SOUTHEASTERN SPECIALTY, INC. (SSI), is a for-profit corporation formed by physicians in the College of Medicine at Southeastern University. SSI, with more than 600 physicians, provides the medical staff for University Hospital. In addition, SSI staffs and administers a network of 25 ambulatory care clinics and centers at ten locations within 50 miles of the hospital. In 2009, SSI generated more than $500 million in revenues from about 40,000 inpatient stays and 750,000 outpatient visits. More than 70 percent of SSI’s revenues come from inpatient stays, but this percentage has been declining, and by 2014, more than half of SSI’s revenues are expected to stem from outpatient services. As improvements are made in technology and third-party payers continue to pressure providers to cut costs, more and more inpatient services will be converted to outpatient and home care. For example, in 1999, 80 percent of SSI’s ophthalmology surgeries took place in University Hospital, while in 20009, 80 percent were conducted in outpatient settings. Although SSI has traditionally provided only specialty services, in 2004 it instituted a “personal physician services” program, in which patients can receive both primary and specialty care from College of Medicine physicians. This was the first step in SSI’s drive to develop an integrated delivery system, which offers a full range of patient services. Now that the system is in place, SSI is contracting with managed care plans to provide virtually all physician services required locally by plan members. Furthermore, SSI is examining the feasibility of contracting directly with employers and hence bypassing managed care plans, but no decision has yet been made. Indeed, state insurance industry representatives expressed opposition to the idea when SSI first announced the possibility of direct contracting. The insurance industry position is that direct contracting with employers to provide a complete healthcare benefit package is an insurance function, which can be undertaken only by licensed insurance plans. As part of its continuing education program, SSI holds monthly “nonclinical grand rounds” for its physicians, in which various staff members and outside specialists conduct seminars on nonclinical topics of interest. As part of this series, Chris Johnson, SSI’s chief financial officer, has been invited to conduct two sessions on the financial risk inherent in integrated delivery systems. His main concern is that physicians, although very sophisticated in clinical matters, have a very limited understanding of basic financial risk concepts and will not appreciate the financial issues involved in integrated delivery systems without first gaining an understanding of basic financial risk concepts. Thus, he plans to devote the entire first session to basic concepts. In preparation for the seminar, Chris developed the return distributions for the five investments shown in Exhibit 1. To create the table, he first hypothesized that five economic states are possible for the coming year, ranging from poor to excellent. Next, he estimated the one-year returns on each investment under each state. The five investments are (1) T-bills, (2) real asset investment Project A, (3) real asset investment Project B, (4) an index fund designed to proxy the returns on the Standard & Poor (S&P) 500 stock index, and (5) an equity investment in SSI itself. T-bills are short-term (one year or less maturity) U.S. Treasury debt securities; Project A is a proposed sports medicine clinic; and Project B is a Medicaid-funded project for providing family health services to an underserved area. Note that Chris developed the returns for Projects A and B and for SSI as a whole by assessing the impact of each economic state on healthcare utilization and reimbursement patterns. In addition to the returns on these alternative investments, Chris developed the following questions to use as the structure for his presentation. See if you can answer them.

Part 1 Calculate the expected rate of return on each of the five investment alternatives listed in Exhibit 1. Based solely on expected returns, which of the potential investments appears best?

Part 2 a. Calculate the standard deviations of returns for the five alternatives. b. Calculate the coefficients of variation of returns for the five alternatives c. What type of risk do these statistics measure?

Part 3 Suppose SSI forms a two-asset portfolio by investing in both Projects A and B. Assume that the required investment is the same for both projects-say, $5 million each. a. What will be the portfolios’ expected rate of return? b. What will be the portfolio’s standard deviation? c. What will be the portfolio’s coefficient of variation? d. What characteristic of the two return distributions makes risk reduction possible? Part 4 Now consider a portfolio that consists of investments in Project A and the S&P 500 fund containing equal investment in the two assets. Will this portfolio have the same risk-reducing effect as the Project A/Project B portfolio considered in Part 3? Explain. Part 5 Exhibit 2 was developed by crossing out the state of the economy and probability columns of Exhibit 1 and replacing them with years 1, 2, 3, 4, and 5. In other words, part 5 assumes that the distribution represents historical returns earned on each asset in each of the last five years. a. Plot a line on a scatter diagram (regression line) that show the returns on the S&P 500 Fund (the market) on the x-axis and the returns on SSI’s equity on the y-axis. b. Estimate the slope coefficient of the line. c. What is the slope coefficient called? d) How risky is SSI relative to the overall market?

Exhibit 1 Southeastern Specialty, Inc. Estimated One-Year Return Distributions on Five Investments Estimated Return on Investment State of the Economy Probability 1-Year T-Bill (%) Project A (%) Project B (%) S&P 500 Fund (%) Equity in SSI (%) Poor 0.10 7.0 -8.0 18.0 -15.0 0.0 Below average 0.20 7.0 2.0 23.0 0.0 5.0 Average 0.40 7.0 14.0 7.0 15.0 10.0 Above average 0.20 7.0 25.0 -3.0 30.0 15.0 Excellent 0.10 7.0 33.0 2.0 45.0 20.0

Exhibit 2 Southeastern Specialty, Inc. Historical returns Estimated Return on Investment Year 1-Year T-Bill (%) Project A (%) Project B (%) S&P 500 Fund (%) Equity in SSI (%) 1 7.0 -8.0 18.0 -15.0 0.0 2 7.0 2.0 23.0 0.0 5.0 3 7.0 14.0 7.0 15.0 10.0 4 7.0 25.0 -3.0 30.0 15.0 5 7.0 33.0 2.0 45.0 20.0