Disclaimer: This is not financial advice. I just work in the Medicare industry and thought I would share some knowledge. I have no affiliation with any of the companies mentioned in this post. I do own shares in some of the securities discussed.
Direct Contracting (DC) vs Medicare Advantage (MA)
Direct Contracting (DC) works equivalent to Medicare Advantage (MA). The Direct Contracting Entity (DCE) / Medicare Advantage Organization (MAO) receives a monthly payment from Medicare for each Medicare beneficiary enrolled. That payment is meant to cover all the medical costs for the beneficiary. If the medical costs end up being below the payment amount, then the DCE / MAO get to keep the remaining money. If medical costs are higher than expected, the DCE / MAO have to cover the extra costs out of pocket. The main difference between DC and MA is that DC is for Original Medicare patients, which represent 60% of the Medicare beneficiaries across the country. MA represents the other 40%.
Unit Economics
Agilon Health (AGL) was the first DCE to release Q2 earnings, which revealed the first glimpse at DC unit economics. It appears they’re seeing a 2.82% gross margin, which is below the average 4% margin for MA plans. However, all margins (DC and MA) are compressed due to delayed care from COVID in 2020. Also, the actual gross margin will be higher than 2.82% once savings and quality payments are received after the end of the DC performance year. We won’t learn the full unit economics for DC until the reconciliation for performance year 1 occurs in July 2022 (which will include quality payments and savings earned by the DCE).
The appendix at the end has some more details on how the payment is determined in DC.
Growth Potential
The MA market comprises over 24 million Medicare beneficiaries and its growing 9% annually. However, it’s a mature market with established incumbents that only churn 10% of their members each year. This puts a cap on annual growth. There are three possible sources of new MA members each year:
- Newly eligible (i.e. turned 65 years old): 3% annually
- Switch from Original Medicare: 3% annually (net)
- Switch from another MA plan: 10% annually
These sources all feed into the MA growth pool (i.e. the eligible Medicare beneficiaries looking for a MA plan). This is how the MA growth pool breaks down in CLOV’s largest market (New Jersey):
- Newly eligible (i.e. turned 65 years old): 17,867
- Switch from Original Medicare: 31,500
- Switch from another MA plan: 55,833
That adds up to 105,200 Medicare beneficiaries available for enrollment next year, or 19% of the total MA market in New Jersey. The other 81% of the market will stick with their current MA plan, which is a good thing for established plans, but a bad thing for growth.
The DC market, on the other hand, is brand new. The first DCEs (including CLOV) launched in April 2021. That means 60% of all Medicare beneficiaries (38,000,000) that aren’t enrolled in a MA plan are now eligible to be enrolled in a DCE who will then start receiving monthly payments just like a MA plan. Thats over 1,000,000 Original Medicare beneficiaries in New Jersey alone, and CLOV already enrolled 65,000 of them just this year.
To compare, here are the different growth rates in New Jersey for CLOV:
- 2021 MA growth rate: 50,541 -> 59,258 (10% current market share)
- 2021 DC growth rate: 0 -> 65,000 (6.2% current market share)
That’s 7x higher growth in DC compared to MA, and there’s still over 90% of the DC market available (compared to 15–20% of the MA market each year). This large, untapped market represents an incredible growth opportunity over the next five years.
The DC market represents a 10x larger growth opportunity than MA:
- DC: 60% of Medicare beneficiaries (Original Medicare)
- MA: 6% of Medicare Beneficiaries (15% growth pool out of 40% MA).
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DCEs Are Government-Granted Monopolies
Competition in the DC market is extremely limited. Eligible entities had to apply to participate in the DC program, including specifying the specific states they plan to launch in. DC applications opened in 2019 and were accepted until the July 6, 2020 deadline.
Many industry incumbents decided not to apply. It was an election year, so the risk of allocating resources to the application and preparation process was high. A new administration could come in and end the DC program before it even got started. The Biden administration actually did end up halting a subset of the DC program that was supposed to launch in 2022. However, the main DC program that CLOV is participating in has now started and will last until at least the end of 2025
Only 53 DCEs ended up getting approved.
This effectively created a state-level monopoly for approved participants. Only approved DCEs can enroll Original Medicare beneficiaries for the next five years. Based on the powerful industry lobbying and the successful growth of MA, it’s highly likely that the DC program will continue on beyond 2025. This will extend the advantage of the current participants who are approved to establish geographic footholds today.
Even when DC applications open up again, the current 53 participants will have established provider partnerships and enrolled beneficiaries, similar to incumbent MA plans. Beneficiaries only switch to a new DCE if their provider switches (or they choose a new provider). There isn’t a clear benefit for providers to switch DCEs when they’re already onboarded and getting paid.
As more DCEs come to market, margins will likely compress slightly for the incumbent DCEs due to more negotiating power from providers. However, the approved DCEs have the power today, and they can use it to establish provider networks with favorable terms. There’s no new competition for the foreseeable future.
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Direct Contracting Markets
CLOV currently has DCEs approved in the following states effective April 2021:
- Arizona
- Georgia
- Kansas
- New Jersey
- New York
- Pennsylvania
- Rhode Island
- South Carolina
- Texas
- Vermont
Below are some of the key DC markets based on their current MA footprint and latest announcements. There is very limited competition in most of these markets, which makes them a strategic source of growth early on in the DC program. There are two types of DCEs in these markets, which affects the level of competition in each state:
- Standard (CLOV): DCEs allowed to enroll Medicare beneficiaries through claims-based alignment and voluntary alignment. Claims-based alignment is automatic, which results in far higher enrollment rates compared to reaching out to Medicare beneficiaries to try and manually enroll them. CLOV automatically enrolled 65,000 beneficiaries in April 2021 through claims-based alignment, suggesting about 1/3 of eligible beneficiaries can be aligned this way. The remaining 2/3 of the 200,000 eligible beneficiaries in CLOV’s current provider network have not yet been enrolled through voluntary alignment, demonstrating the challenges.
- New Entrant: DCEs only allowed to enroll up to 3,000 Medicare beneficiaries through claims-based alignment each year. The rest of the enrollment must come from voluntary alignment, making this type of DCE far less competitive.
New Jersey DC Market
Based on CLOV’s current DCE Governance Body, New Jersey has been the initial focus for provider partnering and beneficiary enrollment in DC. This makes sense because this is where 90% of CLOV’s current MA enrollment exists, which means they already had a mature network of providers that they recruited for their DCE. CLOV has 65,000 beneficiaries currently enrolled, which represents 19.2% share of the estimated pool of Medicare beneficiaries that could be aligned automatically using claims. They represent the top DCE partner for providers since there are no other Standard DCEs in this market. I expect to see continued growth in enrollment through both voluntary assignment with existing providers and claims-based assignment with new provider partners.
Market Size: Medium
- Eligible Medicare beneficiaries: 1,050,000
- Claims-based alignment beneficiaries: 341,250
Market Competition: Low
- Standard DCEs: 0
- New Entrants: 2
Kansas DC Market
In addition to New Jersey, Kansas is the only other state represented on CLOV’s DCE Governance Body so far. This suggests CLOV is actively partnering with providers in Kansas. In addition to the DCE Governance Body, Dr. Craig Concannon also sits on the board of the Kansas Clinical Improvement Collaborative (KCIC). This is a state-level network of providers in Kansas that work together to improve care quality. This relationship represents a direct channel to enlist partner providers onto CLOV’s Kansas DCE. There are also no other Standard DCEs in this market, enabling them to rapidly gain market share through claims-based alignment.
Market Size: Small
- Eligible Medicare beneficiaries: 433,236
- Claims-based alignment beneficiaries: 140,802
Market Competition: Low
- Standard DCEs: 0
- New Entrants: 2
Georgia DC Market
Georgia appears to be a priority for CLOV’s strategic growth plans in the Southeast, as evidenced by the number of Georgia markets they are launching MA plans in. Georgia sits between South Carolina, Alabama, and Florida, which positions it as an important DC market to establish provider partnerships that potentially extend over state lines in every direction.
Market Size: Medium
- Eligible Medicare beneficiaries: 948,077
- Claims-based alignment beneficiaries: 308,125
Market Competition: Medium
- Standard DCEs: 2
- New Entrants: 3
South Carolina DC Market
South Carolina is another southeastern market that they already have MA plans in. They can leverage their existing provider network to establish and grow their South Carolina DCE. There are no other Standard DCEs in this market, enabling them to rapidly gain market share through claims-based alignment.
Market Size: Medium
- Eligible Medicare beneficiaries: 704,183
- Claims-based alignment beneficiaries: 228,859
Market Competition: Low
- Standard DCEs: 0
- New Entrants: 3
Alabama DC Market
CLOV doesn’t currently have a DCE listed for Alabama, but it’s a likely geography where they could launch one for January 2022 based on their new MA plans there. CMS gave DCE participants the option to either launch April 2021 or defer until January 2022. Participants have only been announced for April 2021 so far. There is only one other Standard DCE in this market, enabling them to rapidly gain market share through claims-based alignment.
Market Size: Small
- Eligible Medicare beneficiaries: 536,782
- Claims-based alignment beneficiaries: 174,454
Market Competition: Low
- Standard DCEs: 1
- New Entrants: 2
Florida DC Market
The Florida market is by far the largest DC market for CLOV, but it also has the highest level of competition. The ValueH partnership is a very important achievement that puts CLOV out ahead of the competition. ValueH owns the Florida Association of ACOs (FLAACO), which is the leading network of provider groups in Florida, creating a direct channel to enlist partner providers onto CLOV’s Florida DCE. CLOV doesn’t currently have a DCE listed in Florida, but based on their ValueH announcement it’s a geography that they will launch in January 2022.
Market Size: Large
- Eligible Medicare beneficiaries: 2,230,000
- Claims-based alignment beneficiaries: 724,750
Market Competition: High
- Standard DCEs: 6
- New Entrants: 5
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Conclusion
CLOV has a government-granted monopoly in multiple states with no incumbents and minimal competition from other DCEs. This gives them unique access to over 5,000,000 Medicare patients over the next five years. Even if the unit economics end up being worse than MA, this represents over 50x growth potential.
Direct Contracting is setting up CLOV to achieve growth on par with what UnitedHealth (UNH) and Humana (HUM) have achieved over the past 10 years:
The fact that the DC market is larger and more open than MA means CLOV could potentially achieve this growth in five years. They have already proven they can execute in the DC market with higher enrollment than any other DCE nationally so far. If retention is similar to MA, then the market share CLOV can establish over the next five years will represent long-term recurring Medicare revenue on par with UnitedHealth, Humana, and the other large MA companies.
The potential growth synergies (local marketing and provider network) between CLOV’s DCEs and MA plans could also lead to higher MA growth for CLOV going forward.
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Appendix
Direct Contracting Payment Model
Provisional Benchmark
- Calculated before Performance Year (PY) to determine Total Care Capitation (TCC) rate (monthly payment during PY)
- Historical Component (65% decreasing to 50%): Beneficiaries claims-aligned in base years (BY) 2017, 2018, and 2019 (base years will not change throughout the life of the model). Historical expenditures are trended forward using USPCC growth trend.
- Regional Component (35% increasing to 50%): DC national reference population + County Relative Cost Index (blended)
- Discount: 2% discount applied to benchmark to ensure CMS savings (rises to 5% in PY 5)
Final Benchmark (calculated after PY as part of reconciliation)
- Provisional Benchmark + Risk Adjustment (HCC scores + CIF)
Risk Adjustment Model
- CMS HCC model (same as MA)
- Risk adjustment applied to the performance year benchmark retrospectively during Final Reconciliation
- Risk adjustment revenue shows up in savings payment (not capitation payment like MA)
- 3% symmetric (up and down) cap on changes in risk score within a DCE
- Reference year = 2 years prior (2019 for PY 2022 to avoid 2020 COVID effect)
- Typical annual risk score increases are 1–2%. CMS predicts a 1.88% risk score increase from 2019 to 2020.
- CMS adjusts MA risk scores relative to FFS risk scores each year to reduce MA payment rates. The minimum (statutory) adjustment level was 5.91% in 2018. The actual difference in average risk scores is 6–10% in MA (depending on the year). This indicates that the 3% DCE risk-adjustment cap is in same range as increased MA risk scores (1–4%).
- Cap does not apply to High Needs DCEs and voluntary aligned beneficiaries. Once a voluntary aligned beneficiary becomes aligned by claims (e.g. following year) the cap starts to apply.
Unit Economics
- Revenue = TCC Revenue (+) Reconciliation Revenue
- Expenses = TCC Services
- Profits = TCC Revenue (-) TCC Services (+) Reconciliation Revenue
TCC Revenue
- Payment Rate = Provisional Benchmark (-) 2% Retention Withhold (-) 5% Quality Withhold (-) X% FFS Withhold
- Starts out high (no FFS claims processed yet at beginning of PY = no FFS Withhold)
- Reduced in subsequent months based on FFS claims from previous months
- Higher is Better: Direct indicator of DCE network strength (percent of all services contracted with DCE), which is correlated with incentive alignment and care coordination
- Higher is Better: Early indicator of leakage (before reconciliation)
- Higher is Better: Indicator of reference risk score (less effect from cap)
- Higher is Better: Stronger network + less leakage means medical margin is baseline profit (from utilization) and reconciliation will result in additional profit (from withholds + risk adjustment)
TCC Services
- 100% participating provider services (+) 1–100% preferred provider services
- Based on network utilization and contractual rates with network
Reconciliation Revenue (all profits)
- Retention = 2% increase in revenue (from retention withhold PY1/2)
- Risk adjustment = up to 3% change in annual revenue (TCC over/under payment relative to final benchmark)**
- Utilization = up to X% change in annual revenue (TCC over/under payment relative to final benchmark)*
- Quality = up to 5% increase in annual revenue (from quality withhold)***
*X% based on FFS withhold: the revenue subtracted from TCC capitation payments to reimburse FFS claims from preferred providers (0–100% FFS) and other providers (100% FFS). If all services occur through participating and preferred providers, savings already realized as medical margin. If additional FFS claims come in during the run out period (three months after PY ends), then TCC overpayment subtracted from savings earned through risk adjustment and withholds.
**Coding Intensity Factor (CIF) likely to reduce overall PY risk scores each year, so cap is effectively lower than 3% (unless voluntary alignment risk scores are large).
***High Performer’s Pool (HPP) comprised of quality withhold not earned back by low performers, which then gets distributed to DCEs with highest quality ratings (percentage not yet defined by CMS, and not included in 5%)
