Quest Diagnostics 2006 Annual Report Download - page 70

Healthcare insurers, including managed care organizations and other healthcare insurance providers, which
typically negotiate directly or indirectly with a number of clinical laboratories on behalf of their members,
represent approximately one-half of our clinical testing volumes and one-half of our net revenues from our
clinical testing. Larger healthcare insurers typically prefer to use large commercial clinical laboratories because
they can provide services to their members on a national or regional basis. In addition, larger laboratories are
better able to achieve the low-cost structures necessary to profitably service the members of large healthcare
plans and can provide test utilization data across various products in a consistent format. In certain markets, such
as California, healthcare insurers may delegate their covered members to independent physician associations, or
IPAs, which in turn negotiate with laboratories for clinical laboratory services on behalf of their members.
The trend of consolidation among healthcare insurers has continued, resulting in fewer but larger insurers
with significant bargaining power to negotiate fee arrangements with healthcare providers, including clinical
laboratories. These healthcare insurers, as well as IPAs, demand that clinical laboratory service providers accept
discounted fee structures or assume all or a portion of the financial risk associated with providing testing services
to their members through capitated payment arrangements. Under these capitated payment arrangements, we and
healthcare insurers agree to a predetermined monthly reimbursement rate for each member of the healthcare
insurer’s plan, regardless of the number or cost of services provided by us. Our cost to perform work reimbursed
under capitated payment arrangements is not materially different from our cost to perform work reimbursed under
other arrangements with healthcare insurers. Since average reimbursement rates under capitated payment
arrangements are typically less than our overall average reimbursement rate, the testing services reimbursed under
capitated payment arrangements are generally less profitable. In 2006, we derived approximately 16% of our
testing volume and 7% of our net revenues from capitated payment arrangements.
Healthcare plans are increasingly offering programs such as preferred provider organizations, or PPOs, and
consumer driven health plans that offer a greater choice of healthcare providers. Pricing for these programs is
typically negotiated on a fee-for-service basis, which generally results in higher revenue per requisition than
under capitation arrangements. Most of our agreements with major healthcare insurers are non-exclusive
arrangements. As a result, under these non-exclusive arrangements, physicians and patients have more freedom of
choice in selecting laboratories, and laboratories are likely to compete more on the basis of service and quality
than they may otherwise. If consumer driven plans and PPO plans increase in popularity, it will be increasingly
important for healthcare providers to differentiate themselves based on quality, service and convenience to avoid
competing on price alone.
Despite the general trend of increased choice for patients in selecting a healthcare provider, recent
experience indicates that some healthcare insurers may actively seek to limit the choice of patients and physicians
if they feel it will give them increased leverage to negotiate lower fees, by consolidating services with a single
or limited network of contracted providers. Historically, healthcare insurers, which had limited their network of
laboratory service providers, encouraged their members, and sometimes offered incentives, to utilize only
contracted providers. In addition, patients who use a non-contracted provider may have a higher co-insurance
responsibility, which may result in physicians referring testing to contracted providers to minimize the expense to
their patients. In cases where members choose to use a non-contracted provider due to service quality or
convenience, the non-contracted provider would be reimbursed at rates considered “reasonable and customary”.
Contracted rates are generally lower than “reasonable and customary” rates because of the potential for greater
volume as a contracted provider. However, a non-contracted laboratory service provider with quality and service
preferred by physicians and patients to that of contracted providers, could potentially realize greater profits than
if it was a contracted provider, provided that physicians and patients continue to have choice in selecting their
provider. Physicians requiring testing for patients are the primary referral source of our clinical laboratory testing
volume, and often refer work to us as a non-contracted provider. Recent experience indicates that at least one
large healthcare insurer United Healthcare Group Inc., or UNH, is looking to restrict or eliminate the choice of
physicians, and in turn their patients, by threatening to impose financial penalties on physicians for referring
patients to non-contracted laboratory service providers. If this approach is successful in influencing physicians to
no longer use non-contracted laboratories, it could make it substantially more difficult for a laboratory service
provider to sufficiently differentiate itself based on quality and service in order to profitably operate as a non-
contracted provider, could lead to other healthcare insurers using similar tactics, and could materially impact our
financial condition, results of operation and cash flows.
We expect that reimbursements for the diagnostic testing industry will continue to remain under pressure.
Today, many federal and state governments face serious budget deficits and healthcare spending is a prime target
for reductions, and efforts to reduce reimbursements and stringent cost controls by government and other payers
for existing tests may continue. However, we believe that as new tests are developed which either improve on
the effectiveness of existing tests or provide new diagnostic capabilities, government and other payers will add
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