Power to the people? How health care reform could result in the disruption of the group health insurance industry

Power to the people? 1

The Patient Protection and Affordable Care Act (ACA), if enacted as written, could redefine the market for health insurance with a speed and significance never before witnessed in this industry, and rarely seen in any other. Based on a desire to provide health insurance to every American, the ACA holds out a promise to society that is in some ways as ambitious as Herbert Hoover’s campaign slogan of “a chicken in every pot and a car in every garage” or Lyndon Johnson’s Great Society. And, like those initiatives, the only certainty is that the impact will be significant.

How significant? Based on Deloitte’s projections, the ACA could increase the market size for individual health insurance by more than five-fold by 2020, raising the number of individual policy holders to approximately 72 million in 2020.1 Much of this increase will likely be net new consumption as uninsured Americans enter the market. At the same time, a transformation of this scale cannot help but have a potentially material impact on the fortunes of incumbent group coverage providers. It is likely that the rise of the individual insurance market lays the foundation for a risky scenario wherein the existing commercial group market serving 159 million people will be forever changed — in fact, Disrupted — by the competitor that can effectively master the needs of the individual consumer.

As used in this document, “Deloitte” means Deloitte Consulting LLP, a subsidiary of Deloitte LLP. Please see www.deloitte.com/us/about for a detailed description of the legal structure of Deloitte LLP and its subsidiaries. Certain services may not be available to attest clients under the rules and regulations of public accounting.

If the principles that have explained and predicted the evolution of markets as diverse as steam shovels, personal computers, automobiles, and airline carriers have anything to tell us about health insurance, health plans face a strategic threat, the likes of which they may have never seen. As the market’s center of gravity shifts from a focus on savvy purchasers of group plans to relatively less-sophisticated purchasers of individual benefits, the door is opened to a full-scale Disruption of incumbent group carriers by smaller, more nimble upstarts. However, by recognizing and acting upon the early warning signals, today’s market leaders may be able to survive and thrive as the market transforms.

We have capitalized “Disruption” to signal that we are using the term in a technical sense. Specif-ically, we are following the convention initiated in The Innovator’s Manifesto, by Michael E. Raynor (Crown Business 2011), the most recent book to explore and extend the theory of Disruptive innovation, first discovered by Clayton M. Christensen (see The Innovator’s Dilemma (HBS Press 1997) and The Innovator’s Solution, co-authored with Michael E. Raynor (HBS Press 2003)).

Disruption

Introduction

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What, me worry?

At first blush, how could significant new consumption of health insurance be considered anything but good for the industry? Even though the changes being considered for this new marketplace are subject to material uncertainty and expected to play out over as much as a decade, surely the well-managed, strategically minded incumbents that dominate today’s landscape will be able to easily navigate these particular winds of creative destruction.

Not so fast. The history of just about every industry is replete with tales of companies with once-unassailable leads that were reduced either to near irrelevance or worse, precisely because they were so well-managed. Via a mechanism of change known as “Disruptive innovation,” upstarts and new entrants have repeatedly usurped just about every kind of throne. And, group health insurance could well be next.

Disruptors start out building demonstrably inferior solutions targeted at insignificant and relatively economically unattractive segments of the market. From this foothold, however, Disruptors find ways to improve the performance of their solutions in ways that even mainstream segments come to find attractive. As more customers switch to Disruptors’ offerings, incumbents begin to respond. However, thanks to their head start, the Disruptors have an insuperable advantage, even when incumbents are much larger and better-resourced. Ultimately, the new Disruptive entrants assume marketplace leadership; usually to the surprise of no one save the erstwhile incumbents.

Power to the people? 3

Southwest Airlines began operations by connecting three cities in Texas (Dallas, Houston, and San Antonio) in 1971.2 Pioneering a number of process innovations in airline operations, Southwest created a cost structure that gave it a decisive advantage, allowing it to be highly profitable while offering prices that competitors found difficult to match. A defining element of Southwest’s operations was a fleet consisting entirely of 737-x series Boeing planes. This conferred material benefits: ease of crew rotation, maintenance, cleaning the planes between flights, and so on. The point-to-point route structure, one class of seating, no meals on the planes, etc., were applicable to any route. However, one critical strategic choice limited the company’s growth prospects: The 737s cost almost two cents per passenger-mile more to operate than 747s and other airframes flown by incumbent national-scale airlines. On short-haul flights, Southwest’s ground efficiency more than made up for that deficit, but the company simply could not compete on routes of more than 500 miles. Consequently, incumbent air carriers were free to ignore the upstart; it simply made no sense to reconfigure their entire operating models to defend such a small, insignificant market that Southwest served.

That changed in 1989 with the introduction of the 737-500 and subsequent generations of 737s. With operating costs much closer to those of the airframes operated by incumbent carriers, Southwest could now apply its lower-cost operating model to highly lucrative long-haul flights. In the wake of adopting the Boeing 737-500 and the next-generation series of the aircraft type, Southwest’s average route length more than doubled. In other words, the new 737s were an enabling technology that allowed Southwest to march upmarket by applying its unique strategy to mainstream segments. The results were dramatic. Southwest jumped from third place in revenue growth (and from a very small base) for 1980-1990 to become the fastest-growing of the major carriers in the decade ending in 2000. During the same time, it remained the most profitable, while its rate of share-price appreciation more than quadrupled.

Many incumbent hub and spoke carriers took notice and tried to replicate Southwest’s model within their existing corporate structures, and all but universally failed thanks to the deeply different business models that define the two approaches. In broad strokes, when the incumbent airlines attempted to set up a low-cost carrier (LCC) subsidiary, they were forced into comparing the marginal cost of leveraging existing assets, such as planes, airport gates, reservation systems, loyalty programs, and staff, with the total cost of setting up something from scratch. Of the four major airlines in the United States that took their turns at the LCC model, all eventually ceded the business to Southwest and its pure-play look-alikes, and closed down their fledging start-ups.

A classic case of Disruption

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Southwest’s experience is textbook Disruption:• Southwestoptimizedabusinessmodelfortheneedsof

a relatively unattractive segment; the company focused its market entry on a small number of short-haul routes.

• SouthwestleveragedthenewBoeing737s,anenabling technology that allowed it to preserve its cost advantages yet match the relevant dimensions of performance demanded by large and lucrative mainstream segments.

Industry Incumbent Disruptor Foothold Enabling technology

Time to disruption (yrs)

Automobiles General Motors Toyota Low-end car buyers

Toyota Production Systems

70

Steel U.S. Steel Nucor Rebar Continuous casting 43

Airlines Multiple incumbents

SouthwestAirlines

Short-haul routes

Boeing 737-500 37

Retail Sears Walmart Discount goods

Logistics management

27

Telecommunications infrastructure

Alcatel-Lucent Cisco Internet protocol routers

The Internet 13

Personal computers Digital Equipment Corporation

Compaq Portable computers

Microprocessors 12

Source: Adapted from The Innovator’s Manifesto (Raynor 2011, op. cit.)

Figure 1. Selected Disruptions

• Incumbentcompetitorswereunabletorespondeffectively due to legacy costs and a continuing need to serve their existing customer segments.

Yet, the Southwest story is not unique. In nearly every industry, there are examples of successful Disruptions. And, in many prominent industries, today’s leaders got there Disruptively (Figure 1).

Power to the people? 5

The last shall be first

Seen through the lens of Disruptive innovation, the opportunities emerging for savvy individual players should give strategically astute health plan executives heart palpitations.

The health insurance exchange markets are to begin operations January 1, 2014. As a result, the individual market for health insurance is anticipated to grow dramatically. According to estimates from the Deloitte Center for Health Solutions (DCHS), by 2020 there may be between 12 and 59 million more individual health plan holders than there are today, making it a market that could rival today’s employer-sponsored market.3

Further, as the individual market evolves with the advent of insurance exchanges and the associated government support for the purchase of individual plans for lower-income earners, smaller employers are likely to evaluate the substitutability of individual and group coverage. Should the individual market advance sufficiently, employers might well be able to drop the subsidized group benefit altogether without suffering in the market for talent. Also, despite the tax credits available for providing insurance to employees, the DCHS estimates that in some cases, it may be more economically attractive for employers to terminate the benefit and pay the penalty ($3,000 per person per year). This could create a powerful feedback effect, leading many more individuals to find their way to the exchanges and the individual plan market.

Although the size of the individual market appears attractive, a market created by regulators at the stroke of midnight on January 1, 2014, may be fraught with risk. Many rules are still to be written — and, potentially, could be done so 50 different ways since the exchanges operate at the state level. Further, the “newly insured” are likely to have a pent-up need for health care, contributing to higher costs to insure. The differences between the exchange individual market, defined by ACA, and the current individual markets are profound. There are many new complexities that add risk and uncertainty to the individual and small-group markets, such as community rating, minimum medical claim loss ratios, guaranteed issue, elimination of preexisting conditions, no rating differences for gender, and limitations on age bands. The only real allowable rate increase for risk is for smokers. Consequently, despite the significant growth expected in the individual market, it is likely to still be smaller and almost certainly less profitable to established commercial group carriers than their existing books of business.

If it stopped there, group carriers would have little to worry about. The rise of competitors relegated to serving a relatively less-profitable niche market segment poses no real threat to today’s leaders in the group market. Two forces, however, are conspiring to set up a Disruption, the likes of which the U.S. health care financing industry has virtually never seen.

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First, the rise of the individual market promises to create a viable foothold for a radically different business model in health care insurance. If this proves true, commercial insurers will likely face the same dilemma that has handcuffed every successful incumbent that fell to a Disruptor: The new game begins long before the old game is over. As long as the group market remains large and profitable — which is likely the case for the foreseeable future — it will be almost impossible for incumbent group carriers to free-up the resources required to develop viable solutions for the individual market, no matter how profitable or fast-growing it might become. Anyone in the insurance industry who may disagree is advised first to reflect long and hard on whether they are somehow exempt from the forces that derailed attempts by the seasoned and successful executives at Continental, Delta, USAir, and any number of other incumbent airlines around the world to launch a successful low-cost carrier in parallel with their existing operations.

Second, success in the individual market is based on providing affordable products and services via offering customers the chance to select the product feature trade-offs that best match their anticipated health care needs with their pocketbooks. The likeliest path to meet this set of requirements is with process and product configuration innovations at enrollment, supported by customer management, informatics, and segmentation that result in new levels of customer intimacy. All of these innovations are likely to be built on new information technology platforms. This means that successful individual carriers are likely to have a business model with a rapidly improving enabling technology. Over time, as this new model matures and becomes more sophisticated, it may give the individual carriers the ability to compete effectively for the group market with higher levels of customization, yet lower costs, than today’s dominant group carriers.

In other words, not only are ACA-driven market changes likely to increase the size of the individual segment, but changes in competitive dynamics could leave group carriers unable to hang on to the segments they currently have.

Is this starting to sound familiar? From success in this smaller, less profitable foothold market, the companies that find ways to enable relevant choice without overwhelming customers should be well on their way to mastering the next set of skills, perhaps achieving better engagement with incentives and health savings accounts that reward the consumers who take better control of their health care needs.

Since these advances are fed by experience with individual consumers and progress in information technology, early leads can prove insurmountable. Within relatively short order, early success in the individual market could put one or more players on the path to breaking the constraints that define competition in the existing group market.

Here is how it could play out.

Power to the people? 7

One for all: Any color, so long as it is black

Historically, the U.S. commercial health insurance industry’s primary customer has been employers. In 2008, fully 59 percent of the non-elderly U.S. population was part of an employer-sponsored group plan, while only 6 percent were in individual plans.4 It is no surprise, therefore, that the individual insurance market has been a relatively immaterial fraction of industry revenue. It is the traditional focus on the employer that explains why the essentially wholesale group insurance market lacks many of the features that define a true retail experience.

The ways that an individual and an employer make purchase decisions are different, as one is truly personal and the other is strictly business. They have different constituencies to please, and, as a result, each values the coverage and service trade-offs with a different yardstick. Individuals only care about their own family’s needs and balancing their health care requirements with their household budgets. Meanwhile, employers must balance the needs of ALL their employees — taking into account where their employees live, what is affordable, and what are their actuarially forecasted health care needs. The employer, perforce, takes a one-for-all approach. According to Deloitte’s 2011 Survey of Health Care Consumers in the United States, 40 percent of those surveyed said they had no choice in the selection of their coverage. However, the employers make up for the lack of choice by paying on average 82 percent of the cost for individual plans and 71 percent of the cost for family plans.5 Not surprisingly, the research also found that 25 percent of consumers surveyed do not even know what they contribute to their coverage each year.

Consequently, the health plan industry operating model is designed primarily to help employers make these trade-offs. Decisions around plan design, medical management and wellness programs, size, scale and location of provider networks, call centers, reporting on medical outcomes and costs, pharmaceutical services, billing and collection of premiums, and appeals and grievances are all heavily weighted toward satisfying the specifications of the employer, not the employees, the ultimate consumers of the coverage. In other words, since the health care insurance market traditionally has been largely a business-to-business transaction, it has evolved into a complex system with limited flexibility for employee customization.

There are no stores with helpful sales people to explain how to use a product, no demos, no debit card billings, no frequent flyer miles for being a good customer, and no “apps” for estimating total calendar year costs; also, there is little customization available to tailor the service to an individual’s needs and budget. But, given the relatively insignificant size of the individual market — barely 10 percent of the group market in number of enrollees, and much less in premium payments6 — it is not surprising that many, if not most, of today’s major carriers have focused primarily on the needs of the much larger and lucrative employer-sponsored market.

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All for one: Pay what you can, get what you want

The majority of the U.S. population under the age of 65 incurs, on average, $500 or less a year on health care-covered costs. Consequently, serving the individual market effectively means keeping the monthly premium cost manageable.

There are many levers that can drive premium costs lower, but no one set of trade-offs will serve every, or even most, customers optimally. Even today, the relatively small numbers of individuals who purchase their own coverage — approximately 16.7 million compared to the 159 million in employer-sponsored plans7 — have much more diverse needs than the group market. Indeed, to speak of the “individual market” as a single segment is grossly misleading, as it is a collage as diverse as the nation’s population.

As a result, the byword in the individual market is “customization” so that consumers can make the choices they feel are best for them. Product variables, such as higher cost-sharing levels, health savings accounts, a more limited or lower-cost group of network providers, different plan designs, patient compliance and wellness incentives, and lower-cost self-service options, are examples of choices that would lower the overall cost of the premium.A successful health plan operating model and enabling technology that gives the subscriber the opportunity to make these choices real-time and online is a very different model than the mature employer-based model currently in use. In addition, the very nature of what is included in the premium and what is billed on an as-needed basis will likely change due to consumer preferences. Navigation support, appointment scheduling, electronic health records, health and nutrition counseling, and financial management might be examples of services paid when needed, similar to Apple’s iTunes when buying a movie or song.

The complexity of making the technical integration work can be daunting, so health plans have invested heavily to enable the integration of these components; not, however, without a great deal of effort and a relatively high level of rigidity in the resulting solutions. This is no vice in the eyes of large customers who purchase a year ahead of time and have the resources to think carefully about what they want and how each piece fits together. While individual consumers also will value this same level of integration and customization, they will need it done in 12 minutes, not 12 months. Today, there simply is no analogue in the health plan world of “build-your-own,” but there is no good reason why, other than the market served by health insurers did not demand it. The new individual market will, and, if it can be done for car financing, college savings, retirement investing, and personal banking, why not for health insurance?

The first-generation insurance exchange products are likely to be inferior to existing commercial group products. They will likely lack comparably broad networks, concierge services, and sophisticated medical management programs because these elements add cost that many consumers will not value or want to pay for. But if Disruption is in the offing, these relative deficiencies will be temporary.

Power to the people? 9

Let the Disruption begin

The important question is, therefore, How and when will the industry get there? Note that the time required for a Disruption varies widely — from 70 years in the case of General Motors versus Toyota, to barely more than a decade for Alcatel-Lucent versus Cisco (Figure 1). The reason lies in the nature of the enabling technology behind each Disruption, for it is improvements that propel the alternative business model along its upmarket march into mainstream segments. Toyota had to rely on advances in its fundamental process technologies, known as the Toyota Production System. By their nature, processes improved more slowly than the mechanical enablers of Nucor’s Disruption of U.S. Steel. In Southwest’s case, airframe technologies improved relatively slowly. However, Walmart grew more quickly, thanks to the information technology elements of its logistics management capabilities. In other words, the pace of a Disruption is a function of how quickly its enabling technologies improve, not the nature of the business model required for success in the foothold market.

We can think of at least three possible Disruptive individual health insurance market entrants that are worth taking seriously.

First, banks could enter the insurance market. This is a possibility that has been considered and even anticipated, yet established financial institutions (FIs) have shown little appetite for expanding into this seemingly adjacent market. Such reluctance has its merits; a frontal attack on the insurance market would provoke a full-scale response from well-resourced incumbent insurance companies defending their core business. This time around, however, FIs might well recognize the Disruptive potential of beginning in the individual space which, thanks to the ACA, could grow rapidly in size and commercial significance and provide a foothold for entering the large and lucrative group market. In other words, the unique nature of the Disruptive opportunity at stake might provoke precisely the market entry that has been predicted for so long.

A second possible entrant already has a small foothold in the individual market: There are a number of Medicaid- and Medicare-only plans — some of which are part of larger plans — that provide a relatively limited variety of individual products. For these players, the birth of the health insurance exchanges and the concomitant rapid increase in the individual market is anticipated to create a strong incentive to build upon their focus on individuals with an increase in the scope and sophistication of the coverage they provide.

Third, beyond banks and insurance companies, those companies with the requisite retail reach and need for significant growth opportunities could well see in the coming shift in market structure just the disequilibrium they need to mount a Disruptive attack of their own. Walmart, for example, is one of several large retailers with the resources and the proven ability to develop the capabilities required to move into adjacent markets of many different types. Consequently, were a large retailer able to develop a viable foothold in the individual market, it would have the wherewithal to capitalize fully on any opportunities that a Disruptive growth trajectory might create.

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These three possibilities need not be an exhaustive list. Even if Disruption itself is predictable, very often the provenance of the eventual victor is not. Could a start-up emerge? Could a technology company with extensive customer data, like Google or Facebook, become a credible competitor?

The specter of Disruption should have incumbent group providers not merely looking over both shoulders, but under every rock and around every corner for possible threats. Entrants into their space will be at first strongly motivated to make it possible for consumers to make customized trade-offs in order to keep premiums low. The solutions they offer will likely be a pale shadow of what is available in employer-sponsored plans; for the new individual market, however, that is not the relevant comparison. All that these products need to be in the early going is better than nothing (and compliant with relevant regulation and legislation).

While incumbent market leaders are, in most cases, far more capable when it comes to designing and launching new insurance products and services, Disruption’s predictions are not based on capabilities — they are based on incentives. Incumbents will likely have weak incentives to serve individuals, while existing individual players will have very strong incentives to expand their product portfolios. Very few market leaders have successfully Disrupted themselves: What may be the only example is Intel launching an early strike on AMD with its cheaper and less powerful Celeron chip to ward off AMD’s march into Intel’s turf.8

If history is a guide, it is the companies that are first to deliver the innovations that provide customized choice and integrated delivery that eventually Disrupt the incumbents. Dominant group carriers will likely be forced by their obligations to their existing customers to provide customization without reductions in coverage, customer satisfaction, or price. In contrast, the would-be Disruptors can “sneak up” on this challenge. They will have the liberty of beginning first with something worse, something built on segmentation analysis as a poor substitute for customization and choice, but then adding the integration and convenience of truly on-demand service as their capabilities permit.

Power to the people? 11

Understanding Disruption: A prophesy defeated?

The forces of inertia created by comfortable incumbency will likely make it systematically very difficult for today’s health plans to focus the attention they should on the burgeoning individual market. If those who fill the needs of the individual market created by the ACA were forever confined to this new market, there would be little to worry about. However, a signal feature of the American economy has always been innovation and change, so complacency is far from justified. The way is clear for smaller players, and even entrants from other industries, to pioneer new business models built on new technologies to set themselves on a trajectory of innovation-driven growth that could re-invent the industry as a whole.

The good news for existing group carriers is that once the forces of Disruption are recognized and understood, they can be used to shape and create the change that otherwise may only have been predicted. Specifically, by understanding the long-term potential of a dramatically different business model, incumbent group carriers can begin building business units devoted to the needs of the emerging individual market. In this way, they can position themselves to be the beneficiaries of Disruptive change, rather than its victims.

Endnotes1 “The Impact of Health Reform on the Individual Insur-

ance Market: A strategic assessment,” The Deloitte Center for Health Solutions, 2011.

2 This version of the Southwest story is summarized from The Innovator’s Manifesto (Raynor 2011, op. cit.), chapter 3.

3 Ibid4 “The Impact of Health Reform on the Individual Insur-

ance Market: A strategic assessment,” Deloitte Center for Health Solutions, 201

5 Ibid6 Deloitte Center for Health Solutions, 20117 Ibid8 See Raynor (2011) op. cit. Note that launching a Disrup-

tion to one’s existing core business is quite different from launching a new business that is Disruptive to someone else. This tends to be more easily done by established organizations. See Christensen, Clayton M. and Michael E. Raynor (2003). The Innovator’s Solution, HBS Press (Boston), pp. 276-277.

Authors

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William Copeland, Jr.Vice ChairmanUS Life Sciences & Health Care LeaderUS Health Plan LeaderDeloitte LLPbcopeland@deloitte.com

Michael RaynorDirectorDeloitte Services LPmraynor@deloitte.com

William (Bill) Copeland, Jr. is the Life Sciences and Health Care National Industry Leader and Health Plans National Sector Leader, and is based in Philadelphia, Pennsylvania.

Michael E. Raynor is the New York Times best-selling author of the recently-released The Innovator’s Manifesto (Crown Business), The Strategy Paradox (Currency/Doubleday 2007) and The Innovator’s Solution (HBS Press 2003).

This publication contains general information only and Deloitte is not, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor.

Deloitte shall not be responsible for any loss sustained by any person who relies on this publication.

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