News / News analysis: On the risk radar

Although Monitor took on its new powers as sector regulator in April, foundation trusts may not have noticed many differences. Okay, compliance is now judged against licence conditions rather than
terms of authorisation, but for many this will have been merely a semantic distinction. This is all set to change next month with the introduction of Monitor’s new regulatory framework.

The risk assessment framework replaces the compliance framework on 1 October. While it builds on the compliance framework, its focus – steered by the Health and Social Care Act – is specifically on risk of failure and risk to the continuity of services rather than on the overall financial position of a provider.

Finding problems at the outset is the clear aim. ‘We’ve designed this new regulatory system to provide us with early warnings about where we need to take action to safeguard vital services on behalf of patients,’ said Adrian Masters, Monitor’s managing director of sector development.

The risk assessment framework (RAF) has two parts. A continuity of services risk rating assesses the risk of a provider of key NHS services (commissioner-requested services, in the new jargon) failing to carry on as a going concern. A second assessment looks at the governance of NHS FTs.

The continuity of services risk rating will replace the existing financial risk rating (FRR). The FRR used a basket of five metrics – EBITDA as a percentage of plan; EBITDA margin; return on assets; income and expenditure surplus margin; and liquidity – rated on a five-point scale, with 5 representing the lowest risk. In comes a much more focused assessment looking at just two metrics – liquidity and capital service capacity ratio. There are also changes to the scoring system with the five-point scale reduced to four.

Patrick Fraher, senior policy adviser at Monitor, described the change as putting a much ‘starker focus’ on key aspects of a trust’s financial risk profile. ‘We’ve recast what was the financial risk rating and put the focus on short- and medium-term indicators of financial sustainability – liquidity (can you pay your bills, can you pay your employees?) and capital service cover (can you meet the cost of your balance sheet?).’

Liquidity

The big change around liquidity is the decision to exclude working capital facilities from the calculation, with a corresponding change to the thresholds between the different risk levels. The liquidity assessment looks at how many days a provider’s liquid assets could keep the organisation running.

There are several reasons for dropping working capital facilities from the assessment. Most important, clauses in most facility documents would mean that the organisation could not access the facility at exactly the time it needed it – when it got into financial distress or was red rated for governance.

‘If we want to spot a risk of financial failure 12 to 18 months out, having these facilities in there, which distort trusts’ financial sustainability or robustness, gets in the way,’ said Mr Fraher.

There are other reasons. Working capital facilities have rarely been used, but there has also been a feeling that some organisations have paid to put facilities in place in part to secure higher liquidity ratings and contribute towards a higher overall risk rating, rather than as a real safety net for running short of cash.

Simon Wombwell, chair of the HFMA’s FT Technical Issues Group, backed the new definition. ‘Given the uncertainty around the use of old working capital facilities in times of short-term distress, their removal from a liquidity metric provides an easy saving for organisations still using them,’ he said.

Most organisations will welcome the removal of working capital facilities from the assessment (although wholly committed facilities – those with no default clauses – will still count). FTs can still put traditional facilities in place, but it will be clear they see a service benefit rather than just chasing ratings.

During the consultation on the RAF (published in draft form in January), several respondents raised concerns that the revised liquidity thresholds would make some trusts appear riskier, despite no change in their circumstances. Monitor said this was particularly the case for trusts relying on the largest banking facilities to meet the thresholds required in the compliance framework. There was also concern that the originally proposed bands were too narrow.

January’s draft RAF put the thresholds at -2 days for the lowest risk rating of 4, -7 for a 3 rating, -12 for a 2 and then the worst rating of 1 for greater negative scores. The final document raises the lowest liquidity risk from -2 days to 0 days and then evens out the gap between thresholds to seven days.

This also tackles concern from some respondents that assigning the lowest risk to a negative liquidity level ‘looked odd from a financial perspective’. Mr Fraher acknowledged that having these levels of liquidity representing low risk was an ‘FT-related phenomenon’. ‘FTs get paid very regularly,’ he said. ‘They are [typically] paid by commissioners on the 15th, they pay salaries on the 28th or 29th and  then sometime towards the end of the next month they pay tax, national insurance and pension contributions. They have a very regular income cycle, so they can run with negative working capital.’

Modelling using previous years, he said, showed that only about one fifth of FTs had a negative working capital, if bank facilities were omitted from the calculation. And most did not represent any financial risk. Monitor’s clear intention is to remove any incentive to stockpile cash for the sake of a good rating. But Mr Fraher admits that the unknown is how the sector will respond.

Capital servicing

The capital servicing metric looks at the degree to which an organisation can cover its financing obligations with generated income. It is measured as revenue available for capital service, which correlates closely to EBITDA, divided by annual debt service.

The proposal here is that having 25% headroom – where revenue available for capital service is 1.25 times the financing costs – would generate a rating of 2. Less would equate to a 1 (the greatest level of risk), while 1.75 times (75% headroom) and 2.5 times (150% headroom) would equate to a 3 and 4 respectively.

Trusts with large private finance initiative deals raised the biggest concerns during consultation. With larger capital service payments than trusts funded through public dividend capital, their capital service ratios are likely to be lower. They also argued that their lower future capital investment requirements – covered by annual unitary payments – should be reflected in the thresholds. Some FTs with large PFIs would have to double their surpluses to score the 4 rating. There were also concerns that the ratio could discourage borrowing and reinvestment in facilities.

But Monitor has stuck to the thresholds set out in the draft framework. Mr Fraher explained that in some cases, PFI trusts did represent higher risks – a result of having more fixed running costs despite potential income fluctuations. But the regulator has accepted that a trust rated as a risk of 2 may in fact not represent a cause for financial concern. So it has introduced  a 2* rating to reflect this.

The HFMA called for such a distinction in its consultation response. It said: ‘A traffic light system could be effective: where an organisation scores a level 2 but has been reviewed by Monitor and deemed to be financially stable, a green indicator could be published alongside the number on Monitor’s website to indicate the organisation is both well managed and risks are appropriately mitigated.’

Scores from the two assessments are weighted equally to produce an overall continuity of services rating (scores are rounded up as with the FRR, so a liquidity rating of 2 and capital service rating of 3 would provide a 3 overall).

The four levels in the rating system have different monitoring and regulatory activity implications (see table). Monitor says about 72% of FTs would have been given a risk rating of 4 in 2012/13 under the RAF and remained in quarterly monitoring across the year (as against 83% under the compliance framework). Some 14% may have been subject to monthly monitoring, while 13% would have scored a 1 or 2, indicating a potentially serious level of financial risk.

FTs will submit their figures in the revised templates at the end of January and the first new ratings will be published in February, with any move to monthly monitoring likely to kick in from March.

Mr Wombwell said Monitor’s description of the framework as an assessment of risk, not a measure of performance, was important. ‘Time will tell whether these metrics are interpreted this way externally. In practice, the application of these metrics creates the definition of what is considered high or low risk for the healthcare sector. This clarity can only be useful to finance teams, finance directors and FT boards.’

The new system, and how NHS FTs react to it, will be watched with interest.