M&A Roundtable: Reps and Warranties Insurance Impact on Healthcare

Intro (00:00):
You're listening to the Alliant M&A Roundtable, providing insights and expertise on the unique risk management needs of private equity firms.

Jon Gilbert (00:11):
Well, thank you all for joining us here today for another series of Alliant M&A Podcasts. With us today are Katie Murphy, Brian Barger and Larry Shapiro, all key members of the M&A team. Katie will be asking Brian and Larry a number of questions around healthcare transactions and some of the things that buyers need to know when they're doing a healthcare deal. It's going to be a lively discussion and thank you all for joining. And with that, I'll turn it over to Katie to start the questions.

Katie Murphy (00:38):
Thank you. So, Brian, as an experienced professional in both health insurance and M&A deals, what makes healthcare investments more unique than others? Is it regulatory concerns like the corporate practice of medicine, HIPAA compliance, or malpractice insurance?

Brian Barger (00:53):
Yeah, Katie. So, at a high level, I think it's all of the above. There are definitely regulatory concerns on both the federal and state level, as you just mentioned. Corporate practice of medicine doctrine is a complex ruling that can easily result in legal issues if not followed correctly, and then HIPAA compliance is an especially sensitive issue for healthcare organizations. But I think a less obvious issue to consider is quality of care, which dovetails with malpractice insurance. So, in recent years, M&A activity has definitely grown in the healthcare industry and that's accelerated the rate of growth in consolidation. And that consolidation creates larger and more financially stable organizations, which provide efficiencies and economies of scale. But it also comes at a cost. The M&A activity brings a range of quality and safety considerations that can drive both operational and liability problems.

Some of those common problems that the organizations, whether it be the private equity fund or the target company, should look to avoid post-close include divergent cultures, which could lead to high staff turnover, inconsistent clinical and operational policies and procedures, ineffective risk management programs, and improper documentation and lapses in communication. And for the communication, you know, that can be both internal and external. With the internal, particularly with regards to physician groups, it's important that these changes are communicated to the physicians and get the physician buy-in as they're proceeding through these transactions. All of these issues can increase the risk of patient or resident harm and potentially result in litigation. So, while the issues might not immediately seem to be a financial consideration, they can certainly result in a financial impact. And I think the best way to address this concern is to be proactive and develop a plan before a transaction closes so that it can be seamlessly rolled out.

Katie Murphy (03:29):
Thanks, Brian, and staying on the corporate practice of medicine, how do private equity buyers structure transactions to get around this hurdle? And how does that impact insurance considerations, particularly when a private equity buyer is the first institutional capital?

Brian Barger (03:44):
Well, again, the corporate practice of medicine doctrine is complex and may require an attorney for advice on navigating it. But you know, there's not necessarily a one size fits all approach to dealing with this doctrine. The doctrine is an act aimed at protecting patients that basically prevents non-medical practitioners from owning a medical practice. Given that it varies by state, I think there are roughly 30 states throughout the US that follow this doctrine. That said, there are some common approaches that we see as insurance professionals relating to business formation and insurance program structures. And so, in those states where it's more difficult for businesses to engage in the practice of medicine, a popular approach is to use a management service organization, also known as an MSO model. Under this model, a management company is formed to operate a medical professional entity, and that MSO may provide space, equipment, supplies, non-professional staff and other needs of practice. For the practice itself, however, a professional entity must be formed, and most importantly, a physician must be found to own the professional entity. And these physicians are often referred to as friendly physicians. With the MSO model, there are certain insurance considerations which would vary by line of coverage, but a common question that comes up is, does the MSO itself need to have malpractice insurance? And if so, how should it be structured? And it's going to vary by deal, but in short, the MSO itself does not necessarily need to have malpractice insurance, since it's not supposed to be doing anything that's related to the practice of medicine. The clinical providers and professional entities, however, do need malpractice insurance. So that being said, an MSO can, in an agreement, agree to providing this insurance, especially if a physician is an owner in the MSO, which we often see is the case with this approach, the MSO entity would be set up as the first named insured and the professional entities and providers would be scheduled as additional named insureds. On the flip side, if the MSO did not provide malpractice coverage for the professional entities and its providers that it contracts with, then each of those entities and providers would need to secure their own coverage.

Katie Murphy (06:55):
Thank you, Brian. Larry, can you tell us about the rep and warranty market generally and certainly specific to healthcare? What trends have you seen in 2022 and expect in 2023? And are there RWI insurers focused on healthcare deals?

Larry Shapiro (07:11):
Sure. So, I mean, I might take a step back and look at '21 first. '21 Was obviously a record year for healthcare M&A transactions, and we saw increased activity across a variety of sectors, which included telehealth and digital health, among the more traditional healthcare target operations. In this past year, we saw the volume normalize and I think with respect to projecting ahead to '23, while there might be more broader challenges in the market as a whole, I think there are widely held expectations for higher volume for healthcare M&A in the coming year. In terms of trends with respect to investment appetite in healthcare sectors, you know, we're expecting that to be high, we're expecting consumer need, you know, for medical care, for drugs and services and medical devices to obviously continue as well. But having spoken to a number of clients and advisors, certainly expect to see investments in the coming year in healthcare systems and pharmacy benefit management operations, digital and telehealth and healthcare software among, again, more core healthcare operations. So, in terms of the transactional insurance market, we now have between 10 and 12 primary underwriting options with insurers that have dedicated capability of underwriting poor healthcare targets. I think the number even broadens when it comes down to insuring transactions with target operations that are in digital health or more software-driven, or for targets that are sort of healthcare ancillary operations. So by and large, I think there should be trends towards increased investment and a capability in the transactional insurance market to really digest a lot of those transactions.

Katie Murphy (08:57):
Thanks, Larry. This one is both for Larry and Brian, Medicare and Medicaid Overbilling. This is obviously a concern for most healthcare companies. Brian, what insurance solutions exist in the market for this today? For example, an exclusive Alliant program, and Larry, what do insurers require for underwriting with regards to billing, coding?

Brian Barger (09:17):
So modern healthcare organizations are definitely challenged with government audits and complex rules, regulations and guidelines, and Medicare and Medicaid overbilling is definitely a key concern there. This is something that there are insurance solutions for. However, coverage for billing errors and omissions is generally not included on a professional liability or malpractice policy. The best way to protect against it is by purchasing a separate regulatory liability E&O policy, and a number of carriers offer products with various levels of coverage. Alliant actually has an exclusive program called FFacts that delivers a comprehensive solution for healthcare organizations. The program provides full retroactive coverage and includes expert defense as well as indemnification for fines and penalties associated with unintentional overbilling, including false claims acts, fines and penalties. FFacts also includes cyber insurance enhancements to make sure that an organization is protected from a data breach. And the offering is flexible enough to cover a broad range of healthcare organizations, whether it be physician groups, allied facilities, hospitals, long-term care facilities, home health clinics, and ambulatory centers and more.

Larry Shapiro (10:57):
And just to follow Brian's comments, I think with respect to transactional insurance underwriters and their expectations, a couple of things to know. One, you know, traditionally speaking with reps and warranties, insurance-insurer expectations are that there's sufficient diligence to prove out the accuracy of the reps that the insurers are effectively insuring. So, they're going to want to see, you know, sufficient scope and depth of diligence and then positive results. Now, when it comes down to billing and coding, focusing back on the diligence expectations for underwriters, the insurers that are underwriting, billing and coding exposure are going to expect buy-side audit or sampling of the files. And it hasn't historically been the case where insurers will expect a statistically valid sampling, but they are going to expect a sampling that is sizeable enough to capture a material number of patient encounters from each of the locations.

I think that insurers in this space, they've got an understanding that they can't expect a zero-error rate. There's probably an expectation that roughly 15% to 20%, or so, think it'll vary by industry, but around 15 to 20% of error rates are common. So, I think that that sort of practical approach has to factor into their expectations. Insurers will expect, you know, buy-side sampling, but I do think that at times sellers or the target itself may do internal or external auditing, and if that's the case, insurers have historically been willing to tailor their expectations.

Katie Murphy (12:30):
Thank you, Larry. Let's talk about the importance of cybersecurity diligence for private equity buyers on healthcare targets. How much do rep and warranty underwriters focus on cybersecurity and what can buyers do to prepare for the best outcome?

Larry Shapiro (12:43):
Yeah, I think there's an increasing focus on the importance of cybersecurity diligence and the significance of the exposure. We've had insurers recently release figures that showed a market increase in claims for healthcare related cybersecurity exposures. So, on each transaction where there is relevant exposure, there's going to be a heightened expectation from underwriters that a full review is undertaken. There's also going to be a heightened expectation that there's adequate cyber insurance in place if possible, and they're going to be looking to understand the history that the target has had in terms of claims.

Katie Murphy (13:21):
That's a great point, Larry. Brian, certain healthcare companies take the position that if they buy more insurance that will result in a bigger settlement. What's your view on this and does this view change with first institutional capital for a company? And Larry, how is this viewed by reps and warranties underwriters?

Brian Barger (13:39):
Well, I think determining the appropriate limits for an organization should be done on a case-by-case basis, but it's certainly true that plaintiff’s attorneys will typically seek out the limits available under a policy. So having higher limits may help you sleep better, but it can make you the deep pocket in a lawsuit. Two important considerations in setting limits for healthcare organization are geographical venue and the class of healthcare. Some states such as Texas, Florida, California, to name a few, have caps on damages that can be awarded. So, you may not need limits as high as elsewhere. And regarding medical specialties, some are more prone to generate higher severity claims than others. For instance, a claim involving an OBGYN is likely to result in a larger settlement than say a dermatologist. Therefore, I would suggest different limits for those different specialties. It really depends on an individual risk, but I think there should be a drive for investors to protect their investment. If there are claims or judgments against you, you can still be responsible for paying any damages that exceed the insurance policy limits.

Larry Shapiro (15:07):
Thanks, Brian. And so, with respect to reps and warranties insurance as part of the traditional engagement, I think that the reps and warranties underwriters are looking to us, in particular, when we've been engaged on the diligence side to assess the adequacy of the insurance and to give our opinion on, you know, the adequacy of underlying limits. So, from that perspective alone, there tends to be a lot of reference from the reps and warranties underwriters to specialist determination, as to adequacy.

Katie Murphy (15:34):
Thank You, Larry.

Jon Gilbert (15:35):
Well, thank you all for sharing your expertise, very interesting dialogue and a lot to consider. Certainly, there's a lot for our private equity firms to consider as well when undertaking healthcare transactions, in particular. Alliant is the largest specialty insurance broker, has deep expertise in both the healthcare industry and the M&A market. Alliant is also the only broker with a dedicated healthcare team as part of the M&A advisory practice making us a very trusted advisor for many clients and future clients. So, thank you all for listening. Join in next time as we'll talk about other topics of interest. For more information, please visit us at www.alliant.com.