffs are appealing this decision. If the legality of the provider fee used to help fund Arizona’s Medicaid expansion is ultimately successfully challenged on appeal, this may result in the loss of certain funding for the state’s Medicaid program, which could potentially result in changes that restrict eligibility and increase the number of uninsured individuals, which would adversely affect our operations in Arizona. In addition, if similar challenges are successful in other states where we operate, we may be similarly adversely affected by such challenges.

AHCCCS and the Medicaid agency in Utah, with the required approval of CMS, set the capitated rates received at Health Choice which subcontracts with physicians, hospitals and other healthcare providers to provide services to its enrollees. If Health Choice fails to manage healthcare costs effectively, these costs may exceed the payments it receives. Our medical loss ratio (medical claims expense as a percentage of premium revenue) for the years ended September 30, 2016, 2015 and 2014, was 92.5%, 88.7% and 88.8%, respectively. Relatively small changes in these medical loss ratios can create significant changes in the profitability of Health Choice. Many factors can cause actual healthcare costs to exceed the capitated rates Health Choice receives, including:

 

    an ability to contract with cost-effective healthcare providers;

 

    the increased cost of individual healthcare services and drug therapies, including specialty drugs;

 

    the type and number of individual healthcare services delivered; and

 

    catastrophes, epidemics, increased acuity levels of our members or other unforeseen occurrences.

Any future growth in membership increases the risk associated with managing health claims expense. If our medical claims expense increases, our financial condition or results of operations may be materially adversely affected.

Effective October 1, 2015, Health Choice’s joint venture, HCIC entered into a contract with the ADHS. The contract has an initial term of three years and includes two additional two-year renewal options that can be exercised at the discretion of ADHS. The contract is terminable by ADHS following HCIC’s failure to carry out a material contract term, condition or obligation. If our existing contract with ADHS is terminated, our financial condition, cash flows and results of operations would be materially adversely affected.

As of January 1, 2017, Health Choice will be exiting the Arizona marketplace exchange. Our decision to exit the exchange was driven by the instability of the Health Reform marketplace, uncertainty and lack of funding around government premium stabilization programs, and the overall nature of the related regulatory environment.

 

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Health Choice’s failure to successfully execute its growth strategy and expand its product lines, including its MSO services, may result in reduction or elimination of anticipated revenue or profitability and could have materially adverse consequences on our financial condition and results of operations.

We have sought to grow Health Choice’s business lines both in Arizona and beyond its core Arizona managed Medicaid operations. These growth initiatives include expansion of our service lines, expansion of our managed Medicaid business into other states, delivery of MSO services to third-party insurers and operation of accountable care networks in a manner that allows participating providers to engage in value- and risk-based contracts with such insurers.

Each of these growth strategies and expansion opportunities involves risks and there can be no assurance that we will successfully execute them. While Health Choice intends to pursue an expansion of its MSO and managed care solutions businesses, there can be no assurance that Health Choice will be successful in its efforts to diversify its client base, service offerings and geographic reach and compete successfully against other more established MSOs. For instance, in 2014, Health Choice Florida commenced operating as a MSO in the state of Florida, and employs approximately 160 employees located primarily in the Tampa area, providing managed care and administrative services for a large national insurer’s managed Medicaid plan members. Such service relationships, including Health Choice Florida’s existing arrangement with a large national insurer, customarily include rigorous performance standards applicable to the third party service provider and significant penalties associated with nonperformance, including termination rights of the service provider. If Health Choice does not meet these performance obligations and contractual penalties are imposed or termination rights are exercised as a result, this may result in an elimination or reduction in our anticipated revenue and profitability.

When we expand our core managed Medicaid business into new markets or service lines, we face competition with other managed Medicaid providers, many of whom may have incumbent relationships with state Medicaid agencies or who may be part of larger, more established regional or national insurance companies. Additionally, where Health Choice contracts with government agencies with respect to new business opportunities, there can be no assurance that such government programs will not be materially changed or that our contracts will be renewed and not be terminated, and as a result, we may not fully realize the potential benefits of these contracts. Furthermore, our development of accountable care networks involves significant challenges. These include efforts of other provider-based health systems to establish competing networks, recruit sufficient numbers of physicians into these networks, develop arrangements with sufficient payors, and effectively coordinate care and manage the health of various populations through these networks in a profitable manner. If we fail to execute successfully on any of these strategies, it will result in reduction or loss of anticipated revenue or profitability.

Our inability to effectively maintain and upgrade information technology systems used in our managed care operations, or the costs associated with such replacements and upgrades, could adversely affect our operations and financial results.

As with the healthcare information technology systems we use in our acute care operations, we invest heavily in our managed care information systems, and these systems evolve rapidly and are subject to extensive regulatory requirements. The replacement of any information technology system upon which we rely may be financially and administratively burdensome to us. Such replacements, upgrades and similar projects require modifications to our capital expenditure plans and constrain our ability to pursue other opportunities requiring significant capital and management resources. Additionally, such upgrades may be time consuming and complex from an administrative standpoint. If our implementation of a replacement technology system is inefficient, delayed or ineffective, we may experience disruptions or delays in our day-to-day administrative and care management processes, experience errors related to sharing of patient care information and declines in member, provider and/or employee satisfaction. Because the healthcare information technology business, regulatory requirements and the needs of our healthcare providers and health plan members continuously evolve, we cannot assure you that we will not incur such financial and administrative difficulties, which may have an adverse effect on our business, and results of operations.

Material risks are associated with participating in government-sponsored programs such as Medicaid, Medicare and the Exchanges, including dependence upon government funding, changes occurring because of the Health Reform Law, compliance with government contracts and increased regulatory oversight.

Health Choice contracts with state departments of health, Medicaid agencies and CMS to provide managed healthcare services. Revenues from the Medicaid and Medicare programs are dependent, in whole or in part, upon annual funding from the federal government through CMS and/or applicable state or local governments. Funding for these programs depends on many factors outside our control, including general economic conditions, tax revenues, continuing government efforts to contain healthcare costs, budgetary constraints at the federal or applicable state or local level, and general political issues and priorities. These governmental agencies have the right not to renew or cancel their contracts with Health Choice on short notice without cause or if funds are not available. Unanticipated changes in funding by the federal or state governments could substantially reduce our revenues and profitability.

 

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State governments have experienced tight budgetary conditions within their Medicaid programs due to difficult macroeconomic conditions and increases in the Medicaid eligible population. We anticipate this will require government agencies with which we contract to find funding alternatives, which may cause reductions in funding. If any state in which Health Choice operates were to decrease premiums paid to Health Choice, or pay Health Choice less than the amount to keep pace with its cost trends, it could have a material adverse effect on Health Choice’s revenues and results of operations. Economic conditions affecting state governments and agencies could also result in delays in receiving premium payments. If there is a significant delay in Health Choice’s receipt of premiums to pay health benefit costs, it could have a material adverse effect on our results of operations, cash flows and liquidity.

At both the federal and state government levels, legislative and regulatory proposals have been made related to, or potentially affecting, the health care industry, including but not limited to limitations on managed care organizations, including benefit mandates, and reform of the Medicaid and Medicare programs. Any such legislative or regulatory action, including benefit mandates or reform of the Medicaid and Medicare programs, could have the effect of reducing the premiums paid to us by governmental programs, increasing our medical and administrative costs or requiring us to materially alter the manner in which we operate. We are unable to predict the specific content of any future legislation, action or regulation that may be enacted or when any such future legislation or regulation will be adopted. Therefore, we cannot predict accurately the effect or ramifications of such future legislation, action or regulation on our managed care business.

The Medicare program has been the subject of recent regulatory reform initiatives, including the Health Reform Law. Effective in 2012, the Health Reform Law tied a portion of each Medicare Advantage plan’s reimbursement to the plan’s “star rating” by CMS, with those plans receiving a rating of three or more stars eligible for quality-based bonus payments. The star rating system considers various measures adopted by CMS, including quality of care, preventative services, chronic illness management and customer satisfaction. Beginning in 2015, plans must have a star rating of four or higher to qualify for bonus payments, and CMS may terminate contracts with plans that do not maintain a minimum star rating of three for three consecutive years. While Health Choice currently has a “three star” rating, if it does not maintain its star rating, its plan may be terminated, and if it does not continue to improve its star rating, it may not be eligible for full-level quality bonuses, which could adversely affect the benefits its plans offer, reduce our customer base, reduce profit margins or eliminate one or more of its plans altogether.

Medicare has implemented a Hierarchical Condition Categories model to adjust capitation payments to private Medicare Advantage healthcare plans for the health expenditure risk of their beneficiaries. The CMS Risk Adjustment Model measures the disease burden which is correlated to diagnosis codes dependent upon clinical documentation and claims files. Each year CMS recalibrates its model, pressuring acuity adjustment payments. If Health Choice does not maintain or continue to improve the effectiveness with which its provider delivery system codes the acuity of its patients, its financial performance could be adversely affected.

Contracts with CMS and the state governmental agencies contain certain provisions regarding data submission, provider network maintenance, quality measures, claims payment, continuity of care, call center performance and other requirements. If Health Choice fails to comply with these requirements, it may be subject to fines or penalties that could adversely affect its profitability.

In addition, Health Choice’s Exchange plan subsidiary in the State of Arizona and its Utah managed Medicaid plan subsidiary are subject to regulations by the respective state’s department of insurance oversight and managed care organization rules. These require those business lines to operate under requirements governing minimum amounts of permissible capital, adequacy of provider networks and other complex rules. Under the rules, if the ratio of the insurer’s adjusted surplus to its risk-based capital falls below statutorily required minimums, the insurer could be subject to regulatory actions ranging from increased scrutiny to conservatorship. We cannot assure you that future action taken by state or federal authorities regarding our Exchange plan products, will not have a material adverse effect on Health Choice’s health plan products or its business, financial condition or results of operations. Effective January 1, 2017, Health Choice will be exiting the Arizona marketplace exchange business.

Failure to comply with various state and federal healthcare laws and regulations, including those directed at preventing fraud and abuse in government funded programs, could cause investigations or litigation, with imposing fines, limitations on Health Choice’s ability to expand, restrictions or exclusions from program participation or other agreements with a federal or state governmental agency that could adversely affect its business, cash flows, financial condition and results of operations.

Managed care organizations have been the subject of federal and state investigations, and we may become subject to additional investigations that could cause significant liabilities or penalties to us and have a material adverse effect on our financial condition and results of operations.

Our managed care business is extensively regulated by the federal government and the states in which we operate. The laws and regulations governing our managed care operations are generally intended to benefit and protect health plan members and providers rather than stockholders and creditors. The government agencies administering these laws and regulations have broad latitude to enforce them. These laws and regulations, along with the terms of our government contracts, regulate how we do business, what services we offer, and how we interact with our members, providers and the public. Any violation by us of applicable laws or regulations could reduce our revenues and profitability, thereby having a material adverse effect on our financial condition and results of operations.

 

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We face a significant risk of litigation and regulatory investigations and actions in the ordinary course of operating our managed care business. The following are examples of types of potential litigation and regulatory investigations we face:

 

    claims by government agencies relating to compliance with laws and regulations;

 

    claims relating to sales practices;

 

    claims relating to the methodologies for calculating premiums;

 

    claims relating to the denial or delay of healthcare benefit payments;

 

    claims relating to claims payments and procedures;

 

    claims relating to provider marketing;

 

    claims by providers for network termination or exclusion;

 

    anti-kickback claims;

 

    medical malpractice or negligence actions based on our medical necessity decisions or brought against us on the theory that we are liable for our providers’ malpractice or negligence;

 

    provider disputes over compensation and termination of provider contracts;

 

    allegations of discrimination;

 

    allegations of breaches of duties;

 

    claims relating to inadequate or incorrect disclosure or accounting in our public filings;

 

    allegations of agent misconduct;

 

    claims related to deceptive trade practices; and

 

    claims relating to audits and contract performance.

As we contract with various governmental agencies to provide managed healthcare services, we are subject to various reviews, audits and investigations to verify our compliance with the contracts and applicable laws and regulations. Any adverse review, audit, investigation or result from litigation could result in:

 

    loss of our right to participate in government-sponsored programs, including Medicaid and Medicare;

 

    forfeiture or recoupment of amounts we have been paid pursuant to our government contracts;

 

    imposition of significant civil or criminal penalties, fines or other sanctions on us and/or our key associates;

 

    reduction or limitation of our membership;

 

    damage to our reputation in various markets;

 

    increased difficulty in marketing our products and services;

 

    restrictions on acquisitions or dispositions;

 

    suspension or loss of one or more of our licenses to act as an insurer, managed care organization or third-party administrator or to otherwise provide a service; and

 

    an event of default under our debt agreements.

In particular, because we receive payments from federal and state governmental agencies, we are subject to various laws commonly referred to as “fraud and abuse” laws, including the FCA, which permit agencies and enforcement authorities to institute suit against us for violations and, in some cases, to seek treble damages, penalties and assessments. Many states, including states where we currently operate, have enacted parallel legislation. Liability under such federal and state statutes and regulations may arise if we know, or it is found that we should have known, that information we provide to form the basis for a claim for government payment is false or fraudulent.

 

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Some courts have permitted FCA suits to proceed if the claimant was out of compliance with program requirements. Liability for such matters could have a material adverse effect on our financial position, results of operations and cash flows. Qui tam actions under federal and state law can be brought by any individual on behalf of the government. Qui tam actions have increased significantly in recent years, causing greater numbers of health care companies to defend false claim actions, pay fines or be excluded from Medicare, Medicaid or other state or federal health care programs as a result of investigations arising out of such actions. Qui tam actions may have been filed against of us of which we are presently unaware, or qui tam actions may be filed against us in the future. If such a qui tam action were successfully brought against Health Choice, it could have a material adverse effect on our financial position, results of operations and cash flows.

Health Choice’s medical membership remains concentrated in certain geographic areas and governmental health plan offerings, exposing us to unfavorable changes in local economic and governmental conditions.

Despite its recent expansion into new service lines and geographic markets, including management and administrative services, the formation of a Utah managed Medicaid plan, its new HCIC joint venture, and provider networking on behalf of our acute care operations in certain markets, Health Choice’s core business remains its Arizona managed Medicaid plan, which as of September 30, 2016 served 259,100 members. Health Choice maintains this business subject to its contract with AHCCCS, the current term of which expires on September 30, 2017, subject to a one-year renewal term at the option of AHCCCS. Health Choice’s continued maintenance of its managed Medicaid business in Arizona depends upon its ability to meet its contractual obligations under its governmental contracts, and win awards for new such contracts during the state’s periodic procurement or request for proposal (“RFP”) process. These RFP processes typically involve intense competition with local and national managed care payors, many of whom have varying operational and greater financial resources than Health Choice. There can be no assurance that Health Choice’s managed Medicaid business will continue to perform effectively in this competitive landscape or continue to be awarded Arizona state contracts during future RFP cycles.

Unfavorable changes in healthcare or other benefit costs, member utilization or reimbursement rates or increased competition in those geographic areas where Health Choice’s membership is concentrated could have a disproportionately adverse effect on our operating results. Health Choice’s membership has been and may continue to be affected by unfavorable general economic and state budgetary conditions, which in recent years have involved challenges such as capitation rate cuts by the state of Arizona and a tightening of eligibility requirements for Medicaid coverage, including past reductions in Medicaid coverage for childless adults.

If Medicaid programs, including the state of Arizona through its AHCCCS program, fail to provide supplemental payments to Health Choice for new or experimental drugs that physicians and consumers deem medically necessary, then Health Choice’s pharmaceutical costs and medical loss ratio may increase, and Health Choice’s profitability may decrease.

New or experimental drugs for which AHCCCS or other governmental agencies do not provide supplemental payments or other subsidies may affect Health Choice’s financial performance. Medical costs involved with a single health plan member’s treatment through new or experimental drugs can exceed Health Choice’s annual capitation payment attributable to such plan member by many multiples. When rates are established during routine contracting cycles for Health Choice in its bids with state Medicaid agencies in Arizona and Utah, the availability and related costs of new and experimental drugs such are often not fully taken into account, which can result in unexpected medical costs in the treatment of patients whose needs for such treatments are determined to be a medically necessary treatment.

In response to development of new pharmaceuticals and treatments, there can be no assurance that state Medicaid programs, including AHCCCS and other governmental agencies, will retroactively or timely adjust their capitation payments to us under our contracts with them, in which case Health Choice may be forced to bear the financial cost of those new pharmaceuticals and treatments for covered patients it manages, either temporarily or permanently. These unanticipated medical costs, if not partially or fully reimbursed by governmental agencies, may increase our medical loss ratio and reduce the profitability of our managed care operations.

Health Choice’s profitability depends upon its ability to accurately predict and control healthcare costs.

A substantial majority of the revenue Health Choice receives is used to pay the costs of healthcare services or supplies delivered to our members. The total healthcare costs it incurs are affected by the number and type of individual services provided and the cost of each service. Our future results of operations will depend, in part, on Health Choice’s ability to accurately predict healthcare costs and to control future healthcare utilization and costs through, utilization management, prior authorization, product design and negotiation of favorable physician provider, hospital and pharmacy contracts. Periodic renegotiations of healthcare provider contracts, coupled with continued consolidation of physician, hospital and other provider groups, may cause increased healthcare costs or limit our ability to negotiate favorable rates. Changes in utilization rates, demographic characteristics, the regulatory environment, healthcare practices, inflation, new technologies, new high cost drug therapies, clusters of high-cost cases, continued consolidation of physician, hospital and other provider groups and numerous other factors affecting healthcare costs may negatively impact our ability to predict and control healthcare costs and, thereby materially adversely affecting our financial condition, results of operations and cash flows. In addition, a large scale public health epidemic, such as the avian flu, Ebola or the Zika virus, could affect our ability to control healthcare costs.

 

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For several years, one of the fastest increasing categories of our healthcare costs has been the cost of hospital-based products and services. Factors underlying the increase in hospital costs include, but are not limited to, the underfunding of public programs, such as Medicaid and Medicare, growing rates of uninsured individuals, new technology, state initiated mandates, alleged abuse of hospital chargemasters, an aging population and, under certain circumstances, relatively low levels of hospital competition. New specialty drugs are being fast tracked through FDA trials. In connection with these new treatments Health Choice must meet certain medical necessity requirements for its Medicaid and Medicare program contracts with regard to the provision of medication therapy. Due to this paradigm, pharmacy costs likely may outpace capitation reimbursement rates, adversely affecting our financial condition.

Changes in the prescription drug industry pricing benchmarks may adversely affect our financial performance.

Pharmaceutical products and services constitute a significant portion of Health Choice’s medical costs. Contracts in the prescription drug industry use certain published benchmarks to establish pricing for prescription drugs. These benchmarks include average wholesale price, referred to as “AWP,” average selling price, referred to as “ASP,” and wholesale acquisition cost. It is uncertain whether pharmacy providers, pharmacy benefit managers, or PBMs, and others in the prescription drug industry will continue to utilize AWP as it has been calculated, or whether other pricing benchmarks will be adopted for establishing prices within the industry. Legislation may lead to changes in the pricing for Medicare and Medicaid programs. Regulators have investigated the use of AWP for federal program payment, and whether using AWP has inflated drug expenditures by the Medicare and Medicaid programs.

Federal and state proposals have sought to change the basis for calculating payment of certain drugs by the Medicare and Medicaid programs. Adoption of ASP in lieu of AWP as the measure for determining payment by Medicare or Medicaid programs for the drugs sold in our mail-order pharmacy business may reduce the revenues and gross margins of this business, which may cause a material adverse effect on our results of operations, financial position and cash flows.

If Health Choice fails to develop and maintain satisfactory relationships with physicians, hospitals and ancillary healthcare providers, our business and results of operations may be adversely affected.

Health Choice contracts with physicians, hospitals and other healthcare providers to provide healthcare services rendered to our health plan members. Its results of operations depend on our ability to contract for these services at competitive rates. In any market, physicians, hospitals and healthcare providers could refuse to contract with any of our health plans, demand higher payments or take other actions that could cause higher medical costs or less desirable products for our customers. In some markets, certain providers, particularly hospitals, physician/hospital organizations and multi-specialty physician groups, may have significant or controlling market positions that could cause a diminished bargaining position for us. If providers refuse to contract with Health Choice, use their market position to negotiate favorable contracts or place us at a competitive disadvantage, our ability to market products or to be profitable in those areas could be materially and adversely affected.

Our ability to develop and maintain satisfactory relationships with healthcare providers also may be negatively affected by other factors not associated with us, such as changes in Medicare and/or Medicaid reimbursement levels, increasing revenue and other pressures on healthcare providers and consolidation activity among hospitals, physician groups and healthcare providers. Ongoing reductions by CMS and state governments in amounts payable to providers for services provided to Medicare and Medicaid enrollees may pressure the financial condition of certain providers and adversely affect our ability to maintain or develop new cost-effective healthcare provider contracts or result in a loss of revenues or customers.

Recent and continuing consolidation among physicians, hospitals and other healthcare providers, development of accountable care organizations and other changes in the organizational structures that physicians, hospitals and healthcare providers choose may change the way these providers interact with us and may change the competitive landscape in which we operate. Sometimes, these organizations may compete directly with us, potentially affecting how we price our products or causing us to incur increased costs if we change our operations to be more competitive.

Out-of-network providers have no pre-established understanding with us about the compensation due for their services. Some states define by law or regulation the amounts due, but usually it is not defined or is established by a standard not clearly translatable into dollar terms. In such instances, providers may believe that they were underpaid and may litigate or arbitrate their dispute with us or try to recover from our customers the difference between what we have paid them and the amount they charged us. The outcome of disputes where we have no provider contract may cause us to pay higher medical or other benefit costs than we projected, which may adversely affect our business and results of operations.

 

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Health Choice depends on the success of its relationships with third parties for various services and functions, including pharmacy benefit and radiation management services.

As part of its operations, Health Choice contracts with third parties for selected services and functions, including pharmacy benefit management services, radiology benefit management services, and various other service providers in areas such as information technology and disease management services. Health Choice’s operations may be vulnerable if these third parties fail to perform their obligations to it or if the arrangement is terminated. If there are delays or difficulties that cause our third party vendors to not perform as expected, Health Choice may not realize, or realize on a timely basis, the anticipated operating efficiencies and financial benefits of these relationships. Violation of or noncompliance with laws by our third party vendors could increase Health Choice’s exposure of liability to its members and government regulators. Noncompliance with any privacy or security laws and regulations or any security breach involving one of its third-party vendors could have a material adverse effect on Health Choice’s business, results of operations, financial condition, liquidity and reputation.

Risk Factors Related to Capital Structure

Servicing our indebtedness requires a significant amount of cash. Our ability to generate sufficient cash depends on numerous factors beyond our control, and we may not generate sufficient cash flow to service our debt obligations, including making payments on our 8.375% Senior Notes and Senior Secured Credit Facilities.

As of September 30, 2016, we have outstanding $849.9 million in aggregate principal amount of 8.375% senior notes due 2019 (“Senior Notes”), which mature on May 15, 2019. We also have entered into our senior secured credit facilities, which include (1) amounts outstanding under our senior secured term loan of $969.3 million, maturing in May 2018 and (2) a senior secured revolving credit facility of $207.4 million, maturing in February 2021 (subject to an earlier springing maturity date under certain circumstances), of which up to $125.0 million may be utilized for issuing letters of credit (together, the “Senior Secured Credit Facilities”). Our ability to borrow funds under our revolving credit facility is subject to the financial viability of the participating financial institutions. If any of our creditors were to suffer financial difficulties, or if the credit markets deteriorated, our ability to access funds under our revolving credit facility could be limited.

We cannot assure you that our business will generate sufficient cash flow from operations or that future borrowing will be available to us under our Senior Secured Credit Facilities in an amount sufficient to enable us to pay the principal and interest on our indebtedness, including the Senior Notes and term loan, or to fund our other liquidity needs. Our ability to fund these payments is subject to general economic, financial, competitive, legislative, regulatory and other factors beyond our control. We may need to refinance all or a portion of our indebtedness, including the Senior Notes and term loan, by maturity. We cannot assure you we can refinance any of our indebtedness, on commercially reasonable terms or otherwise. In addition, the terms of existing or future debt agreements, including the amended and restated credit agreement governing the Senior Secured Credit Facilities and the indenture governing the Senior Notes, may restrict us from effecting any of these alternatives.

During the fiscal year ending September 30, 2017, along with interest on our Senior Secured Credit Facilities, we must repay $10.1 million in principal under our Senior Secured Credit Facilities and $71.2 million in interest under the Senior Notes. If we cannot make scheduled payments on our debt, we will be in default and, as a result:

 

    our debt holders could declare all outstanding principal and interest to be due;

 

    our secured debt lenders could terminate their commitments and commence foreclosure proceedings against our assets; and

 

    we could be forced into bankruptcy or liquidation.

Our substantial indebtedness could adversely affect our financial flexibility and our competitive position.

We have significant indebtedness. As of September 30, 2016, we had $1.86 billion of indebtedness outstanding, besides availability under the revolving credit portion of our Senior Secured Credit Facilities. Our substantial amount of indebtedness could have significant consequences on our financial condition and results of operations. It could:

 

    make it more difficult for us to satisfy our obligations regarding our outstanding debt;

 

    increase our vulnerability to adverse economic and industry conditions;

 

    expose us to fluctuations in the interest rate environment because the interest rates under our Senior Secured Credit Facilities are variable;

 

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    require us to dedicate a substantial portion of our cash flow from operations to make payments on our indebtedness, reducing the availability of our cash flow to fund working capital, capital expenditures and other general corporate purposes;

 

    limit our flexibility in planning for, or reacting to, changes in the business and industry in which we operate;

 

    restrict us from exploiting business opportunities;

 

    place us at a disadvantage compared to our competitors that have less debt; and

 

    limit our ability to borrow additional funds for working capital, capital expenditures, acquisitions, debt service requirements, execution of our business strategy and other general corporate purposes or to refinance our existing debt.

We, including our subsidiaries, can incur substantially more indebtedness, including senior secured indebtedness.

Subject to the restrictions in our Senior Secured Credit Facilities and the indenture governing the Senior Notes, we, including our subsidiaries, may incur significant additional indebtedness. As of September 30, 2016:

 

    we had $849.9 million of senior unsecured indebtedness under the Senior Notes;

 

    we had $969.3 million of senior secured debt outstanding under our Senior Secured Credit Facilities; and

 

    subject to compliance with customary conditions, we had available to us $111.3 million (after consideration of outstanding letters of credit totaling $96.1 million under our revolving credit facility) under the revolving credit portion of our Senior Secured Credit Facilities, which, if borrowed, would be senior secured indebtedness.

Although our Senior Secured Credit Facilities and the indenture governing the Senior Notes contain restrictions on the incurrence of additional indebtedness, these restrictions are subject to several important exceptions, and indebtedness incurred in compliance with these restrictions could be substantial. If we and our subsidiaries incur significant additional indebtedness, the related risks we face could increase.

Agreements governing our indebtedness may restrict our current and future operations, which could adversely affect our ability to respond to changes in our business and to manage our operations.

Agreements governing our indebtedness and the indenture governing the Senior Notes contain, and any future indebtedness may contain, several restrictive covenants that impose significant operating and financial restrictions on us and our subsidiaries, including restrictions on our or our subsidiaries’ ability to:

 

    incur additional indebtedness or issue disqualified stock or preferred stock;

 

    pay dividends or make other distributions on, redeem or repurchase our capital stock;

 

    sell certain assets;

 

    make certain loans and investments;

 

    enter into certain transactions with affiliates;

 

    incur liens on certain assets to secure debt;

 

    to pay dividends or make payments or distributions to us and our restricted subsidiaries; or

 

    consolidate, merge or sell all or substantially all of our assets.

Our ability to comply with these agreements may be affected by events beyond our control, including prevailing economic, financial and industry conditions. These covenants could have an adverse effect on our business by limiting our ability to take advantage of financing, mergers and acquisitions or other corporate opportunities. The breach of any of these restrictions could cause a default under the indenture governing the Senior Notes or under our Senior Secured Credit Facilities.

An increase in interest rates would increase the cost of servicing our debt and could reduce our profitability.

Borrowings under our Senior Secured Credit Facilities bear interest at variable rates. Interest rate changes could affect our interest payments, and our future earnings and cash flows, assuming other factors are held constant. We have previously entered into, and in the future may enter into, interest rate hedging instruments to reduce our exposure to interest rate volatility; however, any hedging instruments we enter into may not fully mitigate our interest rate risk. An increase in interest rates, whether because of an increase in market interest rates or an increase in our own cost of borrowing, would increase the cost of servicing our debt and could materially reduce our profitability.

 

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A failure by us or our subsidiaries to comply with the agreements relating to our outstanding indebtedness, including because of events beyond our control, could cause an event of default that could materially and adversely affect our results of operations and our financial condition.

If we or our subsidiaries defaulted under any of the agreements relating to our outstanding indebtedness, the holders of the defaulted debt could cause all amounts outstanding regarding that debt to be due immediately. Upon acceleration of certain of our other indebtedness, holders of the Senior Notes could declare all amounts outstanding under the Senior Notes immediately due and payable. We cannot assure you that our assets or cash flow would be sufficient to fully repay borrowings under our outstanding debt instruments if accelerated upon an event of default. Further, if we cannot repay, refinance or restructure our secured debt, the holders of such debt could proceed against the collateral securing that indebtedness. In addition, any event of default or declaration of acceleration under one debt instrument could also result in an event of default under one or more of our other debt instruments. In addition, counterparties to some of our contracts material to our business may amend or terminate those contracts if we have an event of default or a declaration of acceleration under certain of our indebtedness, which could adversely affect our business, financial condition or results of operations.

A ratings downgrade or other negative action by a ratings organization could adversely affect us.

Credit rating agencies continually review their ratings for companies they follow. The condition of the financial and credit markets and prevailing interest rates have fluctuated in the past and will continue to fluctuate, potentially to a significant degree, in the future. In addition, developments in our business and operations could lead to a ratings downgrade for us or our subsidiaries. Any such fluctuation in the rating of us or our subsidiaries may impact our ability to access debt markets in the future or increase our cost of future debt which could have a material adverse effect on our results of operations and financial condition.

We are controlled by our principal equity sponsors, who have interests that may conflict with the interests of our Company.

We are controlled by our principal equity sponsors who can control our financial-related policies and decisions. Our principal equity sponsors could cause us to enter into transactions that, in their judgment, could enhance their equity investment, even though such transactions might reduce our cash flows or capital reserves. So long as our principal equity sponsors continue to own a significant amount of our equity interests, they will continue to strongly influence and control the decisions related to our Company. In addition, our principal equity sponsors may from time to time acquire and hold interests in businesses that compete directly or indirectly with us and, therefore, have interests that may conflict with the interests of our Company.

Item 1B.   Unresolved Staff Comments

Not applicable.

Item 2.   Properties.

Our Properties

Information with respect to our hospitals and other healthcare related properties can be found below in this Report.

Our principal executive offices in Franklin, Tennessee are located in approximately 61,000 square feet of office space. Our office space is leased pursuant to a lease contract, which expires on December 31, 2020.

Our principal executive offices, hospitals and other facilities are suitable for their respective uses and generally are adequate for our present needs. Our obligations under our Senior Secured Credit Facilities are secured by, among other things, mortgage liens on all of our material real property and that of certain of our subsidiaries, including the properties listed below. Also, our properties are subject to various federal, state and local statutes and ordinances regulating their operation. Our management does not believe that maintaining compliance with such statutes and ordinances will materially affect our financial position or results of operations.

 

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We operate 17 acute care hospital facilities and one behavioral health hospital facility. Each of our hospitals is included in the acute care operations of our business, as discussed in Note 13 (Segment and Geographic Information) to our audited, consolidated financial statements in this Report. We own ten and lease seven of our hospital facilities. Thirteen of our acute care hospitals are partially owned by unaffiliated third-party investors through nine different partnerships. The following table contains information concerning our hospitals.

 

Hospitals

   City      Licensed
Beds
 

Utah

     

Davis Hospital and Medical Center(1)

     Layton         220   

Jordan Valley Medical Center(2)

     West Jordan         172   

Jordan Valley Medical Center—West Valley Campus(3)

     West Valley City         102   

Mountain Point Medical Center(4)

     Lehi         40   

Salt Lake Regional Medical Center(5)

     Salt Lake City         158   

Arizona

     

Mountain Vista Medical Center(6)

     Mesa         178   

St. Luke’s Medical Center(7)

     Phoenix         200   

St. Luke’s Behavioral Health Center

     Phoenix         124   

Tempe St. Luke’s Hospital(8)

     Tempe         87   

Texas

     

Odessa Regional Medical Center(9)

     Odessa         225   

Southwest General Hospital(10)

     San Antonio         327   

St. Joseph Medical Center(11)

     Houston         790   

The Medical Center of Southeast Texas(12)

     Port Arthur         199   

The Medical Center of Southeast Texas—Victory Campus(13)

     Beaumont         17   

Wadley Regional Medical Center(14)

     Texarkana         370   

Louisiana

     

Glenwood Regional Medical Center(15)

     West Monroe         278   

Arkansas

     

Wadley Regional Medical Center at Hope(16)

     Hope         79   

Colorado

     

Pikes Peak Regional Hospital(17)

     Woodland Park         15   
     

 

 

 

Total

        3,581   

 

(1) Owned by a limited partnership in which we own a 96.4% interest; a “physician-owned hospital” as defined under 42 U.S.C. §1395nn.
(2) On July 1, 2007, Jordan Valley acquired Jordan Valley Medical Center—West Valley Campus, a wholly-owned subsidiary of IASIS. The combined entity is owned by a limited partnership in which we own a 96.0% interest; a “physician-owned hospital” as defined under 42 U.S.C. §1395nn.
(3) A separate campus of Jordan Valley, which is leased under an agreement that expires on September 30, 2028. We have options to extend the term of the lease, which includes two renewal options of five years each.
(4) A separate campus of Jordan Valley that opened in June 2015.
(5) Owned by a limited partnership in which we own a 98.4% interest; a “physician-owned hospital” as defined under 42 U.S.C. §1395nn.
(6) Mountain Vista Medical Center is leased under an agreement that expires on September 30, 2028, and includes two renewal options of five years each. The operations are owned by a limited partnership in which we own a 93.9% interest; a “physician-owned hospital” as defined under 42 U.S.C. §1395nn.
(7) On September 28, 2007, St. Luke’s Medical Center acquired Tempe St. Luke’s Hospital, a wholly-owned subsidiary of IASIS.
(8) A separate campus of St. Luke’s Medical Center.
(9) Owned by a limited partnership in which we own an 88.5% interest; a “physician-owned hospital” as defined under 42 U.S.C. §1395nn.
(10) Owned by a limited partnership in which we own a 94.5% interest; a “physician-owned hospital” as defined under 42 U.S.C. §1395nn.
(11) Owned by a limited liability company in which we own a 79.7% interest; a “physician-owned hospital” as defined under 42 U.S.C. §1395nn.

 

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(12) The Medical Center of Southeast Texas is leased under an agreement that expires on September 30, 2028, and includes two renewal options of five years each. The operations are owned by a limited partnership in which we own an 88.1% interest; a “physician-owned hospital” as defined under 42 U.S.C. §1395nn.
(13) A separate campus of The Medical Center of Southeast Texas that was acquired in September 2015.
(14) Wadley Regional Medical Center (“Wadley”) is leased under an agreement that expires on March 31, 2017, with up to 51 automatic two year renewal periods. The operations are owned by a limited liability company in which we own a 74.2% interest; a “physician-owned hospital” as defined under 42 U.S.C. §1395nn.
(15) Glenwood is leased under an agreement that expires on September 30, 2028, and includes two renewal options for a total of seven years. This facility includes Ouachita, a surgical hospital with 10 licensed beds, which is owned by Glenwood.
(16) Owned by Brim Healthcare of Texas, LLC, the same wholly-owned subsidiary of IASIS that owns a majority equity interest in Wadley.
(17) Pikes Peak Regional Hospital is leased under an agreement that expires on September 11, 2017, and is subject to three five-year renewal periods at our option.

The limited partnership agreements for our physician-owned hospitals provide the limited partners with put rights which allow the units to be sold back to us, subject to certain limitations, at the fair value of the units. See Note 2, Significant accounting policies, to our audited, consolidated financial statements included elsewhere in this Report.

We also operate and lease medical office buildings which are occupied primarily by physicians who practice at our hospitals. We lease office space in the states where our managed care business operates. Health Choice currently maintains business offices in the Phoenix, Arizona, Salt Lake City, Utah and Tampa, Florida markets. We believe these lease arrangements are adequate to meet our managed care services operational needs for the foreseeable future.

Item 3.   Legal Proceedings.

None.

Item 4.   Mine Safety Disclosures.

Not applicable.

 

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PART II

Item 5.   Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

There is no established public trading market for our common interests. At December 21, 2016, all of our common interests were owned by IAS.

See “Item 12—Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters,” of this Report for information regarding our equity compensation plans.

Item 6.   Selected Financial Data.

The following table presents selected historical financial data for the fiscal years ended September 30, 2016, 2015, 2014, 2013 and 2012, and was derived from our audited, consolidated financial statements.

Our audited, consolidated financial statements for the years ended September 30, 2016, 2015 and 2014, together with the related report of the independent registered public accounting firm, are included under “Item 8.—Financial Statements and Supplementary Data” of this Report. The selected financial information and other data presented below should be read in conjunction with the information contained in “Item 7.—Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Report and the audited, consolidated financial statements and the related notes thereto included under “Item 8.—Financial Statements and Supplementary Data” of this Report.

 

     Year Ended September 30,  
     2016     2015     2014     2013     2012  

Statement of Operations Data

          

Total revenue

   $ 3,252,541      $ 2,769,260      $ 2,502,456      $ 2,285,054      $ 2,244,941   

Costs and expenses

          

Salaries and benefits

     987,147        932,815        892,818        848,010        790,080   

Supplies

     335,707        322,236        299,760        294,409        283,663   

Medical claims

     1,135,256        732,680        596,778        467,294        466,125   

Rentals and leases

     86,540        76,620        72,714        52,896        42,785   

Other operating expenses

     552,747        465,867        426,933        393,516        415,097   

Medicare and Medicaid EHR incentives

     (2,178     (6,907     (14,417     (20,723     (21,831

Interest expense, net

     132,374        128,857        130,818        133,206        137,990   

Depreciation and amortization

     106,474        96,472        95,312        94,026        101,264   

Management fees

     5,000        5,000        5,000        5,000        5,000   

Impairment of goodwill

     54,005        —          —          —          —     
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total costs and expenses

     3,393,072        2,753,640        2,505,716        2,267,634        2,220,173   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Earnings (loss) from continuing operations before gain (loss) on disposal of assets and income taxes

     (140,531     15,620        (3,260     17,420        24,768   

Gain (loss) on disposal of assets, net

     1,480        (1,408     3,402        (8,982     2,241   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Earnings (loss) from continuing operations before income taxes

     (139,051     14,212        142        8,438        27,009   

Income tax expense (benefit)

     (22,044     7,449        (2,464     3,647        1,981   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net earnings (loss) from continuing operations

     (117,007     6,763        2,606        4,791        25,028   

Earnings (loss) from discontinued operations, net of income taxes

     (3,433     (1,793     (14,043     5,708        6,560   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net earnings (loss)

     (120,440     4,970        (11,437     10,499        31,588   

Net earnings attributable to non-controlling interests

     (11,115     (12,945     (11,668     (7,215     (8,712
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net earnings (loss) attributable to IASIS Healthcare LLC

   $ (131,555   $ (7,975   $ (23,105   $ 3,284      $ 22,876   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance Sheet Data

          

Cash and cash equivalents

   $ 345,685      $ 378,513      $ 341,180      $ 438,131      $ 48,882   

Total assets

   $ 2,680,283      $ 2,753,632      $ 2,699,836      $ 2,880,265      $ 2,698,485   

Long-term debt, capital leases and other long-term obligations (including current portion)

   $ 1,859,739      $ 1,854,530      $ 1,853,800      $ 1,866,043      $ 1,866,494   

Member’s equity (deficit)

   $ (23,247   $ 117,847      $ 120,005      $ 142,262      $ 141,589   

 

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Selected Operating Data

The following table sets forth certain unaudited operating data for each of the periods presented.

 

     Year Ended September 30,  
     2016     2015     2014  

Acute care operations (1)

      

Number of hospital facilities at end of period

     18        18        16   

Licensed beds at end of period

     3,581        3,661        3,604   

Average length of stay (days) (2)

     4.9        5.0        5.0   

Occupancy rates (average beds in service)

     47.6     48.5     48.5

Admissions (3)

     102,073        102,019        100,909   

Adjusted admissions (4)

     195,330        192,692        186,609   

Patient days (5)

     505,066        506,457        503,648   

Adjusted patient days (4)

     966,510        956,589        931,387   

Surgeries

     68,898        65,683        65,484   

Emergency room visits

     430,740        433,539        411,156   

Net patient revenue per adjusted admission (6)

   $ 9,968      $ 9,721      $ 9,575   

Outpatient revenue as a % of gross patient revenue

     47.7     47.1     45.9
      

Managed care operations

      

Health plan lives (7)

     522,800        273,100        223,400   

MSO lives (8)

     98,000        93,800        83,400   

Accountable care network lives (9)

     57,100        34,300        20,800   
  

 

 

   

 

 

   

 

 

 

Total lives

     677,900        401,200        327,600   
      

Medical loss ratio (10)

     92.5     88.7     88.8

 

(1) Excludes the impact of our Nevada and Florida operations, which are reflected in discontinued operations. Includes St. Luke’s Behavioral Health Center in Phoenix, Arizona.
(2) Represents the average number of days that a patient stayed in our hospitals.
(3) Represents the total number of patients admitted to our hospitals that qualify for inpatient status. Management and investors use this number as a general measure of inpatient volume.
(4) Adjusted admissions and adjusted patient days are general measures of combined inpatient and outpatient volume. We compute adjusted admissions/patient days by multiplying admissions/patient days by gross patient revenue and then dividing that number by gross inpatient revenue.
(5) Represents the number of days our beds were occupied by inpatients over the period.
(6) Includes the impact of the provision for bad debts as a component of revenue.
(7) Represents total lives enrolled across all health plan product lines. Includes Duals, which are members eligible for Medicare and Medicaid benefits, under Health Choice’s contract with CMS to provide coverage as a MAPD SNP, totaling 9,500, 9,900 and 8,700 as of September 30, 2016, 2015 and 2014, respectively.
(8) Represents lives enrolled in Health Choice’s MSO that provides management and administrative services to a large national insurer’s Medicaid plan members in the Tampa and “panhandle” regions of Florida.
(9) Represents attributed health plan member lives from other third-party payors for which Health Choice Preferred accountable care networks manage medical care and participating providers and Health Choice share associated financial risks. This excludes 28,100 and 46,600 attributed Health Choice plan member lives as of September 30, 2016 and 2015, respectively.
(10) Represents medical claims expense as a percentage of premium revenue, including claims paid to our hospitals.

 

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Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operations.

The following discussion and analysis of financial condition and results of operations should be read in conjunction with the “Cautionary Statement Regarding Forward-Looking Statements” and “Item 1A.—Risk Factors,” our audited, consolidated financial statements, the notes to our audited consolidated financial statements, and the other financial information appearing under “Item 8.—Financial Statements and Supplementary Data” of this Report. We intend for this discussion to provide you with information that will assist you in understanding our financial statements, the changes in certain key items in those financial statements from year to year, and the primary factors that accounted for those changes. It includes the following sections:

 

    Executive Overview;

 

    Results of Operations Summary;

 

    Liquidity and Capital Resources; and

 

    Critical Accounting Policies and Estimates.

Data for the years ended September 30, 2016, 2015 and 2014, have been derived from our audited, consolidated financial statements.

EXECUTIVE OVERVIEW

We are a healthcare services company delivering high-quality, cost-effective healthcare through a broad and differentiated set of capabilities and assets that includes acute care hospitals with related patient access points, and a diversified and growing managed care risk platform. Our business model is centered on deploying our acute care expertise and risk platform, either separately or on an integrated basis to manage population health, integrate the delivery and payment of healthcare services and ultimately expand our total market opportunities within our existing and new geographic markets. Our business consists of two operating segments: (i) our acute care operations, which, as of September 30, 2016, included 17 acute care hospitals, one behavioral health hospital and multiple other access points, including 147 physician clinics, multiple outpatient surgical units, imaging centers, and investments in urgent care centers and on-site employer-based clinics, and (ii) our managed care operations, comprised of our diversified and growing risk platform, Health Choice, which operates managed Medicaid and Medicare health plans and an MSO that provides management and administrative services to third-party insurers, as well as accountable care networks in conjunction with our acute care facilities.

Acute Care Operations

As of September 30, 2016, we owned or leased 17 acute care hospital facilities and one behavioral health hospital facility with a total of 3,581 licensed beds, several outpatient service facilities and 147 physician clinics.

We operate our hospitals with a strong community focus by offering and developing healthcare services targeted to the needs of the markets we serve, promoting strong relationships with physicians and working with local managed care plans to develop quality and outcome driven, cost-efficient and innovative reimbursement models. Our major acute care geographic markets include Salt Lake City, Utah; Phoenix, Arizona; five cities in Texas, including Houston, San Antonio and Odessa; and West Monroe, Louisiana.

Since our Company was founded in 1998, we believe we have developed a reputation for operating hospitals that deliver high quality care in our markets at rates that are often more affordable than many other hospitals in our markets with larger local market share than us. Our corporate and divisional infrastructure allows us to leverage savings in information technology services, revenue cycle, hospital supplies, and labor force costs.

Managed Care Operations

Health Choice, headquartered in Phoenix, Arizona, began providing managed Medicaid services under contract with AHCCCS in 1990, making it one of the nation’s first Medicaid managed care plans. Under our ownership beginning in 1999, Health Choice has evolved into a managed care organization and insurer which, while growing its core managed Medicaid business, has expanded to serve certain Medicare Advantage members and is utilizing its population health management expertise to offer MSO-related services to other payors. In collaboration with our hospitals and affiliated physicians in certain of our markets, Health Choice also manages accountable care provider networks.

Health Choice provides the Company with the ability to engage in innovative value-based purchasing initiatives and opportunities. Its leadership team has considerable experience in population health management, physician relations and network development. We believe Health Choice also deploys state of the art disease management and claims processing technology. In light of the current healthcare industry trends toward integrated delivery and clinical integration, we are seeking to use Health Choice’s expertise and technology in the management of the accountable care provider networks we offer to other health plans.

 

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As of September 30, 2016, Health Choice’s related entities managed healthcare services for 677,900 covered lives through multiple health plans, accountable care networks, MSO-related services and other managed care solutions. These include 276,800 managed Medicaid lives served primarily through Health Choice’s core health plan business in Arizona, 225,100 HCIC plan members, 9,500 Medicare Advantage Dual members, 11,400 Exchange lives, 98,000 MSO lives and 85,200 lives attributed to our accountable care networks from multiple payors whose care is managed by our network providers, of which 28,100 lives are members in Health Choice’s managed Medicaid and Exchange plans.

Recent Developments

Health Choice to Exit Arizona Marketplace Exchange Business. As of January 1, 2017, Health Choice will exit the Arizona marketplace exchange. Our decision to exit the exchange was driven by the instability of the Health Reform marketplace, uncertainty and lack of funding around government premium stabilization programs, and the overall nature of the related regulatory environment. During the year ended September 30, 2016, our managed care division incurred pre-tax losses related to its Arizona marketplace exchange product totaling $19.0 million, compared to pre-tax net income of $37,000 in the prior year. Included in these losses for the year ended September 30, 2016, is a premium deficiency reserve of $7.5 million and $10.8 million in final and estimated unfavorable risk adjustment transfer settlements.

Health Choice Integrated Behavioral Health Joint Venture. On October 1, 2015, Health Choice, together with a joint venture partner, began operating an integrated acute and behavioral health plan in Northern Arizona. The joint venture, HCIC, provides standalone behavioral health benefits for 225,100 plan members in Northern Arizona, and acute and behavioral care on an integrated basis for 5,400 members who are seriously mentally ill. We believe that in the future, states other than Arizona may adopt this model of integration of acute and behavioral health benefits under one managed care organization, such as HCIC. Health Choice owns 52% of the joint venture and NARBHA owns 48% of the joint venture.

Operational Improvements in Our Houston Operations. On January 14, 2016, CMS entered into a Systems Improvement Agreement (“SIA”), with our Houston hospital, SJMC. CMS agreed to stay the scheduled termination of SJMC’s Medicare Provider Agreement during the pendency of the SIA, an action which resulted from surveys of the hospital that identified alleged failures to comply with certain Medicare program conditions of participation. As required by the terms of the SIA, we have retained an independent consultant who conducted a comprehensive review, including analysis of the hospital’s current operations, and developed a remediation plan, which was submitted to and approved by CMS in June 2016. The SIA is scheduled to expire in July 2017, following an on-site survey by CMS, provided that SJMC demonstrates compliance with the Medicare conditions of participation for hospitals. As a result of these events, during the year ended September 30, 2016, we incurred $8.9 million of costs related to the SIA process and operational related improvements. Additionally, we experienced a decline in volume as compared to prior year, for which we have been experiencing a recovery during recent months.

Jordan Valley Opens New Cancer Center. In August 2016, we opened our new Jordan Valley Cancer Center, which provides radiation, medical and surgical oncology services in support of the community surrounding Jordan Valley. This facility is a 24,000 square foot health care facility specializing in breast, gastrointestinal, gynecological, neurological and urological cancers. With a highly experienced team of healthcare professionals, the center uses advanced technologies and specialized treatments to serve the oncology needs of the local community.

Opening of Hospital in Lehi, Utah. We opened our new expandable inpatient and outpatient hospital in fast-growing Lehi, Utah, called Mountain Point Medical Center, as a provider-based campus of Jordan Valley, in the latter half of our fiscal year 2015. The campus provides a full range of services, including inpatient intensive care, obstetrics and surgical services. The campus also provides cardiology services, which include a cardiac catheterization lab. Additional outpatient services include emergency, imaging, lab and outpatient surgery. The campus was designed to serve the growing transition to outpatient-related services and was constructed with the capability to expand depending on community need and demand for services in the Lehi area. A medical office building has been constructed immediately adjacent to, and connected with, the hospital to be occupied by primary care and multi-specialty physician groups practicing in the area. We incurred more than $80.0 million in total costs to complete the construction and equipping of this hospital campus. Mountain Point Medical Center serves eight cities in northern Utah County and is in the fastest growing area within the state of Utah. Our 2016 fiscal year was Mountain Point Medical Center’s first full fiscal year of operations.

Odessa Regional Medical Center South Campus. Our 2016 fiscal year represented our first full fiscal year operating Odessa Regional Medical Center’s (“ORMC”) South Campus. In June 2015, ORMC purchased the assets of Basin Healthcare Center, a 14-bed surgical hospital located near ORMC’s main campus. Basis was renamed Odessa Regional Medical Center South Campus, and its addition increases ORMC’s surgical and diagnostic capabilities to deliver high quality inpatient and outpatient services.

 

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Medical Center of Southeast Texas Victory Campus. Our hospital in Port Arthur, Texas, The Medical Center of Southeast Texas acquired the assets of Victory Medical Center, a 17-bed inpatient facility located in Beaumont, Texas, immediately before the commencement of our 2016 fiscal year. The Beaumont facility has been renamed The Medical Center of Southeast Texas Victory Campus. The new campus will enhance our ability to provide accessible healthcare to the residents of Beaumont and the surrounding communities.

Revenue and Volume Trends

Total revenue for the year ended September 30, 2016, increased $483.3 million or 17.5% compared to the prior year. Total revenue is comprised of acute care revenue, which is recorded net of the provision for bad debts, and premium, service and other revenue. Acute care revenue increased $78.8 million or 4.2% compared to the prior year, while premium, service and other revenue in our managed care operations increased $404.5 million or 45.7% compared to the prior year.

Acute Care Revenue

Acute care revenue is comprised of net patient revenue and other revenue. A large percentage of our hospitals’ net patient revenue consists of fixed payment, discounted sources, including Medicare, Medicaid and managed care organizations. Reimbursement for Medicare and Medicaid services are often fixed regardless of the cost incurred or the level of services provided. Similarly, a greater percentage of the managed care companies we contract with reimburse providers on a fixed payment basis regardless of the costs incurred or the level of services provided. Net patient revenue is reported net of discounts and contractual adjustments. The contractual adjustments principally result from differences between the hospitals’ established charges and payment rates under Medicare, Medicaid and various managed care plans. Additionally, discounts and contractual adjustments result from our uninsured discount and charity care programs. Acute care revenue is reported net of the provision for doubtful accounts. Other revenue includes medical office building rental income and other miscellaneous revenue.

Admissions and adjusted admissions increased 0.1% and 1.4%, respectively, for the year ended September 30, 2016, compared to the prior year. Excluding the impact of our Houston operations, admissions and adjusted admissions increased 1.5% and 2.4%, respectively, for the year ended September 30, 2016, compared to the prior year. For the year ended September 30, 2016, our outpatient volumes were positively impacted by increases in outpatient surgeries of 6.5%, however, emergency room visits decreased 0.6%, each compared to the prior year.

The following table provides the sources of our hospitals’ gross patient revenue by payor before discounts, contractual adjustments and the provision for bad debts:

 

     Year Ended September 30,  
     2016     2015     2014  

Medicare

     26.1     26.5     27.0

Managed Medicare

     15.8        15.3        15.1   

Medicaid and managed Medicaid

     21.3        21.3        21.2   

Managed care

     31.5        31.4        30.8   

Self-pay

     5.3        5.5        5.9   
  

 

 

   

 

 

   

 

 

 

Total

     100.0     100.0     100.0
  

 

 

   

 

 

   

 

 

 

The following table provides the sources of our hospitals’ net patient revenue before the provision for bad debts by payor:

 

     Year Ended September 30,  
     2016     2015     2014  

Medicare

     18.8     19.6     20.4

Managed Medicare

     10.6        10.4        10.8   

Medicaid and managed Medicaid

     11.6        12.2        12.8   

Managed care

     43.8        42.7        40.9   

Self-pay

     15.2        15.1        15.1   
  

 

 

   

 

 

   

 

 

 

Total

     100.0     100.0     100.0
  

 

 

   

 

 

   

 

 

 

 

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See “Item 1—Business—Sources of Revenue —Acute Care Revenue” and “Item 1—Business—Government Regulation and Other Factors” included elsewhere in this Report for a description of the types of payments we receive for services provided to patients enrolled in the traditional Medicare plan, managed Medicare plans, Medicaid plans, managed Medicaid plans and managed care plans. In those sections, we also discuss the unique reimbursement features of the traditional Medicare plan, including the annual Medicare regulatory updates published by CMS that impact reimbursement rates for services provided under the plan. We also discuss the future potential impact to reimbursement for certain of these payors under the Health Reform Law.

Industry Developments and Other Items Impacting Our Company

Two Midnight Rule

In 2013, CMS issued the “two midnight rule,” which revised its longstanding guidance to hospitals and physicians relating to when hospital inpatient admissions are deemed to be reasonable and necessary for payment under Medicare Part A. Under the two midnight rule, in addition to services that are designated as inpatient-only, surgical procedures, diagnostic tests and other treatments provided to Medicare beneficiaries are only payable as inpatient services under Medicare Part A when there is a reasonable expectation that the hospital care is medically necessary and will be required across two midnights, absent unusual circumstances. Conversely, hospital stays in which the physician expects the beneficiary to require care that spans less than two midnights are generally inappropriate for payment under Medicare Part A, and should be treated and billed as outpatient services under Part B. The increased scrutiny regarding short-stay admissions by Medicare and other payors has contributed, in part, to the decline in 1-day stays and the increase in observation patients experienced during the last two years.

In 2015, CMS clarified that stays expected to need less than two midnights of hospital care may be payable under Medicare Part A on a case-by-case basis, based on the judgment of the admitting physician, but such cases are subject to medical review. CMS has indicated it expects that inpatient stays under 24 hours will rarely qualify for an exception to the two midnight benchmark.

QIOs conduct reviews of short inpatient stays to determine hospital compliance with the inpatient admission and medical review criteria, referring claim denials to MACs for payment adjustments. Providers that exhibit persistent noncompliance with the two midnight rule may be referred to RACs. We cannot predict the impact on reimbursement of any changes or clarifications by CMS to the two midnight rule or its enforcement, whether by CMS or Congress.

Budget Control Act and Sequestration

The BCA increased the nation’s borrowing authority and takes steps to reduce federal spending and the deficit. The deficit reduction portion of the BCA imposes caps, which began in federal fiscal year 2012, that reduce discretionary spending by more than $900 billion over ten years. The BCA also requires automatic spending reductions of $1.2 trillion for federal fiscal years 2013 through 2021, minus any deficit reductions enacted by Congress and debt service costs. The spending reductions have been extended through federal fiscal year 2025. These automatic spending reductions are commonly referred to as “sequestration.” The spending reductions are split evenly between defense and non-defense discretionary spending, although certain programs (including Medicaid and CHIP), are exempt from these automatic spending reductions, and Medicare expenditures cannot be reduced by more than two percent per fiscal year. We are unable to predict what other deficit reduction initiatives may be proposed by the President or Congress or what impact the results of the 2016 federal election may have on the potential restructuring or suspension of sequestration. It is possible that changes in the law to end or restructure sequestration will result in greater spending reductions than currently required by the BCA.

State Medicaid Budgets

Over recent years, the states in which we operate experienced budget constraints as a result of increased costs and lower than expected tax collections. Health and human services programs, including Medicaid and similar programs, represent a significant portion of state budgets. The states in which we operate responded to these budget concerns, by decreasing funding for Medicaid and other healthcare programs or by making structural changes that resulted in a reduction in hospital reimbursement, as well as more restrictive Medicaid eligibility requirements. In addition, many states have received waivers from CMS in order to implement or expand managed Medicaid programs.

Texas

The Texas legislature and the THHSC recommended expanding Medicaid managed care enrollment in the state, and in December 2011, CMS approved a five-year Medicaid waiver, since extended through December 31, 2017, that: (1) allows Texas to expand its Medicaid managed care program while preserving hospital funding; (2) provides incentive payments for improvements in healthcare delivery; and (3) directs more funding to hospitals that serve large numbers of uninsured patients. All of our acute care

 

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hospitals in Texas currently receive supplemental Medicaid reimbursement, including reimbursement from programs for participating private hospitals that enter into indigent care affiliation agreements with public hospitals or county governments in the state of Texas. Under the CMS-approved programs, affiliated hospitals, including our Texas hospitals, have expanded the community healthcare safety net by providing indigent healthcare services. Revenue recognized under these Texas private supplemental Medicaid reimbursement programs, including amounts recognized under the Texas Medicaid DSH program (“Texas Medicaid DSH”) for the years ended September 30, 2016, 2015 and 2014, was $109.9 million, $109.0 million and $106.7 million, respectively. Under the Medicaid waiver, funds are distributed to participating hospitals based upon both the costs associated with providing care to individuals without third party coverage and the investment made to support coordinating care and quality improvements that transform the local communities’ care delivery systems. The responsibility to coordinate and develop plans that address the concerns of the local delivery care systems, including improved access, quality, cost effectiveness and coordination will be controlled primarily by public hospitals or local government entities that serve the surrounding geographic areas. Complexities of the underlying methodologies in determining the funding for the state’s Medicaid supplemental reimbursement programs, along with a lack of sufficient resources at THHSC to administer the programs, have historically resulted in a delay in related reimbursements. As of September 30, 2016 and 2015, we had $29.4 million and $77.6 million, respectively, in receivables due to our Texas hospitals in connection with these supplemental reimbursement programs, which includes $3.6 million and $20.2 million, respectively, of amounts due under Texas Medicaid DSH. During the year ended September 30, 2016, we have received $65.2 million related to fiscal year 2015 receivables for Texas supplemental reimbursement programs.

Arizona

Beginning in July 2011, in an effort to control its budgeted expenditures and balance its budget, the state of Arizona implemented a plan to reduce its eligible Medicaid beneficiaries, particularly childless adults. Following implementation of this plan by the state of Arizona, Health Choice experienced a significant decline through the end of our fiscal year 2013 in its enrollees, premium revenue and related earnings.

Effective January 1, 2014, Arizona expanded its Medicaid program under the Health Reform Law, which includes increased eligibility for adults, children and pregnant women, and the restoration of eligibility to childless adults that was previously eliminated. Primarily as a result of the Medicaid expansion, and also because of its increase in total coverage area under its most recent AHCCCS contract, enrollment under Health Choice’s Arizona Medicaid product line has increased significantly since January 1, 2014. Growth in covered lives under Health Choice’s Arizona Medicaid product was 7.3%, 15.5% and 13.9% for the years ended September 30, 2016, 2015 and 2014, respectively, each compared to the prior year. This growth included various periods where we experienced a significant increase in newly enrolled childless adults, which typically have higher medical utilization and acuity levels prior to effective management of their care. As a result, we, at times, experienced increased medical costs as we began to serve this newly enrolled population. In addition, in connection with the expanded Medicaid coverage, the state implemented a provider assessment effective January 1, 2014, to fund a portion of the expanded eligibility related to the childless adult population. During the years ended September 30, 2016, 2015 and 2014, we incurred $8.6 million, $8.4 million and $4.5 million, respectively, in provider fee assessments.

Further, while the Arizona legislature approved an expansion of Medicaid in 2013 which became effective on January 1, 2014, a lawsuit filed by several state lawmakers has challenged the legality of a provider fee assessed to all providers and used to help pay for Arizona’s Medicaid expansion. On August 26, 2015, the Arizona State Superior Court upheld the legality of the provider fee, thus preserving the existing funding for Medicaid expansion in Arizona. The plaintiffs are appealing this decision. If the legality of the provider fee used to help fund Arizona’s Medicaid expansion is ultimately successfully challenged on appeal, this may result in the loss of certain funding for the state’s Medicaid program, which could potentially result in changes that restrict eligibility and increase the number of uninsured individuals and adversely affecting our operations in Arizona.

Arizona’s Medicaid expansion in 2014, and Health Choice’s related increase in enrolled members and premium revenue, followed a period of several years during which AHCCCS tightened Medicaid eligibility standards in Arizona and decreased capitation rates paid to managed Medicaid contractors, reflecting state government budgetary pressures and a struggling state economy. These efforts have impacted both our acute care and managed care operations.

Uncompensated Care

While the amount of uncompensated care, including discounts to the uninsured, bad debts and charity care, we deliver to the communities we serve continues to remain high in comparison to historical levels, we have experienced declines in self-pay volume and revenue since the implementation of the Health Reform Law. During the years ended September 30, 2016, 2015 and 2014, our uncompensated care as a percentage of acute care revenue was 20.9%, 20.9% and 21.1%, respectively. During the years ended September 30, 2016, 2015 and 2014, our self-pay admissions represented 6.2%, 6.2% and 6.9%, respectively, of our total admissions.

 

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If we were to experience growth in uninsured volume and revenue, including as a result of any successful legislative efforts to significantly modify or repeal the Health Reform Law following the 2016 federal elections, our uncompensated care may increase and our results of operations would be adversely affected.

The percentages of our insured and uninsured net hospital receivables are summarized as follows:

 

     September 30,
2016
    September 30,
2015
 

Insured receivables

     81.2     77.0

Uninsured receivables

     18.8        23.0   
  

 

 

   

 

 

 

Total

     100.0     100.0
  

 

 

   

 

 

 

The percentages of hospital receivables in summarized aging categories are as follows:

 

     September 30,
2016
    September 30,
2015
 

0 to 90 days

     63.3     63.0

91 to 180 days

     19.0        19.1   

Over 180 days

     17.7        17.9   
  

 

 

   

 

 

 

Total

     100.0     100.0
  

 

 

   

 

 

 

Premium, Service and Other Revenue

Premium, service and other revenue generated by our managed care operations represented 39.6%, 31.9% and 27.9%, of our total revenue for the years ended September 30, 2016, 2015 and 2014, respectively.

Health Choice contracts with state Medicaid programs in Arizona and Utah to provide specified health services to qualified Medicaid enrollees through contracted healthcare providers. Most of its premium revenue is derived through a contract with AHCCCS, the state agency that administers Arizona’s Medicaid program. The contract requires Health Choice to arrange for healthcare services for enrolled Medicaid patients in exchange for fixed monthly premiums, based upon negotiated per capita member rates, and supplemental payments from AHCCCS. Premium revenue includes adjustments to revenue related to the program settlement process for the Arizona managed Medicaid plan under the related state contract. This program settlement process reconciles estimated amounts due to or from the state based on the actual premium revenue and medical costs and contractually mandated limits on profits and losses. Although estimates of future program settlement amounts are recorded in current periods, the program settlement process typically occurs in the 18 months post-plan year, when actual (rather than projected) claims and member eligibility data become available and a net settlement amount is either due to or from the state. Adjustments to the estimates of future program settlement amounts are recorded as a component of premium revenue.

Health Choice also contracts with CMS to provide coverage as a MAPD SNP. This contract allows Health Choice to offer Medicare and Part D drug benefit coverage to new and existing dual-eligible members (i.e., those that are eligible for Medicare and Medicaid). In accordance with CMS regulations, SNPs are now expected to meet additional requirements, including requirements relating to model of care, cost-sharing, disclosure of information and reporting of quality measures.

One notable provision of the Health Reform Law is the annual health insurer fee (“HIF”) that applies to most health plans, including commercial health plans and Medicaid managed care plans like Health Choice. While characterized as a “fee” in the text of the Health Reform Law, the intent of Congress was to impose a broad based health insurance industry excise tax, with the understanding that the tax could be passed on to consumers, most likely through higher commercial insurance premiums. However, because Medicaid is a government-funded program, Medicaid health plans have no alternative but to look to their respective state partners for payment to offset the impact of this tax. Arizona has agreed to reimburse all of the managed Medicaid plans, for the economic impact of this fee. In addition to the reimbursement of the fee, the state of Arizona has agreed to reimburse insurers for the impact resulting from these fees being treated as non-deductible for income tax purposes. For the years ended September 30, 2016, 2015 and 2014, we recognized expense for the HIF totaling $15.5 million, $11.9 million and $6.0 million, respectively, which was offset by expected reimbursement from the state of Arizona of $20.0 million, $15.7 million and $8.2 million respectively. Effective January 1, 2017, the HIF will be placed on a one year moratorium.

 

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RESULTS OF OPERATIONS SUMMARY

Consolidated

The following table sets forth, for the periods indicated, results of our consolidated operations expressed in dollar terms and as a percentage of total revenue. Such information has been derived from our audited, consolidated statements of operations.

 

     Year Ended
September 30, 2016
    Year Ended
September 30, 2015
    Year Ended
September 30, 2014
 

($ in thousands):

   Amount     %     Amount     %     Amount     %  

Revenue

            

Acute care revenue before provision for bad debts

   $ 2,349,516        $ 2,244,071        $ 2,140,270     

Less: Provision for bad debts

     (385,903       (359,241       (337,118  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Acute care revenue

     1,963,613        60.4     1,884,830        68.1     1,803,152        72.1

Premium, service and other revenue

     1,288,928        39.6     884,430        31.9     699,304        27.9
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total revenue

     3,252,541        100.0     2,769,260        100.0     2,502,456        100.0

Costs and expenses

            

Salaries and benefits

     987,147        30.4     932,815        33.7     892,818        35.7

Supplies

     335,707        10.3     322,236        11.6     299,760        12.0

Medical claims

     1,135,256        34.9     732,680        26.5     596,778        23.8

Rentals and leases

     86,540        2.7     76,620        2.7     72,714        2.9

Other operating expenses

     552,747        17.0     465,867        16.7     426,933        17.1

Medicare and Medicaid EHR incentives

     (2,178     (0.1 %)      (6,907     (0.2 %)      (14,417     (0.6 %) 

Interest expense, net

     132,374        4.1     128,857        4.7     130,818        5.2

Depreciation and amortization

     106,474        3.3     96,472        3.5     95,312        3.8

Management fees

     5,000        0.2     5,000        0.2     5,000        0.2

Impairment of goodwill

     54,005        1.7     —          —          —          —     
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total and expenses

     3,393,072        104.3     2,753,640        99.4     2,505,716        100.1

Earnings (loss) from continuing operations before gain (loss) on disposal of assets and income taxes

     (140,531     (4.3 %)      15,620        0.6     (3,260     (0.1 %) 

Gain (loss) on disposal of assets, net

     1,480        0.0     (1,408     (0.1 %)      3,402        0.1
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Earnings (loss) from continuing operations before income taxes

     (139,051     (4.3 %)      14,212        0.5     142        0.0

Income tax expense (benefit)

     (22,044     (0.7 %)      7,449        0.3     (2,464     (0.1 %) 
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net earnings (loss) from continuing operations

     (117,007     (3.6 %)      6,763        0.2     2,606        0.1

Loss from discontinued operations, net of income taxes

     (3,433     (0.1 %)      (1,793     (0.0 %)      (14,043     (0.6 %) 
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net earnings (loss)

     (120,440     (3.7 %)      4,970        0.2     (11,437     (0.5 %) 

Net earnings attributable to non-controlling interests

     (11,115     (0.3 %)      (12,945     (0.5 %)      (11,668     (0.4 %) 
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net loss attributable to IASIS Healthcare LLC

   $ (131,555     (4.0 %)    $ (7,975     (0.3 %)    $ (23,105     (0.9 %) 
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

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With the exception of the discussion on income taxes included below, see our following year-over-year segment analyses for more details regarding our operating and financial results.

Income Taxes

The following discussion sets forth, for the periods indicated, the impact of income taxes on our consolidated results. Such information has been derived from our audited, consolidated statements of operations.

Years Ended September 30, 2016 and 2015

Income tax expense—We recorded a benefit for income taxes from continuing operations of $22.0 million, resulting in an effective tax rate of 15.9% for the year ended September 30, 2016, compared to an income tax expense of $7.4 million, for an effective tax rate of 52.4% in the prior year. The change in the effective tax rate was primarily attributable to (1) the decrease in net earnings from continuing operations, which altered the rate impact of non-deductible expenses, non-controlling interests, and state income taxes including the Texas margins tax; (2) the $54.0 million goodwill impairment charge recorded in the year ended September 30, 2016, of which $13.0 million is non-deductible for tax purposes; and (3) an increase in the valuation allowance against deferred tax assets. The valuation allowance charged to earnings (loss) from continuing operations was $22.3 million for the year ended September 30, 2016, compared to $1.0 million for the year ended September 30, 2015.

Years Ended September 30, 2015 and 2014    

Income tax expense—We recorded a provision for income taxes from continuing operations of $7.4 million, resulting in an effective tax rate of 52.4% for the year ended September 30, 2015, compared to an income tax benefit of $2.5 million, for an effective tax rate of (1,737.5)% in the prior year. The change in the effective tax rate was primarily attributable to certain adjustments recorded in the year ended September 30, 2014, including (1) the reversal of $3.7 million in previously recorded tax expense related to compensation deduction limitations applicable to certain health insurers; (2) a $1.1 million tax benefit resulting from a change in our estimate of the state impact of deferred tax assets and liabilities; and (3) a $1.9 million charge related to employee stock option exercises. The effective tax rate was also impacted by (1) an increase in the nondeductible HIF; (2) the increase in net earnings from continuing operations, which reduced the rate impact of nondeductible expenses such as the HIF, as well as state income taxes including the Texas margins tax; and (3) the lower ratio of net earnings from non-controlling interests to net earnings from continuing operations, as compared to the prior year.

 

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Acute Care Operations

The following table sets forth, for the periods indicated, results of our acute care operations expressed in dollar terms and as a percentage of total acute care revenue. Such information has been derived from our audited, consolidated statements of operations.

 

     Year Ended
September 30, 2016
    Year Ended
September 30, 2015
    Year Ended
September 30, 2014
 

($ in thousands):

   Amount     %     Amount     %     Amount     %  

Acute care revenue

            

Acute care revenue before provision for bad debts

   $ 2,349,516        $ 2,244,071        $ 2,140,270     

Less: Provision for bad debts

     (385,903       (359,241       (337,118  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Acute care revenue

     1,963,613        99.1     1,884,830        99.1     1,803,152        99.3

Revenue between segments (1)

     18,134        0.9     16,480        0.9     13,079        0.7
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total acute care revenue

     1,981,747        100.0     1,901,310        100.0     1,816,231        100.0

Costs and expenses

            

Salaries and benefits

     910,669        46.0     878,652        46.2     857,893        47.2

Supplies

     334,607        16.9     321,492        16.9     299,527        16.5

Rentals and leases

     82,598        4.2     73,798        4.0     71,016        3.9

Other operating expenses

     479,981        24.1     403,884        21.2     385,957        21.3

Medicare and Medicaid EHR incentives

     (2,178     (0.1 %)      (6,907     (0.4 %)      (14,417     (0.8 %) 

Interest expense, net

     132,374        6.7     128,857        6.8     130,818        7.2

Depreciation and amortization

     101,122        5.1     92,163        4.8     91,150        5.0

Management fees

     5,000        0.3     5,000        0.3     5,000        0.3

Impairment of goodwill

     54,005        2.7     —          —          —          —     
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total costs and expenses

     2,098,178        105.9     1,896,939        99.8     1,826,944        100.6

Earnings (loss) from continuing operations before gain (loss) on disposal of assets and income taxes

     (116,431     (5.9 %)      4,371        0.2     (10,713     (0.6 %) 
Gain (loss) on disposal of assets, net      1,480        0.1     (1,408     (0.0 %)      3,402        0.2
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Earnings (loss) from continuing operations before income taxes

   $ (114,951     (5.8 %)    $ 2,963        0.2   $ (7,311     (0.4 %) 
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) Revenue between segments is eliminated in our consolidated results.

 

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Years Ended September 30, 2016 and 2015

Total acute care revenue — Total acute care revenue for the year ended September 30, 2016, was $1.98 billion, an increase of $80.4 million or 4.2% compared to $1.90 billion in the prior year. The increase in total acute care revenue during the year is primarily due to an increase in adjusted admissions of 1.4% and an increase in net patient revenue per adjusted admission of 2.5%, both compared to the prior year.

Net adjustments to estimated third-party payor settlements, also known as prior year contractuals, resulted in an increase in total acute care revenue for the years ended September 30, 2016 and 2015, of $3.1 million and $7.0 million, respectively.

Salaries and benefits — Salaries and benefits expense for the year ended September 30, 2016, was $910.7 million, or 46.0% of total acute care revenue, compared to $878.7 million, or 46.2% of total acute care revenue in the prior year. Excluding the impact of stock-based compensation, salaries and benefits expense as a percentage of total acute care revenue was 45.7% for the year ended September 30, 2016, compared to 45.8% in the prior year. Included in salaries and benefits for the years ended September 30, 2016 and 2015, was $4.7 million and $0.2 million, respectively, of labor costs associated with our systems improvement efforts at our Houston hospital.

Supplies — Supplies expense for the year ended September 30, 2016, was $334.6 million, or 16.9% of total acute care revenue, compared to $321.5 million, or 16.9% of total acute care revenue in the prior year.

Rentals and leases — Rentals and leases expense for the year ended September 30, 2016, was $82.6 million, or 4.2% of total acute care revenue, compared to $73.8 million, or 4.0% of total acute care revenue in the prior year. The increase in our rentals and leases expense includes the full year impact of our new leases associated with the expansion of our footprint, including Victory Medical Center in Beaumont, Texas, two radiation oncology centers in the Houston, area, and a medical office building in Lehi, Utah.

Other operating expenses Other operating expenses for the year ended September 30, 2016, were $480.0 million, or 24.1% of total acute care revenue, compared to $403.9 million, or 21.2% of total acute care revenue in the prior year. Other operating expenses were adversely impacted during the year ended September 30, 2016, by the unfavorable development of a small number of prior year professional liability claims totaling $11.9 million, while the prior year included favorable development totaling $8.7 million associated with our professional liability reserves related to prior years. Additionally, other operating expenses during the year ended September 30, 2016, were impacted by $4.1 million of costs related to our systems improvement efforts at our Houston hospital, $4.4 million of costs related to our ongoing clinical and revenue cycle system conversion and an increase in certain legal and advisory related fees.

Years Ended September 30, 2015 and 2014

Total acute care revenue — Total acute care revenue for the year ended September 30, 2015, was $1.90 billion, an increase of $85.1 million or 4.7% compared to $1.82 billion in the prior year. The increase in total acute care revenue during the year is primarily due to an increase in adjusted admissions of 3.3% and an increase in net patient revenue per adjusted admission of 1.5%, both compared to the prior year.

Net adjustments to estimated third-party payor settlements, also known as prior year contractuals, resulted in an increase in total acute care revenue for the years ended September 30, 2015 and 2014, of $7.0 million and $3.9 million, respectively.

Salaries and benefits — Salaries and benefits expense for the year ended September 30, 2015, was $878.7 million, or 46.2% of total acute care revenue, compared to $857.9 million, or 47.2% of total acute care revenue in the prior year. Excluding the impact of stock-based compensation, salaries and benefits expense as a percentage of total acute care revenue was 45.8% for the year ended September 30, 2015, compared to 46.6% in the prior year. The improvement in our salaries and benefits expense as a percentage of total acute care revenue, excluding the impact of stock-based compensation, is the result of leveraging our growth in total acute care revenue, as well as a reduction in employee benefit costs, compared to the prior year.

Supplies — Supplies expense for the year ended September 30, 2015, was $321.5 million, or 16.9% of total acute care revenue, compared to $299.5 million, or 16.5% of total acute care revenue in the prior year. The increase in supplies expense as a percentage of total acute care revenue is primarily attributable to an increase in implant costs associated with the growth in certain cardiac and orthopedic surgical procedures, as well as an increase in drug costs.

Other operating expenses — Other operating expenses for the year ended September 30, 2015, were $403.9 million, or 21.2% of total acute care revenue, compared to $386.0 million, or 21.3% of total acute care revenue in the prior year.

 

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Managed Care Operations

The following table sets forth, for the periods indicated, results of our managed care operations expressed in dollar terms and as a percentage of premium, service and other revenue. Such information has been derived from our audited, consolidated statements of operations.

 

     Year Ended
September 30, 2016
    Year Ended
September 30, 2015
    Year Ended
September 30, 2014
 

($ in thousands):

   Amount     %     Amount      %     Amount      %  

Premium, service and other revenue

              

Premium revenue

   $ 1,246,913        96.7   $ 844,242         95.5   $ 687,002         98.2

Service and other revenue

     42,015        3.3     40,188         4.5     12,302         1.8
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Premium, service and other revenue

     1,288,928        100.0     884,430         100.0     699,304         100.0

Costs and expenses

              

Salaries and benefits

     76,478        5.9     54,163         6.1     34,925         5.0

Supplies

     1,100        0.1     744         0.1     233         0.0

Medical claims (1)

     1,153,390        89.5     749,160         84.7     609,857         87.2

Rentals and leases

     3,942        0.3     2,822         0.3     1,698         0.2

Other operating expenses

     72,766        5.7     61,983         7.0     40,976         5.9

Depreciation and amortization

     5,352        0.4     4,309         0.5     4,162         0.6
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total costs and expenses

     1,313,028        101.9     873,181         98.7     691,851         98.9
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Earnings (loss) before income taxes

   $ (24,100     (1.9 %)    $ 11,249         1.3   $ 7,453         1.1
  

 

 

   

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

 

(1) Medical claims paid to our hospitals of $18.1 million, $16.5 million and $13.1 million for the years ended September 30, 2016, 2015 and 2014, respectively, are eliminated in our consolidated results.

Years Ended September 30, 2016 and 2015

Premium revenue—Premium revenue was $1.25 billion for the year ended September 30, 2016, an increase of $402.7 million or 47.7%, compared to $844.2 million in the prior year. The increase in premium revenue was driven by the addition of HCIC, our Northern Arizona joint venture, which became effective on October 1, 2015, as well as membership growth in our other health plan product lines. As of September 30, 2016, total lives served across all product lines increased 69.0% compared to the prior year. For the year ended September 30, 2016, enrollment in our Medicaid product line increased 7.4% compared to the prior year. Premium revenue was negatively impacted by unfavorable final and estimated risk adjustment transfer settlements of $10.8 million related to our Arizona marketplace exchange, which we have notified Arizona regulators that we will exit effective January 1, 2017.

Service and other revenue—Service and other revenue was $42.0 million for the year ended September 30, 2016, an increase of $1.8 million or 4.4%, compared to $40.2 million in the prior year. Included in service and other revenue for the year ended September 30, 2016, was $20.0 million in revenue related to the reimbursement of the HIF assessed in connection with the Health Reform Law, compared to $15.7 million in the prior year.

Salaries and benefits—Salaries and benefits expense for the year ended September 30, 2016, was $76.5 million, or $5.9% of premium, service and other revenue, compared to $54.2 million, or 6.1% of premium, service and other revenue in the prior year.

Medical claims—Medical claims expense was $1.15 billion for the year ended September 30, 2016, an increase of $404.2 million or 54.0%, compared to $749.2 million in the prior year. Medical claims expense as a percentage of premium revenue, or MLR, related to our health plan products was 92.5% for the year ended September 30, 2016, compared to 88.7% in the prior year. Excluding the impact of our Arizona marketplace exchange product, our MLR for the year ended September 30, 2016, was 91.2%, compared to 88.8% in the prior year. The remaining increase in MLR was driven primarily by the impact of rising pharmacy costs, particularly related to high-cost specialty drugs, increased acuity levels for certain higher cost enrollment groups, as well as growth in new members with higher medical costs.

 

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Other operating expenses—Other operating expenses for the year ended September 30, 2016, were $72.8 million, or 5.7% of premium, service and other revenue, compared to $62.0 million, or 7.0% of premium, service and other revenue in the prior year. Other operating expenses for the year ended September 30, 2016, include the impact of $3.6 million in incremental HIF related expenses. The decrease in other operating expenses as a percentage of premium, service and other revenue is due primarily to leveraging the growth in membership and premium revenue.

Years Ended September 30, 2015 and 2014

Premium revenue—Premium revenue was $844.2 million for the year ended September 30, 2015, an increase of $157.2 million or 22.9%, compared to $687.0 million in the prior year. The increase in premium revenue was driven by membership growth in our health plan product lines. As of September 30, 2015, total lives served across all product lines increased 22.5% compared to the prior year. For the year ended September 30, 2015, enrollment in our Medicare and Medicaid product lines increased 13.8% and 20.3%, respectively, compared to the prior year. Premium revenue for our managed Medicaid product line has been favorably impacted by the expansion of the Medicaid program in connection with the Health Reform Law. For the year ended September 30, 2015, premium revenue on a per member per month basis for our health plan products increased 2.1% compared to the prior year.

Service and other revenue—Service and other revenue was $40.2 million for the year ended September 30, 2015, compared to $12.3 million in the prior year. This increase was primarily driven by revenue from our MSO subsidiary, which began operations on June 1, 2014. Additionally, during the year ended September 30, 2015, we recognized $15.7 million of revenue related to reimbursement of the HIF assessed in connection with the Health Reform Law, compared to $8.2 million in the prior year.

Salaries and benefits—Salaries and benefits expense for the year ended September 30, 2015, was $54.2 million, or 6.1% of premium, service and other revenue, compared to $34.9 million, or 5.0% of premium, service and other revenue in the prior year. Salaries and benefits for the year ended September 30, 2015, compared to the prior year have been impacted by additional employees associated with our new MSO subsidiary, which began operations on June 1, 2014.

Medical claims—Medical claims expense was $749.2 million for the year ended September 30, 2015, compared to $609.9 million in the prior year. Medical claims expense as a percentage of premium revenue, or MLR, related to our health plan products was 88.7% for the year ended September 30, 2015, compared to 88.8% in the prior year. Excluding the impact of prior period medical expense development, our MLR for the year ended September 30, 2015, was 87.0%, compared to 89.6% in the prior year. The decline in our adjusted MLR for the year ended September 30, 2015, compared to the prior year, was primarily attributable to improvements in medical costs resulting from effectively managing the care of Arizona’s childless adult population subsequent to the expansion of the state’s Medicaid program on January 1, 2014.

Other operating expenses—Other operating expenses for the year ended September 30, 2015, were $62.0 million, or 7.0% of premium, service and other revenue, compared to $41.0 million, or 5.9% of premium, service and other revenue in the prior year. Other operating expenses for the year ended September 30, 2015, included the impact of $5.9 million in incremental HIF-related expenses.

 

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Summary of Operations by Quarter

The following table presents unaudited quarterly operating results for the years ended September 30, 2016 and 2015. We believe that all necessary adjustments have been included in the amounts stated below to present fairly the quarterly results when read in conjunction with the audited, consolidated financial statements. Results of operations for any particular quarter are not necessarily indicative of results of operations for a full year or predictive of future periods.

 

     Quarter Ended  
     Sept. 30,
2016
     June 30,
2016
     March 31,
2016
     Dec. 31,
2015
 
     (in thousands)  

Total revenue

   $ 814,423       $ 813,983       $ 821,287       $ 802,848   

Loss from continuing operations before income taxes

     (85,382      (34,611      (15,285      (3,773

Net loss from continuing operations

     (76,299      (27,027      (10,400      (3,281
     Quarter Ended  
     Sept. 30,
2015
     June 30,
2015
     March 31,
2015
     Dec. 31,
2014
 
     (in thousands)  

Total revenue

   $ 716,601       $ 686,294       $ 696,827       $ 669,538   

Earnings (loss) from continuing operations before income taxes

     (3,647      2,386         18,496         (3,023

Net earnings (loss) from continuing operations

     (2,985      1,368         8,749         (369

LIQUIDITY AND CAPITAL RESOURCES

Overview of Cash Flow Activities for the Years Ended September 30, 2016 and 2015

Our cash flows are summarized as follows (in thousands):

 

     Year Ended September 30,  
     2016      2015  

Cash flows from operating activities

   $ 135,867       $ 170,521   

Cash flows from investing activities

   $ (131,437    $ (125,569

Cash flows from financing activities

   $ (37,258    $ (7,619

Operating Activities

Cash flows provided by operating activities were $135.9 million for the year ended September 30, 2016, compared to $170.5 million in the prior year. During the year ended September 30, 2016, operating cash flows declined as a result of losses due primarily to the performance of our Arizona marketplace exchange product, rising pharmacy costs, including specialty drugs, increased medical costs associated with higher acuity members at Health Choice, operational costs and lost volume associated with the SIA at our Houston hospital and reductions in Medicare and Medicaid reimbursement, including reductions in DSH and other supplemental reimbursement programs.

At September 30, 2016, we had $353.3 million in net working capital, compared to $508.7 million at September 30, 2015. Net accounts receivable increased $24.6 million to $342.4 million at September 30, 2016, from $317.7 million at September 30, 2015.

Investing Activities

Cash flows used in investing activities were $131.4 million for the year ended September 30, 2016, compared to $125.6 million in the prior year. Purchases of property and equipment for the year ended September 30, 2016, were $123.1 million, which included $22.6 million related to our on-going conversion to a new integrated clinical and revenue cycle system, compared to $141.7 million in the prior year, which included $29.0 million to complete the construction of a new greenfield hospital campus in Lehi, Utah. During the year ended September 30, 2015, we acquired the assets of Victory Medical Center of Beaumont and Basin Healthcare Center in Odessa for a combined total of $25.3 million. Also included in the year ended September 30, 2015, was $42.6 million in proceeds received from the sale of our Nevada operations.

 

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Financing Activities

Cash flows used in financing activities were $37.3 million for the year ended September 30, 2016, compared to $7.6 million in the prior year. Included in the years ended September 30, 2016 and 2015, were principal debt payments totaling $10.1 million. Also during the year ended September 30, 2016, we made financing obligation payments totaling $8.0 million related to our on-going conversion to a new integrated clinical and revenue cycle system and $5.2 million in payments associated with the extension of our revolving credit facility in February 2016. During the year ended September 30, 2015, we received $12.0 million in proceeds from lease financing related to the construction of a medical office building completed as part of our new greenfield hospital campus opened that year. During the year ended September 30, 2016, distributions to non-controlling interest holders totaled $10.5 million, compared to $8.2 million in the prior year.

Capital Resources

As of September 30, 2016, we had the following debt arrangements:

 

    $1.232 billion in Senior Secured Credit Facilities; and

 

    $849.9 million in 8.375% Senior Notes due 2019.

At September 30, 2016, amounts outstanding under our Senior Secured Credit Facilities consisted of $969.3 million in term loans. In addition, we had $96.1 million in letters of credit outstanding under the revolving credit facility. The weighted average interest rate of outstanding borrowings under the Senior Secured Credit Facilities was 4.5% for the year ended September 30, 2016, compared to 4.5% in the prior year.

Amended Term Loan Facility

We are a party to a senior credit agreement (the “Amended and Restated Credit Agreement”) with Wilmington Trust, National Association, as administrative agent, which provides for a $1.025 billion senior secured term loan facility maturing in May 2018 (the “Term Loan Facility”). Principal under the Term Loan Facility is due in equal quarterly installments in an aggregate annual amount equal to 1% of the principal amount of $1.007 billion outstanding as of the effective date, February 20, 2013, of a repricing amendment, with the remaining balance due upon maturity of the Term Loan Facility.

Borrowings under the Term Loan Facility bear interest at a rate per annum equal to, at our option, either (1) a base rate determined by reference to the highest of (a) the federal funds rate plus 0.50%, (b) the prime rate (determined by reference to The Wall Street Journal) and (c) a one-month LIBOR rate, subject to a floor of 1.25%, plus 1.00%, in each case, plus a margin of 2.25% per annum or (2) the LIBOR rate for the interest period relevant to such borrowing, subject to a floor of 1.25%, plus a margin of 3.25% per annum.

The Term Loan Facility is unconditionally guaranteed by IAS and certain of our subsidiaries (collectively, the “Subsidiary Guarantors”; IAS and the Subsidiary Guarantors, the “Guarantors”) and is required to be guaranteed by all of our future material wholly-owned subsidiaries, subject to certain exceptions. All obligations under the Amended and Restated Credit Agreement are secured, subject to certain exceptions, by substantially all of our assets and the assets of the Guarantors, including (1) a pledge of 100% of our equity interests and the equity interests held by us and the Subsidiary Guarantors, subject to certain exceptions, (2) mortgage liens on all of our material real property and that of the Guarantors and (3) all proceeds of the foregoing.

The Amended and Restated Credit Agreement requires us to mandatorily prepay borrowings under the Term Loan Facility with net cash proceeds of certain asset dispositions, following certain casualty events, following certain borrowings or debt issuances and from a percentage of annual excess cash flow.

The Amended and Restated Credit Agreement contains certain restrictive covenants, including, among other things: (1) limitations on the incurrence of debt and liens; (2) limitations on investments other than, among other exceptions, certain acquisitions that meet certain conditions; (3) limitations on the sale of assets outside of the ordinary course of business; (4) limitations on dividends and distributions; and (5) limitations on transactions with affiliates, in each case, subject to certain exceptions. The Amended and Restated Credit Agreement also contains certain customary events of default, including, without limitation, a failure to make payments under the Term Loan Facility, cross-defaults, certain bankruptcy events and certain change of control events.

 

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Revolving Credit Facility

We are a party to a revolving credit agreement (the “Revolving Credit Agreement”) with JPMorgan Chase Bank, N.A. (“JPMorgan”), as administrative agent, which provides for a $207.4 million senior secured revolving credit facility, of which up to $125.0 million may be utilized for the issuance of letters of credit (the “Revolving Credit Facility”). The Revolving Credit Facility matures in February 2021 (the “Stated Revolver Maturity Date”), provided that, if prior to the Stated Revolver Maturity Date, (x) any loans are outstanding under the Term Loan Facility on the date that is 91 days prior to the maturity date under the Term Loan Facility (such date, the “Springing Term Maturity Date”) or (y) any notes are outstanding under our indenture, dated as of May 3, 2011, by and among IASIS, IAS and The Bank of New York Mellon Trust Company, N.A., as Trustee, relating to our Senior Notes (the “Indenture”), on the date that is 91 days prior to the maturity date under the Indenture (such date, the “Springing Notes Maturity Date”), then the maturity date will automatically become the earlier of the Springing Term Maturity Date or the Springing Notes Maturity Date.

The Revolving Credit Agreement provides us with the right to request additional commitments under the Revolving Credit Facility without the consent of the lenders thereunder, subject to a cap on aggregate commitments of $300.0 million, a pro forma senior secured net leverage ratio (as defined in the Revolving Credit Agreement) of less than or equal to 3.75 to 1.00 and customary conditions precedent.

The Revolving Credit Facility does not require installment payments prior to maturity.

Borrowings under the Revolving Credit Facility bear interest at a rate per annum equal to, at our option, either (1) a base rate determined by reference to the highest of (a) the prime rate of JPMorgan, (2) the federal funds rate plus 0.50% and (3) a LIBOR rate subject to certain adjustments plus 1.00%, in each case, plus a margin of 2.50% per annum or (2) the LIBOR rate for the interest period relevant to such borrowing, plus a margin of 3.50% per annum. In addition to paying interest on outstanding principal under the Revolving Credit Facility, we are required to pay a commitment fee on the unutilized commitments under the Revolving Credit Facility, as well as pay customary letter of credit fees and agency fees.

The Revolving Credit Facility is unconditionally guaranteed by the Guarantors and is required to be guaranteed by all of our future material wholly-owned subsidiaries, subject to certain exceptions. All obligations under the Revolving Credit Agreement are secured, subject to certain exceptions, by substantially all of our assets and the assets of the Guarantors, including (1) a pledge of 100% of our equity interests and the equity interests held by us and the Subsidiary Guarantors, subject to certain exceptions, (2) mortgage liens on all of our material real property and that of the Guarantors and (3) all proceeds of the foregoing.

The Revolving Credit Agreement contains restrictive covenants and events of default substantially similar to the restrictive covenants and events of default in the Amended and Restated Credit Agreement; provided, that under the Revolving Credit Agreement, we are required to maintain, on a quarterly basis, a maximum senior secured gross leverage ratio (as defined in the Revolving Credit Agreement). In addition, certain of the baskets available to us under the negative covenants in the Amended and Restated Credit Agreement are suspended under the Revolving Credit Agreement until such time, if any, as we have consummated a qualifying underwritten public offering and achieved a specified total gross leverage ratio (as defined in the Revolving Credit Agreement).

8.375% Senior Notes due 2019

We, together with our wholly owned subsidiary IASIS Capital Corporation (together, the “Issuers”) issued an $850.0 million aggregate principal amount of Senior Notes, which mature on May 15, 2019, pursuant to the Indenture, dated as of May 3, 2011, among the Issuers and certain of the Issuers’ wholly owned domestic subsidiaries that guarantee the Term Loan Facility and the Revolving Credit Facility. The Indenture provides that the Senior Notes are general unsecured, senior obligations of the Issuers, and initially will be unconditionally guaranteed on a senior unsecured basis by certain of our subsidiaries.

At September 30, 2016, the outstanding principal balance of the Senior Notes was $849.9 million. The Senior Notes bear interest at a rate of 8.375% per annum, payable semi-annually, in cash in arrears, on May 15 and November 15 of each year.

The Issuers may redeem the Senior Notes in whole or in part, at any time at a price equal to 102.094% of the aggregate principal amount of the Senior Notes plus accrued and unpaid interest and special interest, if any, to but excluding the redemption date, subject to compliance with certain conditions. On May 15, 2017, the redemption price declines 2.094 percentage points, at which point and thereafter the redemption price is equal to 100% of the aggregate principal amount of the Senior Notes plus accrued and unpaid interest and special interest, if any, to but excluding the redemption date.

The Indenture contains covenants that limit our (and our restricted subsidiaries’) ability to, among other things: (1) incur additional indebtedness or liens or issue disqualified stock or preferred stock; (2) pay dividends or make other distributions on, redeem or repurchase our capital stock; (3) sell certain assets; (4) make certain loans and investments; (5) enter into certain transactions with affiliates; (6) impose restrictions on the ability of a subsidiary to pay dividends or make payments or distributions to us and our restricted subsidiaries; and (7) consolidate, merge or sell all or substantially all of our assets. These covenants are subject to a number of important limitations and exceptions.

 

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The Indenture also provides for events of default, which, if any of them occurs, may permit or, in certain circumstances, require the principal, premium, if any, interest and any other monetary obligations on all the then outstanding Senior Notes to be due and payable immediately. If we experience certain kinds of changes of control, we must offer to purchase the Senior Notes at 101% of their principal amount, plus accrued and unpaid interest and special interest, if any, to but excluding the repurchase date. Under certain circumstances, we will have the ability to make certain payments to facilitate a change of control transaction and to provide for the assumption of the Senior Notes by a new parent company resulting from such change of control transaction. If such change of control transaction is facilitated, the Issuers will be released from all obligations under the Indenture and the Issuers and the trustee will execute a supplemental indenture effectuating such assumption and release.

Credit Ratings

The table below summarizes our corporate rating, as well as our credit ratings for our Senior Secured Credit Facilities and Senior Notes as of the date of this Report:

 

     Moody’s    Standard & Poor’s

Corporate credit

   B2    B

Senior secured term loan facility

   Ba3    B

Senior secured revolving credit facility

   Ba3    BB-

Senior Notes

   Caa1    CCC+

Outlook

   Stable    Stable

Other

We executed interest rate swaps with Citibank, N.A. (“Citibank”) and Barclays Bank PLC (“Barclays”), as counterparties, with notional amounts totaling $350.0 million, of which $50.0 million expired on September 30, 2014, $100.0 million expired on September 30, 2015, and $200.0 million expired on September 30, 2016. Under the agreements, we were required to make quarterly fixed rate payments to our counterparty at an annual rate ranging from 1.6% to 2.2%. Our counterparties were obligated to make quarterly floating rate payments to us based on the three-month LIBOR rate, subject to a floor of 1.25%.

Capital Expenditures

We plan to finance our proposed capital expenditures with cash generated from operations, borrowings under our senior secured credit facilities and other capital sources that may become available. We expect our capital expenditures for fiscal 2017 to be $125.0 million to $135.0 million, including $30.0 million to $35.0 million related to our conversion of information systems.

Liquidity

We rely on cash generated from our operations as our primary source of liquidity, as well as available credit facilities, project and bank financings and the issuance of long-term debt. From time to time, we have also utilized operating lease transactions that are sometimes referred to as off-balance sheet arrangements. We expect that our future funding for working capital needs, capital expenditures, long-term debt repayments and other financing activities will continue to be provided from some or all of these sources. Each of our existing and projected sources of cash is impacted by operational and financial risks that influence the overall amount of cash generated and the capital available to us. For example, cash generated by our business operations may be impacted by, among other things, economic downturns, federal and state budget initiatives, weather-related catastrophes and adverse industry conditions. Our future liquidity will be impacted by our ability to access capital markets, which may be restricted due to our credit ratings, general market conditions, leverage capacity and by existing or future debt agreements. For a further discussion of risks that can impact our liquidity, see “Item 1A.—Risk Factors”.

Including available cash at September 30, 2016, we have available liquidity as follows (in millions):

 

Cash and cash equivalents

   $ 345.7   

Available capacity under our senior secured revolving credit facility

     111.3   
  

 

 

 

Net available liquidity at September 30, 2016

   $ 457.0   
  

 

 

 

Net available liquidity assumes 100% participation from all lenders currently participating in our senior secured revolving credit facility. In addition to our available liquidity, we expect to generate significant operating cash flows in fiscal 2017. We will also utilize proceeds from our financing activities as needed.

 

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The Amended and Restated Credit Agreement requires us to prepay borrowings under the senior secured term loan facility with net cash proceeds of certain asset dispositions unless such proceeds are reinvested within 12 months in existing facilities or 24 months in a greenfield construction project (36 months if there is a binding commitment for such investment within such 12 or 24 month periods). The Indenture similarly requires us to make prepayments with net cash proceeds of certain asset dispositions unless such proceeds have been either reinvested or used to prepay our obligations under the senior secured term loan facility within 365 days (an additional 180 days exists if there is a binding commitment for such investment).

Based upon our current level of operations and anticipated growth, we currently believe we have sufficient liquidity to meet our cash requirements over the short-term (next 12 months) and over the next three years. In evaluating the sufficiency of our liquidity for both the short-term and long-term, we have considered the expected cash flow to be generated by our operations, cash on hand and the available borrowings under our Senior Secured Credit Facilities, compared to our anticipated cash requirements for debt service, working capital, capital expenditures and the payment of taxes, as well as funding requirements for long-term liabilities.

We are unable at this time to extend our evaluation of the sufficiency of our liquidity beyond three years. We cannot assure you that our operating performance will generate sufficient cash flow from operations or that future borrowings will be available under our Senior Secured Credit Facilities, or otherwise, to enable us to grow our business, service our indebtedness, or make anticipated capital expenditures and tax payments. For more information, see our risk factors in “Item 1A.—Risk Factors” of this Report.

One element of our business strategy is to selectively pursue acquisitions and strategic alliances in existing and new markets. Any acquisitions or strategic alliances may result in the incurrence of, or assumption by us, of additional indebtedness. We continually assess our capital needs and may seek additional financing, including debt or equity as considered necessary to fund capital expenditures and potential acquisitions or for other corporate purposes. Our future operating performance and our ability to service or refinance our debt will be subject to future economic conditions and to financial, business and other factors, many of which are beyond our control. For more information, see our risk factors in “Item 1A.—Risk Factors” of this Report.

We do not have any relationships with unconsolidated entities or financial partnerships, such entities often referred to as structured finance or special purpose entities, established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Accordingly, we are not materially exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in such relationships.

 

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Tabular Disclosure of Contractual Obligations

The following table reflects a summary of obligations and commitments outstanding including both the principal and interest portions of long-term debt, capital leases and other long-term obligations at September 30, 2016.

 

     Payments Due By Period  
     1 Year      2-3 Years      4-5 Years      More than
5 Years
     Total  
     (in millions)  

Contractual Cash Obligations

              

Long-term debt, with interest (1)

   $ 124.7       $ 1,946.5       $ —         $ —         $ 2,071.2   

Capital leases and other long-term obligations, with interest

     7.9         15.6         4.9         16.7         45.1   

Medical claims

     167.0         —           —           —           167.0   

Operating leases

     67.4         120.8         107.3         268.3         563.8   

Estimated self-insurance liabilities

     14.7         16.9         14.1         14.6         60.3   

Purchase obligations

     54.4         33.9         7.8         2.7         98.8   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Subtotal

   $ 436.1       $ 2,133.7       $ 134.1       $ 302.3       $ 3,006.2   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

     Amount of Commitment Expiration Per Period  
     1 Year      2-3 Years      4-5 Years      More than
5 Years
     Total  
     (in millions)  

Other Commitments (2)

              

Guarantees of surety bonds

   $ 21.8       $ —         $ —         $ —         $ 21.8   

Letters of credit

     96.1         —           —           —           96.1   

Other commitments

     12.4         18.4         3.3         —           34.1   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Subtotal

     130.3         18.4         3.3         —           152.0   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total obligations and commitments

   $ 566.4       $ 2,152.1       $ 137.4       $ 302.3       $ 3,158.2   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) We applied an interest rate of 4.5% to our Term Loan Facility and 8.375% to our Senior Notes.
(2) Excludes $2.9 million of unrecognized tax benefits and related interest that could result in a cash settlement, of which $2.5 million relates to timing differences between book and taxable income that may be offset by a reduction of cash tax obligations in future periods. We have not included these amounts in the above table as we cannot reliably estimate the amount and timing of payments related to these liabilities.

Seasonality

The patient volumes and total revenue at our healthcare operations are subject to seasonal variations and generally are greater during the quarter ended March 31 than other quarters. These seasonal variations are caused by a number of factors, including seasonal cycles of illness, climate and weather conditions in our markets, vacation patterns of both patients and physicians and other factors relating to the timing of elective procedures and patient deductibles and co-insurance limits.

Inflation

We believe that hospital industry operating margins have been, and may continue to be, under pressure because of changes in payor and service mix and growth in operating expenses in excess of the increase in prospective payments under the Medicare and Medicaid programs. In addition, as a result of increasing regulatory and competitive pressures, our ability to maintain operating margins through price increases is limited. Additionally, wages and other expenses increase during periods of labor shortage. We cannot predict our ability to cover or offset future cost increases.

 

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CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Our consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles. In preparing our financial statements, we make estimates, judgments and assumptions that affect the reported amounts of assets and liabilities at the dates of the financial statements and the reported amounts of revenue and expenses during the reporting periods. Actual results could differ from those estimates.

We have determined an accounting estimate to be critical if: (1) the accounting estimate requires us to make assumptions about matters that were highly uncertain at the time the accounting estimate was made and (2) changes in the estimate would have a material impact on our financial condition or results of operations. There are other items within our financial statements that require estimation but are not deemed critical as defined herein. Changes in estimates used in these and other items could have a material impact on our financial statements.

The estimates, judgments and assumptions used by us under “Allowance for Doubtful Accounts,” “Allowance for Contractual Discounts and Settlement Estimates,” “Insurance Reserves,” “Medical Claims Payable,” “Reinsurance,” “Goodwill and Other Intangibles”, “Stock-based Compensation,” and “Income Taxes” are, we believe, reasonable, but involve inherent uncertainties as described below, which may or may not be controllable by management. As a result, the accounting for such items could result in different amounts if management used different assumptions or if different conditions occur in future periods.

Allowance for Doubtful Accounts. Our ability to collect outstanding receivables from third-party payors and patients is critical to our operating performance and cash flows. The primary collection risk lies with uninsured patient accounts or patient accounts for which primary insurance has paid but a patient portion remains outstanding. The provision for bad debts and the allowance for doubtful accounts relate primarily to amounts due directly from patients. Our estimation of the allowance for doubtful accounts is based primarily upon the type and age of the patient accounts receivable and the effectiveness of our collection efforts. Our policy is to reserve a portion of all self-pay receivables, including amounts due from the uninsured and amounts related to co-payments and deductibles, as these charges are recorded. We monitor our accounts receivable balances and the effectiveness of our reserve policies on a regular basis and review various analytics to support the basis for our estimates. These efforts primarily consist of reviewing the following:

 

    Cash collections as a percentage of net patient revenue less bad debts;

 

    Changes in the aging and payor mix of accounts receivable, including increased focus on accounts due from the uninsured and accounts that represent co-payments and deductibles due from patients;

 

    Revenue and volume trends by payor, particularly the self-pay components;

 

    Trending of days revenue in accounts receivable;

 

    Various allowance coverage statistics; and

 

    Historical write-off and collection experience using a hindsight or look-back approach.

We regularly perform hindsight procedures to evaluate historical write-off and collection experience throughout the year to assist in determining the reasonableness of our process for estimating the allowance for doubtful accounts. We do not pursue collection of amounts related to patients who qualify for charity care under our guidelines. Charity care accounts are deducted from gross revenue and do not affect the provision for bad debts.

At September 30, 2016 and 2015, our self-pay receivables, including amounts due from uninsured patients and co-payment and deductible amounts due from insured patients, were $279.1 million and $276.7 million, respectively, while our allowance for doubtful accounts was $221.4 million and $210.1 million, respectively. For the year ended September 30, 2016, 2015 and 2014, the provision for bad debts was 16.4%, 16.0% and 15.8%, respectively, of acute care revenue before provision for bad debts. Significant changes in payor mix or business office operations could have a significant impact on the provision for bad debts, as well as our results of operations and cash flows.

Allowance for Contractual Discounts and Settlement Estimates. We derive a significant portion of our net patient revenue from Medicare, Medicaid and managed care payors that receive discounts from our standard charges. For the years ended September 30, 2016, 2015 and 2014, Medicare, Medicaid and managed care revenue together accounted for 84.8%, 84.9% and 84.9%, respectively, of our hospitals’ net patient revenue before the provision for bad debts.

 

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We estimate contractual discounts and allowances based upon payment terms outlined in our managed care contracts, by federal and state regulations for the Medicare and various Medicaid programs, and in accordance with terms of our uninsured discount program. Contractual discounts for most of our patient revenue are determined by an automated process that establishes the discount on a patient-by-patient basis. The payment terms or fee schedules for most payors have been entered into our patient accounting systems. Automated (system-generated) contractual discounts are recorded, at the time a patient account is billed, based upon the system-loaded payment terms. In certain instances for payors that are not significant or who have not entered into a contract with us, we make manual estimates in determining contractual allowances based upon historical collection rates. At the end of each month, we estimate contractual allowances for all unbilled accounts based on payor-specific six-month average contractual discount rates.

For governmental payors such as Medicare and Medicaid, we determine contractual discounts or allowances based upon the program’s reimbursement (payment) methodology (i.e., either prospectively determined or retrospectively determined based on costs as defined by the government payor). These contractual discounts are determined by an automated process in a manner similar to the process used for managed care revenue. Under prospective payment programs, we record contractual discounts based upon predetermined reimbursement rates. For retrospective cost-based revenues, which are less prevalent, we estimate contractual allowances based upon historical and current factors which are adjusted as necessary in future periods, when final settlements of filed cost reports are received. Net adjustments to estimated third-party payor settlements, also known as prior year contractuals, resulted in an increase in acute care revenue of $3.1 million, $7.0 million and $3.9 million for the years ended September 30, 2016, 2015 and 2014, respectively.

Management continually reviews the contractual estimation process to consider and incorporate updates to laws and regulations and the frequent changes in managed care contractual terms that result from contract renegotiations and renewals. All contractual adjustments, regardless of type of payor or method of calculation, are reviewed and compared to actual payment experience on an individual patient account basis. Discrepancies between expected and actual payments are reviewed, and as necessary, appropriate corrections to the patient accounts are made to reflect actual payments received. If a discrepancy exists between the payment terms loaded into the contract management system and the actual discount based on payments received, the system is updated accordingly to ensure appropriate discounting of future charges.

Additionally, we rely on other analytical tools to ensure our contractual discounts are reasonably estimated. These include, but are not limited to, monitoring of collection experience by payor, reviewing total patient collections as a percentage of net patient revenue (adjusted for the provision for bad debts) on a trailing twelve-month basis, gross to net patient revenue comparisons, contractual allowance metrics, etc. As well, patient accounts are continually reviewed to ensure all patient accounts reflect either system-generated discounts or estimated contractual allowances, as necessary.

Medicare and Medicaid regulations and various managed care contracts are often complex and may include multiple reimbursement mechanisms for different types of services provided in our healthcare facilities, requiring complex calculations and assumptions which are subject to interpretation. Additionally, the services authorized and provided and resulting reimbursement are often subject to interpretation. These interpretations sometimes result in payments that differ from our estimates. Additionally, updates to regulations and contract renegotiations occur frequently, necessitating continual review and assessment of the estimation process by management. We have made significant investments in our patient accounting information systems, human resources and internal controls, which we believe greatly reduces the likelihood of a significant variance occurring between the recorded and estimated contractual discounts. Given that most of our contractual discounts are pre-defined or contractually based, and as a result of continual internal monitoring processes and our use of analytical tools, we believe the aggregate differences between amounts recorded for initial contractual discounts and final contractual discounts resulting from payments received are not significant. Finally, we believe that having a wide variety and large number of managed care contracts that are subject to review and administration on a hospital-by-hospital basis minimizes the impact on our total revenue of any imprecision in recorded contractual discounts caused by the system-load of payment terms of a particular payor. We believe that our systems and processes, as well as other items discussed, provide reasonable assurance that any change in estimate related to contractual discounts is immaterial to our financial position, results of operations and cash flows.

Insurance Reserves. Given the nature of our operating environment, we may become subject to professional and general liability or workers’ compensation claims or lawsuits. We maintain third-party insurance coverage for individual malpractice and workers’ compensation claims to mitigate a portion of this risk. In addition, we maintain excess coverage limiting our exposure to an aggregate annual amount for claims. We estimate our reserve for self-insured professional and general liability and workers’ compensation risks using historical claims data, demographic factors, severity factors, current incident logs and other actuarial analysis. At September 30, 2016 and 2015, our professional and general liability accrual for asserted and unasserted claims was $54.2 million and $52.7 million, respectively. For the years ended September 30, 2016, 2015 and 2014, our total premiums and self-insured retention cost for professional and general liability insurance was $29.8 million, $3.8 million and $17.4 million, respectively.

The estimated accrual for professional and general liability and workers’ compensation claims could be significantly affected should current and future occurrences differ from historical claims trends. The estimation process is also complicated by the complexity and changing nature of tort reform in the states in which we operate. While we monitor current claims closely and consider outcomes when estimating our insurance accruals, the complexity of the claims and wide range of potential outcomes often hampers timely adjustments to the assumptions used in the estimates.

 

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Valuations from our independent actuary for professional and general liability losses resulted in a change in related estimates for prior years which increased (decreased) professional and general liability expense by the following amounts (in millions):

 

Year ended September 30, 2016

   $ 11.2   

Year ended September 30, 2015

   $ (8.7

Year ended September 30, 2014

   $ (4.1

Our estimate of the reserve for professional and general liability claims is based upon actuarial calculations that are completed semi-annually. The changes in estimates noted above were recognized in the periods in which the independent actuarial calculations were received. The key assumptions underlying the development of our estimate (loss development, trends and increased limits factors) have not changed materially, as they are largely based upon professional liability insurance industry data published by the Insurance Services Office, a leading provider of data, underwriting, risk management and legal/regulatory services. The changes in professional and general liability expense related to changes in prior year estimates reflected above for the years ended September 30, 2016, 2015 and 2014, are the result of actual claims experience that differ when compared to the industry benchmarks for loss development included in the original actuarial estimate.

Sensitivity in the estimate of our professional and general liability claims reserve is reflected in various actuarial confidence levels. We utilize a statistical confidence level of 50% in developing our best estimate of the reserve for professional and general liability claims. Higher statistical confidence levels, while not representative of our best estimate, provide a range of reasonably likely outcomes upon resolution of the related claims. The following table outlines our reported reserve amounts compared to reserve levels established at the higher statistical confidence levels (in millions):

 

As reported at September 30, 2016

   $ 54.2   

75% Confidence Level

   $ 58.6   

90% Confidence Level

   $ 73.0   

Valuations from our independent actuary for workers’ compensation losses resulted in a change in related estimates for prior years which decreased workers’ compensation expense by the following amounts (in millions):

 

Year ended September 30, 2016

   $ (0.7

Year ended September 30, 2015

   $ —     

Year ended September 30, 2014

   $ (1.2

 

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Medical Claims Payable. Medical claims expense, excluding claims paid to our hospitals, was $1.14 billion, $732.7 million and $596.8 million for the years ended September 30, 2016, 2015 and 2014, respectively. For the years ended September 30, 2016, 2015 and 2014, $18.1 million, $16.5 million and $13.1 million, respectively, of health plan payments made to hospitals and other healthcare entities owned by us for services provided to our enrollees were eliminated in consolidation.

The following table shows the components of the change in medical claims payable (in thousands):

 

     Year Ended September 30,  
     2016      2015      2014  

Medical claims payable, beginning of year

   $ 104,296       $ 79,449       $ 57,514   

Reinsurance recoverable, beginning of year

     (18,927      (2,920      (4,647
  

 

 

    

 

 

    

 

 

 

Net claims payable, beginning of year

     85,369         76,529         52,867   

Medical claims expense attributable to:

        

Current year

     1,117,081         715,658         592,642   

Prior year

     18,175         17,022         4,136   
  

 

 

    

 

 

    

 

 

 

Medical claims expense

     1,135,256         732,680         596,778   

Medical claims payments attributable to:

        

Current year

     (957,963      (634,295      (510,900

Prior year

     (117,869      (89,545      (62,216
  

 

 

    

 

 

    

 

 

 

Medical claims paid

     (1,075,832      (723,840      (573,116

Net claims payable, end of year

     144,793         85,369         76,529   

Reinsurance recoverable, end of year

     22,231         18,927         2,920   
  

 

 

    

 

 

    

 

 

 

Medical claims payable, end of year

   $ 167,024       $ 104,296       $ 79,449   
  

 

 

    

 

 

    

 

 

 

As reflected in the table above, medical claims expense for the year ended September 30, 2016, includes $18.2 million in increased medical costs related to prior years. This includes $1.4 million in increased prior year medical costs related to Health Choice’s Arizona Exchange product, which we are exiting effective January 1, 2017. Excluding development from our Arizona Exchange product, medical claims expense for the year ended September 30, 2016, includes $16.8 million in increased medical costs related to prior years. This unfavorable development for the year ended September 30, 2016, is attributable to higher than anticipated medical costs relating to increased acuity levels for certain higher cost enrollment groups and growth in new members who demonstrated pent up demand for care and higher medical costs during their initial time of enrollment in the plan. Medical claims expense for the years ended September 30, 2015 and 2014, includes a $17.0 million and $4.1 million increase, respectively, in medical costs related to prior years resulting from changes in unfavorable development, which were primarily due to Arizona’s expansion of the state’s Medicaid program effective January 1, 2014, and the related increase in the childless adult population that typically experiences higher medical costs.

Additional adjustments to prior year estimates may be necessary in future periods as more information becomes available.

 

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We estimate our medical claims payable using historical claims experience (including severity and payment lag time) and other actuarial analysis including number of enrollees, age of enrollees and certain enrollee health indicators to predict the cost of healthcare services provided to enrollees during any given period. While management believes that its estimation methodology effectively captures trends in medical claims costs, actual payments could differ significantly from our estimates given changes in healthcare costs or adverse experience. For example, our medical claims payable is primarily composed of estimates related to the most recent three months and periods prior to the most recent three months. The claims trend factor, which is developed through a comprehensive analysis of claims incurred in prior months, is the most significant component used in developing the claims liability estimates for the most recent three months. The completion factor is an actuarial estimate, based upon historical experience, of the percentage of incurred claims during a given period that have been adjudicated as of the date of estimation. The completion factor is the most significant component used in developing the claims liability estimates for the periods prior to the most recent three months. The following table illustrates the sensitivity of our medical claims payable at September 30, 2016, and the estimated potential impact on our results of operations, to changes in these factors that management believes are reasonably likely based upon our historical experience and currently available information (dollars in thousands):

 

Claims Trend Factor

     Completion Factor  

Increase (Decrease)

in Factor

   Increase (Decrease) in
Medical Claims
Payable
     Increase (Decrease)
in Factor
    Increase (Decrease) in
Medical Claims
Payable
 
(3.0%)    $ (6,236      1.0   $ (8,262
(2.0)      (4,157      0.5        (4,304
(1.0)      (2,079      (0.5     4,775   
1.0      2,079         (1.0     9,696   

Reinsurance. We enter into reinsurance arrangements to reduce the risk associated with certain higher-cost claims. We are not completely relieved of our liability to the ultimate insured, but our liability is limited to the credit risk exposure associated with the reinsurer. Premiums ceded to the reinsurer are recorded as a reduction to premium revenue, and expected recoveries are recorded as a reduction to medical claims expense. Amounts receivable from reinsurers include both an estimate based upon actual known claims and an estimate associated with the incurred but not yet reported portion of medical claims payable.

Goodwill and Other Intangibles. The accounting policies and estimates related to goodwill and other intangibles are considered critical because of the significant impact that impairment could have on our financial results. We record all assets and liabilities acquired in purchase acquisitions, including goodwill, indefinite-lived intangibles, and other intangibles, at fair value as required by Accounting Standards Codification (“ASC”) 360, Property, Plant and Equipment. The initial recording of goodwill and other intangibles requires subjective judgments concerning estimates of the fair value of the acquired assets. Goodwill, which was $767.7 million at September 30, 2016, is not amortized but is subject to tests for impairment annually or more often if events or circumstances indicate it may be impaired. An impairment loss is recorded to the extent that the carrying amount of goodwill exceeds its implied fair value. The implied fair value of goodwill is determined by assessing the fair value of the reporting unit based upon discounted cash flow projections. Estimated cash flows may extend far into the future and, by their nature, are difficult to determine over an extended timeframe. Factors that may significantly affect the estimates include, among others, competitive forces, customer behaviors and attrition, changes in revenue growth trends, cost structures and technology, and changes in discount rates and specific industry or market sector conditions. As of September 30, 2016, the annual goodwill evaluation indicated an impairment of goodwill in our acute care Arizona reporting unit, and a non-cash charge of $54.0 million was recorded to write-off the goodwill related to that reporting unit. In addition, we determined that our Texas reporting unit was at risk for future impairment because its estimated fair value exceeded its carrying value by less than 15%. The estimated fair value of our acute care Texas reporting unit has been impacted by events and circumstances that have occurred at our Houston hospital during fiscal 2016. Additionally, revenue at certain of our Texas hospitals was negatively impacted by a decline in crude oil prices that occurred in fiscal years 2015 and 2016. We view the impact of these events on the estimated fair value of our acute care Texas reporting unit to be temporary in nature.

Other identifiable intangible assets, net of accumulated amortization, were $16.6 million at September 30, 2016, compared to $19.9 million at September 30, 2015. These are amortized over their estimated useful lives and are evaluated for impairment if events and circumstances indicate a possible impairment. Such evaluation of other intangible assets is based on undiscounted cash flow projections. Other key judgments in accounting for intangible assets include useful life and classification between goodwill and indefinite-lived intangibles or other intangibles which require amortization.

See “Goodwill and Other Intangible Assets” in Note 7 to the audited, consolidated financial statements for additional information regarding intangible assets. The impact of a 5% impairment charge to goodwill or intangible assets would result in a reduction in pre-tax income of $39.2 million.

Stock-based Compensation. We account for stock-based compensation awards in accordance with ASC 718, Compensation—Stock Compensation, which requires a fair-value based method for measuring the value of stock-based compensation. Fair value is measured once at the date of grant and is not adjusted for subsequent changes. Our stock-based compensation plans include programs for stock options and restricted stock unit (“RSU”) awards.

 

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We estimate the grant date fair value, and the resulting stock-based compensation expense, using the Black-Scholes-Merton option-pricing model. The Black-Scholes-Merton option-pricing model requires the use of highly subjective assumptions which determine the fair value of stock-based awards. These assumptions include:

Expected term—The expected term represents the period that stock-based awards are expected to be outstanding. We used the simplified method to determine the expected term, which is calculated as the average of the time-to-vesting and the contractual life of the awards.

Expected volatility—Since we are currently privately held and do not have any trading history for our common stock, the expected volatility was estimated based on the average volatility for comparable publicly traded peer companies over a period equal to the expected term of the awards. When selecting comparable publicly traded peer companies on which we based our expected stock price volatility, we selected companies with comparable characteristics to us, including enterprise value, risk profiles, and with historical share price information sufficient to meet the expected life of the stock-based awards. The historical volatility data was computed using the daily closing prices for the selected companies’ shares during the equivalent period of the calculated expected term of the stock-based awards.

Risk-free interest rate—The risk-free interest rate is based on the U.S. Treasury zero coupon issues in effect at the time of grant for periods corresponding with the expected term of the award.

Expected dividend—No recurring dividends have been authorized and we do not expect to pay cash dividends in the foreseeable future. Therefore, we used an expected dividend yield of zero.

In addition to the Black-Scholes-Merton assumptions, we estimate our forfeiture rate based on an analysis of our actual forfeitures and will continue to evaluate the adequacy of the forfeiture rate based on actual forfeiture experience, analysis of employee turnover behavior, and other factors. The impact from any forfeiture rate adjustment would be recognized in full in the period of adjustment and if the actual number of future forfeitures differs from our estimates, we might be required to record adjustments to stock-based compensation in future periods. These assumptions represent our best estimates, but these estimates involve inherent uncertainties and the application of management’s judgment. As a result, if factors change and we use different assumptions, our equity-based compensation expense could be materially different in the future.

Income taxes. Our income tax expense, deferred tax assets and liabilities, and liabilities for unrecognized tax benefits reflect management’s best estimate of current and future taxes to be paid. We estimate and record a valuation allowance to reduce deferred tax assets to the amount we believe is more likely than not to be realized in future periods. We assess the available positive and negative evidence to estimate whether sufficient future taxable income will be generated to permit use of the existing deferred tax assets. A significant piece of objective negative evidence evaluated was the cumulative loss incurred over the three-year period ended September 30, 2016. Such objective evidence makes it difficult to rely on more subjective evidence, such as our projections for future profitability. Accordingly, we have limited our estimate of future taxable income to the amount of projected future reversals of taxable temporary differences, which are expected to reverse in the same periods and jurisdictions and of the same character as the temporary differences giving rise to the deferred tax assets.

On the basis of this evaluation, as of September 30, 2016, a valuation allowance of $35.3 million has been established to recognize only the portion of deferred tax assets that is more likely than not to be realized. The amount of the deferred tax asset considered realizable could be adjusted in the future if objective negative evidence in the form of cumulative losses is no longer present and additional weight is given to subjective evidence, or if future operating results impact the expected reversal of taxable temporary differences available to produce future taxable income.

Certain tax matters require interpretations of tax law that may be subject to future challenge and may not be upheld under tax audit. Significant judgment is required in determining and assessing the impact of such tax-related contingencies. We apply the provisions of ASC 740, Income Taxes (“ASC 740”), which prescribe a comprehensive model for the financial statement recognition, measurement, presentation, and disclosure of uncertain tax positions taken or expected to be taken in income tax returns. Only tax positions that meet the more-likely-than-not recognition threshold have been recognized in connection with these provisions.

The provisions regarding accounting for uncertainty in income taxes permit interest and penalties on underpayments of income taxes to be classified as interest expense, income tax expense, or another appropriate expense classification based on our accounting election. Our policy is to classify interest and penalties as a component of income tax expense.

Item 7A.     Quantitative and Qualitative Disclosures About Market Risk.

        We are subject to market risk from exposure to changes in interest rates based on our financing, investing and cash management activities. We do not, however, hold or issue financial instruments or derivatives for trading or speculative purposes. At September 30, 2016, the following components of our senior secured credit facilities bear interest at variable rates at specified margins above either the agent bank’s alternate base rate or the LIBOR rate: (i) a $1.025 billion, seven-year term loan; and (ii) a $207.4 million, five-year revolving credit facility. As of September 30, 2016, we had outstanding principal of variable rate debt of $969.3 million.

We have managed our market exposure to changes in interest rates by implementing a comprehensive interest rate hedging strategy that includes converting variable rate debt to fixed rate debt. We have previously executed interest rate swaps for non-trading and non-speculative purposes with Citibank and Barclays, as counterparties, with notional amounts totaling $350.0 million, of which $50.0 million expired on September 30, 2014, $100.0 million expired on September 30, 2015, and $200.0 million expired on September 30, 2016.

Although changes in the alternate base rate or the LIBOR rate would affect the cost of funds borrowed in the future, we believe the effect, if any, of reasonably possible near-term changes in interest rates on our remaining variable rate debt or our consolidated financial position, results of operations or cash flows would not be material. Holding other variables constant, including levels of indebtedness, a 0.125% increase in current interest rates would have no estimated impact on pre-tax earnings and cash flows for the next 12 month period given the 1.25% LIBOR floor that exists in our Term Loan Facility, and given that we currently have no outstanding borrowings under our Revolving Credit Facility.

We currently believe we have adequate liquidity to fund operations as noted above through the generation of operating cash flows, cash on hand and access to our senior secured revolving credit facility. Our ability to borrow funds under our senior secured revolving credit facility is subject to the financial viability of the participating financial institutions. While we do not anticipate any of our current lenders defaulting on their obligations, we are unable to provide assurance that any particular lender will not default at a future date.

 

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Item 8.   Financial Statements and Supplementary Data.

IASIS Healthcare LLC

Index to Consolidated Financial Statements

 

     Page  

Report of Independent Registered Public Accounting Firm

     88   

Consolidated Balance Sheets at September 30, 2016 and 2015

     89   

Consolidated Statements of Operations for the Years Ended September  30, 2016, 2015 and 2014

     90   

Consolidated Statements of Comprehensive Income (Loss) for the Years Ended September 30, 2016, 2015 and 2014

     91   

Consolidated Statements of Equity (Deficit) for the Years Ended September 30, 2016, 2015 and 2014

     92   

Consolidated Statements of Cash Flows for the Years Ended September  30, 2016, 2015 and 2014

     93   

Notes to Consolidated Financial Statements

     94   

 

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Report of Independent Registered Public Accounting Firm

The Board of Directors of

IASIS Healthcare Corporation, sole member of IASIS Healthcare LLC

We have audited the accompanying consolidated balance sheets of IASIS Healthcare LLC (“the Company”) as of September 30, 2016 and 2015, and the consolidated statements of operations, comprehensive income (loss), equity and cash flows for each of the three years in the period ended September 30, 2016. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the auditing standards of the Public Company Accounting Oversight Board (United States) and in accordance with the auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of IASIS Healthcare LLC at September 30, 2016 and 2015, and the consolidated results of its operations and its cash flows for each of the three years in the period ended September 30, 2016, in conformity with U.S. generally accepted accounting principles.

As discussed in Note 2 to the consolidated financial statements, the Company changed the classification of all deferred tax assets and liabilities to noncurrent on the September 30, 2016 consolidated balance sheet as a result of the adoption of FASB Accounting Standards Update 2015-17, Balance Sheet Classification of Deferred Taxes.

/s/ Ernst & Young LLP

Nashville, Tennessee

December 21, 2016

 

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IASIS HEALTHCARE LLC

CONSOLIDATED BALANCE SHEETS

(In Thousands)

 

     September 30,
2016
    September 30,
2015
 
ASSETS     

Cash and cash equivalents

   $ 345,685      $ 378,513   

Accounts receivable, less allowance for doubtful accounts of $221,441 and
$210,066 at September 30, 2016 and 2015, respectively

     342,368        317,729   

Inventories

     65,042        62,593   

Deferred income taxes

     —          2,645   

Prepaid expenses and other current assets

     143,048        200,555   
  

 

 

   

 

 

 

Total current assets

     896,143        962,035   

Property and equipment, net

     939,784        894,766   

Goodwill

     767,659        821,339   

Other intangible assets, net

     16,601        19,896   

Other assets, net

     60,096        55,596   
  

 

 

   

 

 

 

Total assets

   $ 2,680,283      $ 2,753,632   
  

 

 

   

 

 

 
LIABILITIES AND EQUITY     

Accounts payable

   $ 143,415      $ 131,152   

Salaries and benefits payable

     47,464        80,833   

Accrued interest payable

     27,831        26,896   

Medical claims payable

     167,024        104,296   

Other accrued expenses and current liabilities

     138,996        98,324   

Current portion of long-term debt, capital leases and other long-term obligations

     18,086        11,816   
  

 

 

   

 

 

 

Total current liabilities

     542,816        453,317   

Long-term debt, capital leases and other long-term obligations

     1,841,653        1,842,714   

Deferred income taxes

     91,633        118,477   

Other long-term liabilities

     90,295        95,553   

Non-controlling interests with redemption rights

     120,809        114,922   

Member’s equity (deficit)

     (23,247     117,847   

Non-controlling interests

     16,324        10,802   
  

 

 

   

 

 

 

Total equity (deficit)

     (6,923     128,649   
  

 

 

   

 

 

 

Total liabilities and equity

   $ 2,680,283      $ 2,753,632   
  

 

 

   

 

 

 

See accompanying notes.

 

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IASIS HEALTHCARE LLC

CONSOLIDATED STATEMENTS OF OPERATIONS

(In Thousands)

 

     Year Ended
September 30,
 
     2016     2015     2014  

Revenues

      

Acute care revenue before provision for bad debts

   $ 2,349,516      $ 2,244,071      $ 2,140,270   

Less: Provision for bad debts

     (385,903     (359,241     (337,118
  

 

 

   

 

 

   

 

 

 

Acute care revenue

     1,963,613        1,884,830        1,803,152   

Premium, service and other revenue

     1,288,928        884,430        699,304   
  

 

 

   

 

 

   

 

 

 

Total revenue

     3,252,541        2,769,260        2,502,456   

Costs and expenses

      

Salaries and benefits (includes stock-based compensation of $5,277, $7,031 and $11,891, respectively)

     987,147        932,815        892,818   

Supplies

     335,707        322,236        299,760   

Medical claims

     1,135,256        732,680