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Can Hawaii Feed Itself?

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The Next Wonder Drug

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Hawaii Employee Retirement System: Underfunded by $7 Billion

BY DENNIS HOLLIER

The state got just what it was expecting in its Christmas stocking. Unfortunately, it was another lump of coal – more bad news about the state of Hawaii Employee Retirement System, which covers both state and county employees. In its five-year report, the actuary firm of Gabriel Roeder Smith & Company claims the system’s future liabilities now exceed the assets set aside to pay for them by $7.1 billion. That’s nearly $5,500 for every man, woman and child in the state.

Worse still, because of the arcane rules governing actuarial accounting, those figures don’t fully incorporate the system’s huge market losses in 2008 and 2009. Consequently, an additional $1.5 billion will be added to the state’s unfunded liability over the next two years. This means the state’s legally required contribution to the pension system will increase to more than $671 million a year by 2015.

The actuary’s findings were hardly a surprise to those familiar with the state’s pension system. In fact, Wes Machida, the conscientious new ERS administrator, spent much of the holiday season playing Grinch, briefing legislators and members of the incoming administration on what to expect in the report.

 

ERS's III, 721 members include all qualifies state and country employees

    Pension benefits for state and county workers, once earned,
are guaranteed by the state constitution; they cannot be
reduced even in a budget crisis.

 

One of the most remarkable aspects of the current shortfall is how quickly it has grown. As recently as 2000, the pension system covering government workers for the state and Hawaii’s four counties was 94 percent funded. This year, by some measures, the funding ratio has declined to less than 60 percent, and the prospects for paying down the deficit appear more and more remote.

 

There are a couple of factors behind the relentless growth of the pension liability. The first is that, like most state retirement systems, the ERS is a defined-benefit system. In other words, state and county employees are guaranteed set benefits when they retire, based on how many years they have worked and their average salaries at the time of retirement. In addition, those benefits, once earned, are guaranteed by the Hawaii Constitution; they cannot be reduced, even in response to a fiscal crisis such as the state’s recent budget shortfalls. This is typical of defined-benefit systems. In 1979, when New York City went bankrupt, it reneged on hundreds of millions of dollars owed to contractors and bondholders, but never failed to make pension payments to retirees.

 

To pay for these enormous liabilities, the ERS – again, like almost all state pension systems – is a “pre-funded plan.” In theory, enough assets are set aside and invested each year to generate income to offset future liabilities. A pension is said to be “fully funded” when current assets are projected to pay for all future liabilities. Funding comes from three sources: employee contributions, employer contributions and interest earned on the system’s assets. Each contributes to the shortfall.

 

Increase in ERS membership

      Click to enlarge image.

Digging a Hole

In Hawaii, employee contributions are set by law at around 12 percent of payroll for firefighters and police, and 6 percent for other employees. According to Machida, employee contributions amounted to $361 million in 2010, which included $187 million in one-time payments as members changed plans within the system, leaving $174 million in normal employee contributions.

The amount paid by state and county employers is also governed by statute, which prescribes an “actuarially required contribution,” or ARC, sufficient to fully fund the system within 30 years. As lifespans have increased and payrolls have expanded, the counties’ and state’s required contributions have soared: In 2000, the ARC was about $175 million; by 2010, it had reached more than $550 million – $400 million for state employers, and in excess of $150 million for the counties. Even so, the unfunded liability has grown.

The system’s investment earnings scenario isn’t any rosier. Here, too, state law predominates, setting the pension fund’s anticipated rate of return on its investments at a robust 8 percent. But this number has little bearing on the system’s actual earnings. In the past 10 years, returns only reached as high as 8 percent four times. In fact, the system’s market earnings over the past decade have averaged only 2.8 percent, not even keeping pace with inflation. With such inflated earnings expectations, not only is income overestimated, but future liabilities are underestimated.

Assuming Liability

Employer contribution in millions

     Click to enlarge image.

There are, in fact, a slew of other actuarial assumptions that affect the size of the pension system’s liability. For example, Machida notes, the system assumes an average life expectancy of 83 years. Every year, though, actual life expectancy increases. “The average life span of a female schoolteacher is over 90 years,” Machida says.
Other assumptions are more financial. “For example, there were more promotions than expected,” Machida says. “Salary increases were projected at 3 percent or 4 percent; but professors, for example, at one point were given a 9 percent to 11 percent raise. Police officers were getting a 9 percent raise.” Similarly, more benefits were added to the pension system without consideration for how we would pay for them. It will be hard to get back these costs.

Distressingly, most strategies to address the system’s weaknesses hinge on manipulating some of these manini-seeming assumptions: extending the age of retirement; changing the definition of “base pay”; changing the way cost-of-living allowances are calculated. Because the benefits of retirees and existing employees are protected by the state constitution, any changes can probably only apply to new hires. That means the cost of addressing the system’s long-term liability will have to be spread over a small pool of members.

Annual pension payments in millions

     Click to enlarge image.

 

Machida says these assumptions aren’t the main reason the state’s unfunded liability has grown so dramatically. He ascribes most of the increase to an old rule that allowed legislators to seize any annual earnings over 8 percent and apply them to the state’s ARC. In 2001, the worst year, the state used approximately $150 million of these “excess” earnings to help balance the budget. Between 1999 and 2003, according to Machida, more than $350 million in excess earnings were diverted from the pension system. “In 2004, with the assistance of (then) Governor Lingle, we introduced legislation to take that away,” Machida says. But the damage has been done. “If that money had not been taken,” he says, “the system today would be almost fully funded.”

Whatever the proximate causes of the pension-system shortfalls, the effect is a vicious circle: When current income and contributions aren’t enough to pay current benefits – a condition that began in 2006 and is projected to accelerate rapidly for the next five or six years – the only option is to sell off portfolio assets to cover the difference. In 2011, the ERS is projected to cannibalize nearly $200 million in portfolio assets; by 2020, that figure could reach $600 million a year. That’s the opposite of a “pre-paid pension fund.”

How to Fix It

Fixing this problem is going to take time. The formula, according to Machida, is straightforward. C+I=B: contributions plus investment earnings must equal benefits paid. To make that equation balance, each variable will have to be tweaked. First, the employer’s contribution must increase. “This isn’t an option,” it’s a necessity, Machida says. Failure to comply with state law would have disastrous effects on state and county bond ratings.

The scale of the increases necessary will be painful. The recent actuarial report by Gabriel Roeder Smith already raises the ARC to 19.7 percent of payroll for firefighters and police, and 15 percent for general employees, which should yield $671 million a year by 2015. Even that won’t be sufficient. To generate the extra $182 million needed, the actuaries recommend increasing those figures to 27.3 percent and 18.8 percent, respectively, which will yield an additional $43 million. The ARC already constitutes about 10 percent of the state’s general fund budget; it’s hard to see where the additional revenue will come from to pay for the increase.

Dollars contributed to the plan in FY 2010

The interest variable in the pension equation also comes into play in the actuaries’ calculation. By assuming an additional 1 percent yield on the system’s investments, they add another $117 million to the pot. (Although they don’t mention it in their report, raising the assumed rate of return also lowers the current unfunded liability.) But, as Machida points out, raising the targeted investment return comes with higher levels of risk, which further could jeopardize ERS assets.

In fact, making up the state’s unfunded liability on the left side of the pension equation is probably impossible in the long term. That means legislators are left with the politically difficult option of reducing retiree benefits. Machida outlines the possibilities:

• Raise the retirement age;
• Increase the number of years it takes employees to become vested;
• Change how final salaries are calculated; and
• Constrain future payroll growth.

Some version of all of these reductions will likely be necessary, but can the Legislature make them happen?

Estimated yields based on actual and market value of assets

     Although, by statute, the ERS assumes its portfolio will earn 8
percent annually, its actual performance has been erratic at best.
Since 2001, market earnings have averaged only 2.8 percent.
 Click to enlarge image.

To begin with, as Machida points out, the benefits of existing employees are protected by the state Constitution. That means new hires will likely bear the brunt of any changes in benefits. Calvin Say, the longtime Speaker of the House, acknowledges the challenges faced by the Legislature. “I’ve introduced a number of bills to deal with the unfunded liability,” he says. “One that I had was to increase the retirement age from 55 to 60 so you can contribute to the trust fund longer. But you can’t address these changes with present employees. You can’t change this for the current retirees. It’s all going to be based on new employees.”

Kalbert Young, the Abercrombie administration’s incoming director of the state Department of Budget and Finance, makes much the same point. “I would say that the governor is interested in looking at what are the available means for resolving the liability issue,” he says. “Admittedly, though, it’s a very big number; and given the condition and depth of the problem, our timeline for resolving it may not be in the near term.” In other words, future state and county employees will be paying the tab for generations.

EUTF fond in even worse

That’s assuming today’s politicians can enact the necessary changes. Machida points out that, because they will likely only affect new hires, any prospective reduction in employee benefits are probably not subject to collective bargaining. Nevertheless, it’s difficult to envision the Legislature enacting major reductions without at least the tacit support of the public unions, by no means a sure thing. House Speaker Calvin Say remarks on how difficult it’s been trying to make these kinds of changes in the past: “For me, it’s been a sincere effort to try to control both the employers’ and the employees’ contributions,” he says. “But present employees do not understand that. They don’t want Calvin Say to force them to pay more for their pension contribution. But something’s got to give.”

Say remains optimistic. “Overall, I feel very confident, because, at the end of the day, the state government is obligated to fulfill its responsibility. So, yes, we’ll address that unfunded liability one way or the other. It will probably be through the guise of taxation.”

The Big Picture

“But time is of the essence,” says Machida. That’s because, as glum as the Gabriel Roeder Smith report seems, it may still understate the size of the problem. To understand why, it helps to put Hawaii’s retirement system in a national context. Since 2000, the number of states with fully funded pension systems has declined from 26 to four, according to a recent report by the Pew Center on the States. Hawaii is in the bottom quartile, one of 19 states described as having “serious concerns.” Remarkably, Pew data do not even include the effects of the Great Recession of 2008. Once those losses are incorporated into the picture, the perspective will be much worse.

Despite its baleful conclusions, the Pew report is squarely in the mainstream of actuary standards. It relies on the states’ own analyses and draws its conclusions using normal actuarial accounting procedures. There is a growing number of analysts, though, who believe that traditional actuarial accounting and its assumptions are part of the problem and help mask the true scale of the states’ pension crises. The most inflammatory of these is Joshua Rauh, a researcher at Northwestern University’s Kellogg School of Management, whose 2010 report suggests the states’ total unfunded liability may be several times larger than the findings in the Pew report. For example, he predicts Hawaii’s ERS will go broke in 2020.

Not surprisingly, Rauh’s conclusions have been largely discounted in the public pension community. “Among public pension actuaries,” says Keith Brainard, executive director of the National Association of State Retirement Agencies, “I think you would find the overwhelming perspective that Joshua Rauh’s findings and recommendations are inappropriate.” Even ERS administrator Machida – by no means an apologist for the status quo – downplays Rauh’s conclusions: “The ERS is not going to run out of money in 2020.”

But Rauh isn’t alone in raising questions about the size of the unfunded liabilities facing state pensions. For example, Andrew Biggs, of the American Enterprise Institute, uses a standard financial process called “options pricing” to reach much higher figures. In the case of the Illinois State Employees’ Retirement System, his analysis more than doubles the state’s total liability, from $23.8 billion to $47.3 billion.

Applying the same formula to Hawaii’s total liability swells our unfunded liability from $7.1 billion to more than $14 billion. Of course, the calculation isn’t that simple. It’s worth noting, though, that even pension actuaries are beginning to look at other ways of measuring pension liabilities. All of these suggest that our total liability is higher than the $18.8 billion actuarial valuation in the Gabriel Roeder Smith report. Rauh, basing his discounting rate on 30-year Treasury notes, calculated Hawaii’s total liability at $24.2 billion. The state’s own actuaries calculated a total liability of $21.5 billion when they used the market value of assets instead of the traditional actuarial method. Pessimism is clearly becoming part of the mainstream.

In fact, the actuary’s report to the ERS board in December included some startling language. Under the heading, “What does this all mean?” the report states: “If the assumptions are met for all years beginning July 1, 2010, and the current contribution policies remain, the system is not expected to run out of money. But it is very close.” (Italics added.) Worse still is how long the actuary says it will take to fully fund the system, given the same set of assumptions: never.

Pension Benefits

In FY 2010:

$925 million was paid by the plan to about 39,000 retirees and beneficiaries.

 

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The Billion Dollar Gamble: State Investment

BY DENNIS HOLLIER

Photo: istockphoto.com

What a difference a billion dollars makes.

Until recently, the state treasury – officially, the Treasury Management Branch of the Financial Administration Division of the Department of Budget and Finance – has operated in relative obscurity. With its staff of seven or eight employees, the treasury acts as cash manager for the state government. Its primary responsibility is to make sure the state always has enough cash reserves to meet its ongoing obligations: payroll, debt service, pension contributions, etc.

The treasury also manages the day-to-day investment of so-called excess funds: monies collected, but not yet spent, by state agencies. As it happens, that’s a lot of money – more than $3 billion at last count. Even so, these investments are hardly sexy, consisting mostly of safe, low-yield, highly liquid instruments like U.S Treasury securities, Federal Agency securities, collateralized CDs and something called SLARS, student loan auction rate securities. In other words: boring, boring, boring.

Then, in February 2008, the market for those auction rate securities collapsed. Overnight, the state’s $1 billion investment in SLARS ceased to be either safe or liquid. And suddenly, the treasury didn’t seem so boring after all.

Where the money goes

So, where did it go wrong? Georgina Kawamura, director of the Department of Budget and Finance, and the official state treasurer, describes treasury operations as a juggling act. “Here’s the day,” she says. “We get daily reports from the banks to let us know our ‘checking account’ balance. We also know, on a daily basis, what investments will mature.” These figures, combined with information about payments that will go out, constitute the calculus of the day’s excess funds, the funds available for investment. This begins yet another juggling act.

For the most part, treasury investments are scheduled to mature around large payments. Scott Kami, administrator of the Financial Administration Division (FAD), which oversees day-to-day operations of the treasury, gives the example of payday. Payroll, he says, averages about $8 million per pay period. “Normally, we schedule about half of that to mature on Friday, and the other half to mature on the following Monday. Because, historically, that’s how the checks clear.”

Armed with that information, treasury accountants can now contact brokers, banks and other financial institutions to find investment opportunities. In this way, the treasury’s responsibilities of cash management and investing are always intertwined. Every debt obligation and every dollar of excess cash must be meticulously tracked because, as Kawamura points out, “All the money is invested. All of it is earning interest.”

And yet, in a scathing report on the Department of Budget and Finance released in March, state auditor Marion Higa turns most of these mundane details on their head. For example, the treasury uses an almost indecipherable, handwritten, color-coded monthly calendar to monitor its investments. It calculates excess cash from manually prepared worksheets rather than electronic spreadsheets like Excel. And it deals with brokers through a decidedly informal system of e-mail and faxes.

Still worse, Higa says, is the treasury’s lack of oversight. The report notes that the FAD failed to prepare and review bank reconciliations, failed to produce a monthly investment report, and routinely allowed investment classes to exceed their statutory limits. In her view, it was this lax supervision that allowed the SLARS calamity. When the independent accounting firm Accuity conducted the state’s fiscal year 2008 certified annual financial report, it also said flawed internal controls led to the SLARS purchase. In her report, Higa points out that treasury staff never even saw the offering documents for these investments. Those documents clearly state many of the risks pertaining to SLARS.

The state uses a handwritten monthly calendar to monitor the
treasury’s $3 billion portfolio.

What Are SLARS?

Auction rate securities are basically debt instruments consisting of bundles of securities – in this case, student loans. The interest rates are set through periodic auctions: sellers offer securities at the lowest rate they’re willing to accept; buyers indicate the highest rate they’re willing to pay and how many they want to buy at that rate. This process is designed to determine the lowest interest rate at which all available shares of a security can be sold at par. This is called the clearing rate, and it serves as the interest rate for that entire issue of SLARS until the next auction. In the event an auction fails, the rate is set based on a pre-established relationship to some benchmark, usually the London Interbank Offered Rate, or LIBOR. Naturally, brokers assure buyers that auctions never fail.

To be fair, these auctions appeared to work efficiently for more than 20 years. And because the auctions usually happened every seven, 28 or 35 days, investors like the state treasury could treat SLARS as liquid investments, even though the underlying securities might not mature for 35 years. But sustaining that liquidity meant that all the available SLARS had to sell at every auction. That didn’t always happen, but the underwriting broker quietly bought enough to keep the auction from failing. Between auctions, brokers often tried to unload these securities on their customers.

Nevertheless, in 2007, when the financial markets began to implode, these securities began to accumulate on the wire-houses’ books, and brokers regarded them nervously. They encouraged their sales divisions to push ARS aggressively, even though insiders knew the auctions were becoming tenuous. Another sign of some distress in the market was the steady increase in interest rates, which, in the case of SLARS, eventually reached 7.35 percent (compared with 2.07 percent for two-year CDs.) For most investors, higher interest rates reflect higher risk. And yet, in the six months leading up to the market failure, the Hawaii treasury’s holdings in SLARS went from $427 million to over $1 billion, and from just 14 percent of the state’s portfolio to nearly 30 percent.

Of course, the state of Hawaii wasn’t the only investor surprised by the failure of the ARS market. Thousands of individuals and hundreds of institutional investors were caught off guard. A diverse group of government entities – states, counties, water-district boards, et al. – now found themselves stuck with these now long-term investments. Although most individual investors eventually recouped their investments through settlements with the wire houses that underwrote the auctions and government regulators, institutional investors have been obliged to write down their ARS as part of the “mark to market” standards of generally accepted accounting practices. In the summer of 2008, for example, the state acknowledged a $114 million impairment on its certified annual financial report as a result of its SLARS holdings. Though Hawaii may have the largest holdings, it hasn’t taken the worst blow. Jefferson County, Ala., is verging on bankruptcy due to the failure of the auctions.

Closer to home, Maui County found itself stuck with more than $30 million in SLARS when the market crashed. Like the state, Maui seems to have relied on assurances by a broker, in this case, Merrill Lynch, that these were highly liquid securities. Also like the state, Maui invested heavily in SLARS in the months leading up to the market failure.

Different Responses

Despite the similarities between Maui and the state, there have been striking differences in how they responded to the SLARS debacle. For example, the state continues to defend its investment. “The one thing that gets lost in this whole discussion about ARS,” says Scott Kami, “is that the securities themselves are very sound investments. There hasn’t been any default on them, and we continue to get all our interest paid when it comes due.” Moreover, he says, the yield on the state’s ARS, approximately 1.9 percent, is higher than that earned by the state’s other investments. He points out the yield on 30-day CDs is almost zero.

Kawamura takes another tack. “I think people have put too much emphasis on the write-down,” she says. “Everyone thinks we’ve lost money. We have not.” She acknowledges that accounting principles required the state to estimate an impairment on its SLARS holdings. She also admits that if the state were to sell its holdings today, it would likely incur an additional $250 million loss. But Kawamura views these as purely paper losses. “That’s assuming that you’re going to sell,” she says. “Of course, we haven’t sold, and we don’t intend to.”

But Maui County treasurer Suzanne Doodan is not convinced by the state’s arguments. “I spouted those same lines for the first few months,” she says. “But these are no longer short-term instruments; you have to compare them to 30-year investments.” So, while the state’s 1.9 percent yields on SLARS may look good compared to current rates for bank repos or short-term CDs, they’re low even compared to the 4.75 percent yield on a 30-year U.S. Treasury note. SLARS might have been attractive as short-term investments, but they are liabilities as long-term investments.

This difference in perspective led Maui to pursue a different strategy than the state. This January, the Maui County filed a federal lawsuit against Merrill Lynch, the broker that sold them the SLARS. (To see Maui’s lawsuit filing, click here to download the PDF file.) Like other institutional investors around the country, Maui alleges Merrill sold SLARS as “cash equivalents” even though it knew, or should have known, these investments were unsuitable for Maui’s needs.

The state declines to discuss whether it’s pursuing legal action related to SLARS. “We’re obviously letting our attorneys take care of reviewing our options,” says Kawamura. Tung Chan, commissioner of securities at the Department of Commerce and Consumer Affairs, acknowledges receiving complaints “against these companies – Citi and Merrill – related to ARS.” DCCA policy, though, is not to disclose the name of the complainant. It remains to be seen if the state, in steadfastly defending its investment in SLARS, has lost its opportunity for legal recourse.

“I wonder if they missed the date to file,” Doodan says. “I think it’s a two-year statute of limitations.”

A Better Way

There are other important differences between Maui and the state, according to Doodan. “To my knowledge, the state has only used two brokers for years and years and years,” she says. “In contrast, we go out to at least five, six, seven, eight brokers. And every few years, we go out and solicit new brokers.” It’s also interesting, she notes, that, while Maui has suspended doing business with Merrill, the state continues to use the same broker who sold them the SLARS as bond underwriters. (This same broker, Pete Thompson, of Morgan Stanley Smith Barney, played a key role in persuading the Legislature in 1998 to add SLARS to the list of acceptable investments for the state treasury.)

There is another difference between Maui and the state. To coordinate its investments and cash-management obligations, Maui uses sophisticated, Web-based software called QED. This program was specifically designed for treasury operations and automates many basic functions of a treasury. It continuously updates the status of investments, including the current value of securities. It also provides templates for more than 600 different reports, most of which can be produced almost instantaneously. This ease of reporting simplifies the supervision and oversight of the county treasury. That’s probably why more than 40 states and thousands of counties and smaller government entities use QED.

For its part, the state relies upon a software program called Microsoft Dynamics, which is primarily a program for enterprise solutions or customer contact management. Although it has been adapted to be used for financial purposes, it doesn’t address many of the specific needs of a state treasury. As one expert put it, “This is like hunting an elephant with a shotgun.” This may help explain the treasury’s failure to routinely produce the reports called for by its own investment policies. It may also explain why the state’s investment activities are largely tracked on manual worksheets or even handwritten calendars.

Most state treasuries are far more transparent and seem to sustain much more oversight than Hawaii’s. New Mexico – an apt comparison with Hawaii because of its population of 2 million people and treasury of about $5 billion – offers an excellent model for an efficiently run treasury. “I can tell you,” says chief investment officer Sheila Duffy, “we have a lot of oversight in New Mexico. And we like it.”

Structurally, that oversight takes the form of two standing committees. The Treasury Investment Committee, Duffy says, consists of treasury officials and two securities experts from private industry. The other oversight group, the Board of Finance, supervises the broader activities of the state treasury, which corresponds roughly with Hawaii’s Department of Budget and Finance. Neither group is passive.

“We have a once-a-month report, a book really, that we deliver to the Treasury Committee” and to Board of Finance, Duffy says. This substantial report – produced automatically using QED software – summarizes the treasury’s existing investments, including asset details, yields, and trends compared to a benchmark. These reports and the minutes from committee meetings are available on the treasury’s Web site, along with numerous other reports and resources. In contrast, although Hawaii’s state treasury policy requires monthly status reports for the director of the Department of Budget and Finance, this report hasn’t been prepared since 2007, according to the state auditor. Moreover, there’s no outside authority to review such a report.

The Cure

How can Hawaii improve its often informally structured, poorly supervised and cloistered state treasury? And what can we do about its extraordinary burden of SLARS?

As for the auction rate securities, the answer may be nothing. “For now, our liquidity issue is covered,” says Kawamura, by which she means that, as the treasury’s longer-term investments mature – and they’re allowed by statute to carry some investments out to five years – these are gradually replaced with the SLARS. And the state seems intent on either holding onto them until maturity – another 35 years, in some cases – or waiting until it’s possible to sell them at par. That might seem farfetched. After all, the allegations of fraud, negligence and collusion that have been leveled at the wire houses have stigmatized SLARS as an investment. But some believe the SLARS market will revive; Kami said as much in his Dec. 27 testimony at the state Legislature. Even Maui County finance director Kalbert Young holds out hope.

“I would point out,” Young says, “since the SLARS market failed in February 2008, there’s been a slow return of activity in this market.” He doesn’t mean the actual resumption of successful auctions – not yet, anyway – but that the underlying securities have started looking increasingly attractive to investors. “We’ve been getting calls from other institutions interested in buying our ARS,” he says. “Not at par, of course, but better than it was. Even Merrill Lynch was willing to purchase some.” Nevertheless, Young says, “we still want to pursue our legal filings.”

Improving Hawaii’s treasury operations may prove easier. It’s simple enough to look to the examples of other states, like New Mexico and New Jersey, that have modernized their treasuries. Software solutions typically come with extensive consulting services and are cost effective. (QED costs less than $100,000 a year, after the initial setup.) But the most important lessons probably come from history.

After the disastrous 1994 bankruptcy of Orange County, when the county treasurer’s wild, unsupervised speculation in risky derivatives cost the county over $2 billion, the California state auditor issued some familiar-sounding recommendations: Have a Board of Supervisors approve the treasury’s investment policies; appoint a committee to oversee investment decisions; require frequent, detailed reports from the treasurer; and establish stricter rules governing the selection of brokers and investment advisers.
Those sound a lot like the recommendations of the Hawaii state auditor. They’re also suspiciously close to the kinds of best practices employed in New Mexico. In other words: boring, boring, boring.

Risky Strategies

State’s mix of risky & safe, traditional investments

CASh

Demand Deposits1
$229,770,000

Cash with Fiscal Agents
$5,980,000

U.S. Unemployment Trust
$265,499,000

Investments

Investments Time Certificates of Deposit2
$618,192,000

U.S. Government Securities
$528,130,000

Student Loan Auction Rate Securities3
$1,006,975,000

Repurchase Agreements4
$1,151,620,000

Total Investments
$3,304,917,000

Total Cash and Investments
$3,806,166,000

1. The state routinely failed to reconcile bank statements. In addition, funds were often left in sub-accounts that did not earn interest.

2. At least five times, the state exceeded the 50 percent limit on CDs from a single issuer.

3. The state’s portfolio of SLARS remains at roughly 30 percent of its total investments.

4. Repurchase agreements exceeded the 70 percent statutory limit in four out of 12 months.

Source: State auditor’s report

 

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The Hegemony of HMSA

The hegemony of the Hawaii Medical Service Association is nearly complete. For better or worse, it touches almost every facet of healthcare in the state. It has cowed some of the largest insurance companies in the world, and humbled its tiny local competitors. It has given Hawaii’s consumers the lowest average health insurance costs in the nation, and burdened our healthcare providers with some of the country’s lowest reimbursement rates. It is one of the most influential institutions in the state. And it’s not going anywhere.

Nearly a monopoly

Most people are well aware of the company’s near monopoly as the largest supplier of health insurance in the state. According to J.P. Schmidt, the state insurance commissioner, HMSA controls nearly 70 percent of the market. Even that number understates its dominance. Kaiser Permanente, with roughly 22 percent of the state’s health insurance market, is usually thought of as HMSA’s largest competitor. But it’s not entirely clear that health maintenance organizations like Kaiser compete directly with preferred-provider organizations like HMSA. Consumers seem to clearly prefer one business model or the other, a fact reflected in the two companies’ stable market shares. Among the companies offering PPOs — by far the more popular form of health insurance — HMSA’s market share climbs to nearly 85 percent.

But the company’s dominance on the demand side is more remarkable. That’s because, in order to stay in business, nearly every doctor, hospital and clinic in the state has to sell their services to HMSA. Economists call this a monopsony — a market situation in which many sellers compete for a single buyer — and just like a monopoly, it concentrates enormous power in a single player. And this aggregation of power may be irreversible. A 2003 American Medical Association report to the U.S. Department of Justice noted: “There may well exist a ‘tipping point’ in health insurance markets, where an incumbent’s market share is so large that new entry is impossible.” In fact, HMSA’s market share really hasn’t changed in decades.

Government’s role

That hasn’t stopped J.P. Schmidt from trying. Since taking office in 2003, one of the insurance commissioner’s primary focuses has been to lure new insurers to Hawaii. Part of that is simply creating a regulatory climate more conducive to doing business. “One of the things that helps attract insurers is the approach of the regulators,” Schmidt says. “Some states take an adversarial attitude; I think that actually works to the detriment of the state. Insurance companies are less interested in working in that environment. They also employ more gamesmanship — hiding and dodging and weaving to avoid sanctions from the regulator.”

 

Schmidt has also tried to address specific regulatory and market conditions that deter new insurers from coming to Hawaii. He’s looked into regulating the size of HMSA’s burgeoning surplus (nearly $500 million), which competitors view as an obstacle to competition. They fear HMSA can use the surplus to subsidize unfair rates, under-pricing possible competitors. For the past several years, Schmidt has also unsuccessfully pushed for the Legislature to remove the existing 4.5 percent premium tax exemption. “Nonprofit companies, like HMSA, are exempt from the premium tax,” Schmidt says. “That’s an immediate 4.5 percent handicap for for-profit companies. That’s simply too high a hurdle for most of them to overcome.”

J.P. Schmidt,
Hawaii state insurance commissioner

So far, Schmidt’s main accomplishment has been reintroducing rate regulation, after a two-year hiatus. This means insurance companies again have to submit rate changes to the insurance commissioner for approval. “We review them to make sure that the assumptions in the rate are properly supported,” Schmidt says. “Then, we approve the rate if it’s not excessive and it’s not inadequate or unfairly discriminatory.” Although the regulation prevents overcharging, its main purpose seems to be protecting competitors from unrealistically low rates. It’s a backhanded way to prevent HMSA from using its enormous reserves in a price war with competitors.

Still, rate regulation certainly hasn’t noticeably troubled HMSA. In fact, HMSA and Kaiser, which both opposed its reintroduction, now say they favor rate regulation and competition in general. “People should have a choice,” says Steve van Ribbink, HMSA’s CFO. “And we’re encouraged by the fact that about 700,000 people have chosen HMSA. We appreciate their business. As for rate regulation, I think it’s fine. I think it gives people comfort to know somebody’s looking at the rates, that no one’s being dealt with unfairly.” Even so, he’s quick to add, “But it hasn’t changed how we go about doing things.”

Big deal for Summerlin

Perhaps the most promising sign for rate regulation occurred this winter, when Summerlin Insurance, a Nevada-based company, outbid HMSA to insure the 600-plus employees at The Honolulu Advertiser. Schmidt had been courting Summerlin for some time. “We began to talk to Summerlin my first year on the job,” Schmidt says. “They had been doing some business in the state as a third-party administrator for union plans, so they had some networks built up, and that provided them some comfort coming into the market.” Nevertheless, Summerlin — which declined to comment for this story — remains a small player in Hawaii and its arrival hardly represents a dramatic change.

Bill Donahue, executive director of the 700-member Hawaii Independent Physicians Association, says there isn’t any new competition resulting from the return of rate regulation “and there never will be.”

Bill Donahue,
executive director of
Hawaii Independent Physicians Association

“During the 1970s, we passed a statute called the Prepaid Healthcare Act,” he says. The first of its kind in the United States, the PHCA requires that all employers provide health insurance for their employees. It placed a tremendous economic burden on the state’s employers, but Hawaii has the highest rate of health insurance coverage in the country. “It was a wonderful and tremendously progressive piece of legislation,” Donahue says.

As do most revolutionary changes, this one came with unintended consequences. Requiring employers to provide coverage is meaningless without establishing what must be covered, so PHCA required that any health insurance company had to offer coverage equivalent to “the prevailing plan.” Since HMSA controlled the majority of the market, that meant any new insurer’s plan had to match what HMSA offered. (Moreover, both HMSA and Kaiser have representatives on the commission that decides whether new entrants to the marketplace meet these standards.) The result is that HMSA determines what constitutes health insurance coverage in the state.

“Let’s say you were Aetna or United Health,” Donahue says, referring to two of the largest medical insurers on the Mainland. “If you came here, you would be coming into a marketplace where your competitor dictates the rules.

“And that’s in addition to the problem of the premium tax,” he says. “You’re already operating at a 4.5 percent disadvantage.”

Furthermore, Donahue, like many other industry observers, says there’s no large population in Hawaii to entice large, national insurers. “We’re a small marketplace in the middle of the ocean,” he says. “What are there, like 1.3 million people here? That’s like Boston, but without Rhode Island or New Hampshire or the rest of Massachusetts nearby.”

Niche players

Commissioner Schmidt, of course, also has hopes for the so-called “little sisters”—companies like Summerlin, the Hawaii Medical Assurance Association and the University Health Alliance. He points out that UHA is increasing membership, and HMAA, which once operated almost like a closely held corporation, is creating an independent board and seems eager to grow. “The additional competition is, I think, a very good thing for the people of Hawaii,” Schmidt says. Donahue demurs. “They’re just niche players,” he says. “They have relationships with certain employers, but they’re not in a position to make a break-out move.”

It’s an opinion confirmed in conversations with executives at the little sisters. Rodney Park, CFO of HMAA, points out, “We never try to take on 300- or 400-employee companies; we focus on mom-and-pops. They’re looking for service. They don’t have an HR department or know all the nuances of insurance. A lot of the time, we deal directly with the proprietor.” Although this approach has garnered HMAA a consistent share of the market, that share has always been less than 5 percent.

UHA COO Howard Lee notes that, with more than 50,000 members, UHA is probably the third-largest commercial insurer in the state; but it’s still dwarfed by the 700,000-plus membership of HMSA. “If we continue to be successful, we would like to expand our market share,” he says. “But we have to make sure that we’re prudent so we can be here for the long run.” Modest ambitions like these reflect a kind of fatalism about the dominance of HMSA.

John McComas, CEO of AlohaCare and a respected observer of the health insurance industry, points to another HMSA advantage. “They have the vast majority of the employers in the state,” he says. This “utilization experience” — the actuarial data that comes from handling so many groups for so long — is the lifeblood of the insurance industry. “It allows you to predict with a great deal of accuracy what your expenses are going to look like. Other groups don’t know that.” This means other insurers — especially newcomers like Summerlin — lack the basic information to make long-term pricing decisions. And yet, for the employers who purchase insurance, price is typically the major consideration.

McComas notes, “In order for me to take a group away from HMSA, I have to offer better benefits or lower premiums. And it can’t be 2, 3 or 4 percent lower — that wouldn’t be worth the trouble. Employers are saying, ‘Come to me with a 15, 20, 25 percent decrease in my healthcare costs.’ ” But the truth is, other insurers will never be able to compete with HMSA on price. “Because HMSA is such a large buyer, they have much more leverage in negotiations with hospitals and physicians,” McComas says. “Consequently, HMSA is probably going to have the best hospital rates out there.” This is the value of a monopsony.

Of course, neither monopolies or monopsonies are all bad. Even Bill Donahue, who describes himself as “one of the biggest critics of HMSA,” is quick to point out some of its saving graces: lower rates for consumers, financial assistance for doctors and hospitals to modernize their record-keeping, and online care for those unable to visit their physician.

Hawaii has the Lowest Premiums

Average Single Premium Per Enrolled Employee (Employer-Based Health Insurance, 2006)

Rank

Employee
Contribution

Employer
Contribution

Total

United States

$782

$3,336

$4,118

1

Hawaii

$355

$3,194

$3,549

2

Arkansas

$713

$2,854

$3,567

3

Idaho

$572

$3,001

$3,573

4

Nevada

$537

$3,046

$3,583

5

Mississippi

$741

$2,963

$3,704

6

Tennessee

$749

$2,998

$3,747

7

North Dakota

$682

$3,105

$3,787

8

Kentucky

$682

$3,109

$3,791

9

Kansas

$767

$3,066

$3,833

10

Utah

$847

$3,041

$3,849

 

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