By Craig Standen
Healthcare executives are facing an increasingly complex operating environment, where growing pressure on margins is resulting in greater reliance on investment performance of various asset pools to maintain a stable financial profile. Healthcare providers must take risks to grow and add value. At the same time, since the 2008 financial crisis, many organizations are focusing more time and attention on developing strategies to better withstand the impact of macro, systemic shocks, and respond appropriately should similar events occur in the future.
Risk is inherent in the pursuit of business objectives, and effective risk management is a key success factor in today’s volatile market environment. The traditional asset-only approach to portfolio decision-making does not take into account the correlation among and impact of risks present across the organization. As such, the financial dynamics of healthcare systems and hospitals necessitate comprehensive, proactive and ongoing review of broader enterprise risks and more specifically the impact that asset allocation decisions and investment returns have on financial and operational performance.
As operating uncertainty has grown in the healthcare sector, management and boards are recognizing the benefits of closely linking strategy development with a better understanding of the associated risks. An Enterprise Risk Management (ERM) framework provides a useful construct to identify, measure, monitor and respond to risks present across an organization. For healthcare providers, there are four main components of enterprise risk:
Unrestricted liquidity provides operating and working capital, has long-term growth expectations, and supports strategic objectives, including capital spending requirements. The unrestricted liquidity pools also carry risks associated with the allocation strategy.
Capital structures of many providers are composed of various forms of debt, each of which has their own risk profiles and interest rate sensitivity. In addition, financial covenants require providers to consistently meet defined financial performance thresholds or risk a potential default. And rating agency views on capital structure risks will factor into the credit rating and impact a provider’s cost of or access to capital.
Operations/capital budgeting risks encompass competitive positioning activities, execution of strategic initiatives, including spending needs and Affordable Care Act implementation, which drive financial performance and attainment of a desired rating level.
Defined benefit plans have an additional set of risks for those that have them. Contribution requirements impact cash flow and plan funded status will directly impact the balance sheet. In addition, the discount rate used to determined benefit obligations, as well as earnings on plan assets, are subject to interest rate sensitivity.
ERM is a systematic and strategic process that closely links organizational strategy, operations, finance and treasury. It is designed to identify potential events/risks that may impact the organization and helps prioritize and appropriately manage identified risks within the organization’s defined risk ‘appetite.’
Organizational risk ‘appetite’ is a key consideration in setting objectives and developing strategy, including asset allocation decisions. There are several factors that can help providers determine their own unique risk appetite.
Current risk profile is an inventory of the level and range of organizational risks across various categories; some examples include financial, operational, market, and/or reputational risks.
Capacity for risk is the maximum amount of risk that an organization can sustain and remain in business.
Tolerance for risk is the acceptable amount of variation around the desired outcome.
Desired level of risk represents the ‘desired’ risk/return profile.
There is no standard or ‘correct’ risk appetite, just one that is deemed appropriate for a particular organization after evaluating the trade-offs associated with having a ‘high’, ‘medium’ or ‘low’ risk appetite. Once a risk appetite has been determined, it is important to align strategy objective and expected outcomes appropriately. A highly risk averse hospital would probably not feel comfortable with an 80 percent equity allocation; conversely, a health system with a tolerance for higher risk and volatility would probably not invest the lion’s share of their investment assets in Treasury bills and money market funds.
With clear or better understanding of the type of risks present across their organization, how these risks are correlated, and the tolerance or ‘appetite’ for risk, providers will be in a better position to make more informed decisions about strategic asset allocation.
Stochastic modeling is an important tool SEI uses to evaluate more broadly the impact of asset allocation decisions on financial performance and key financial metrics – including bond covenants – and more closely aligns asset allocation decisions to organizational goals and objectives. Using multi-year financial projections (ideally) and other data that covers each of the enterprise risk components noted above, stochastic modeling uses statistical analysis to generate probability distributions of expected outcomes under a range of economic environments, which helps highlight the risk/return profiles of potential asset allocation strategies.
Risk is inherent in the pursuit of business objectives and effective risk management is a key success factor for any organization, and ERM principles provide a model for identifying, measuring and monitoring enterprise risks to better enable you to achieve your organizational goals and objectives. Finally, a siloed, asset-only approach to allocation decision making will give you one answer, but not necessarily the right answer without taking into account the risks present across your organization and linking those decisions to broader organizational goals and objectives.
Craig Standen serves as the Director of Healthcare Advisory Services for SEI’s Institutional Group. Based in Oaks, Pa., SEI is one of the largest investment outsourcing firms in the world. Craig can be reached at [email protected].
Throughout the year, our writers feature fresh, in-depth, and relevant information for our audience of 40,000+ healthcare leaders and professionals. As a healthcare business publication, we cover and cherish our relationship with the entire health care industry including administrators, nurses, physicians, physical therapists, pharmacists, and more. We cover a broad spectrum from hospitals to medical offices to outpatient services to eye surgery centers to university settings. We focus on rehabilitation, nursing homes, home care, hospice as well as men’s health, women’s heath, and pediatrics.
