05 Aug 2002  Research & Ideas

Are Consumers the Cure for Broken Health Insurance?

"The health insurance system in the United States is broken, and business is paying the price," says HBS professor Regina E. Herzlinger. In this excerpt from Harvard Business Review, she describes how consumers may just be the cure. PLUS: Q&A with the author.


The health insurance system in the United States is broken, and business is paying the price. Employers' insurance premiums reached an estimated $450 billion in 2000, and then shot up again, at three times the rate of inflation, in 2001. With managed-care cost controls collapsing, patient-protection legislation promising to set off a round of expensive lawsuits, and costly genomic technologies on the horizon, the price of insurance is almost certain to continue its upward spiral in the years ahead. And what do companies get for their massive expenditures? A lot of unhappy employees. Workers fret about the quality of the care they receive, the burden of out-of-pocket expenses, and gaps in coverage for long-term care, prescriptions, and catastrophic illnesses. For business, health care has become a lose-lose proposition: You pay way too much, and you get way too little.

It wasn't supposed to be like this. About twenty years ago, managed care was widely viewed as the silver bullet that would curb cost increases while ensuring patients good and convenient treatment. But managed care has been a bust. The original HMO models—vertically integrated systems for managing care or those that use gatekeepers to impose stringent controls on care—were resisted by patients and physicians. In response, the managed care organizations began relaxing their controls, allowing patients more freedom to see specialists and out-of-network doctors. Costs began to climb again, yet patients and providers continued to feel constrained. Now, no one's happy—not the insurers, not the patients, not the doctors and nurses, not the hospitals, and certainly not the companies that are footing the bill.

The situation is dire, but there is a way out of the mess—and the key lies with the business community. If companies are willing to embrace a new model of health coverage—one that places control over costs and care directly in the hands of employees—the competitive forces that spur productivity and innovation in consumer markets can be loosed upon the inefficient, tradition-bound health care system. Rather than imposing a top-down solution, as managed care vainly tried to do, consumer-driven health care would work from the bottom up, enabling providers and patients jointly to create better, cheaper ways to deliver care.

The essential problem with the health care industry is that is has been shielded from consumer control— by employers, insurers, and the government.
— Regina E. Herzlinger

When consumers take control

When consumers apply pressure on an industry, whether it's retailing or banking, cars or computers, it invariably produces a surge of innovation that increases productivity, reduces prices, improves quality, and expands choices. The essential problem with the health care industry is that it has been shielded from consumer control—by employers, insurers, and the government. As a result, costs have exploded as choices have narrowed. Today, approximately 40 percent of all employers and 92 percent of small ones offer employees only a single health insurance plan. And even when companies offer three or four options, precious little distinguishes them—most managed-care plans provide the same benefits, insure virtually identical levels of expenses, reimburse providers in similar ways for a limited array of traditional services, and last for only one year. In essence, managed care comes in just two flavors: plans that place constraints on access to physicians and hospitals for a lower price, and plans that offer readier access for a higher price. The lack of choice and control ensures that many consumers' and providers' needs go unmet and that industry inefficiency goes unchecked.

In many ways, the current health insurance model resembles the way companies used to manage their employees' retirement savings. In traditional defined benefit plans, pension investments and returns were determined by employers; workers were given no choice, no control, and very little information. When employees began to manage their retirement savings using 401(k)s and other defined contribution plans that allowed them to invest pretax money, the effects were dramatic and far-reaching. First, the number and variety of investment choices skyrocketed, as new mutual fund companies rushed into the market with creative, differentiated offerings. Today, according to Institutional Investor, more than 90 percent of employers offer seven or more distinctly different investment options to their employees, ranging from indexed bond funds to microcap equity funds. Second, sources providing advice and information about mutual-fund investment results proliferated, with companies like Morningstar supplying individual investors with the data and advice they needed to make intelligent choices. Third, despite widespread fears that people would lack the financial acumen to manage their own savings, defined contribution returns outpaced those from defined benefit plans. Watson Wyatt, a benefits and compensation consultancy, determined that the returns of 401(k) plans exceeded those of defined benefit investments not only in the boom period from 1995 through 1998 but also in the down market years of 1990, 1993, and 1994. And, fourth, consumer pressure and intensified competition forced the entire U.S. securities industry to become more customer oriented and more efficient; prices for stock trades and other transactions plunged through the 1990s.

The shift to employee-controlled pension plans succeeded—despite enormous skepticism.
— Regina E. Herzlinger

The shift to employee-controlled pension plans succeeded—despite enormous skepticism. Many worried about the willingness of employees to invest in defined contribution plans and of employers to support them. Others worried whether low-income employees or those in small companies would get left behind. But a Fidelity study showed that most employees have embraced the plans, and, between 1989 and 1998, employers' annual contributions increased by more than $20 billion. Fidelity also found higher participation rates in smaller plans and roughly equal savings rates between active highly paid employees and others.

The recent problems with the 401(k) plans of failed companies like Enron show that pension schemes remain imperfect. We need more discussion of such topics as the use of company stock in retirement plans and the right balance between defined contribution and defined benefit plans. Nonetheless, it remains clear that, overall, consumers have fared very well in defined contribution plans.

A similar consumerist revolution can take place with health care benefits—if companies are willing to give their employees substantially enhanced choice among health plans, much greater control over how much they spend for various health care needs, and much more information to help them make the right choices. Just as we saw with the securities industry, entrepreneurs will respond to the unleashing of consumer demands with clearly differentiated products featuring various combinations of benefits, levels of insurance coverage, payment systems for providers, lengths of policies, and sources of information. The competition among the new products, in turn, will control costs while improving the overall quality of coverage and care.

Five questions for Regina E. Herzlinger

Professor Herzlinger shared her vision for health care in an email interview with HBS Working Knowledge senior editor Martha Lagace. Herzlinger's next book, Consumer-Driven Health Care, will be published in January 2003 by Jossey-Bass.

Lagace: You have a bold idea for transforming the current health care system into a consumer-driven model. What, in a nutshell, are the advantages to your proposal? And the risks?

Herzlinger: The pros of consumer-driven health care:

· Unlike today's cookie-cutter insurance policies, under consumer-driven health care enrollees can tailor health insurance policies to their specific needs—e.g., insurance for long-term care and drugs; easy access to integrated teams that specialize in treating chronic diseases and disabilities; pre-tax savings accounts for uninsured health care needs, such as hearing aids and support in modifying lifestyles; and "bonus" long-term policies that reward those who switch to healthy lifestyles.

· Insurers and providers will receive risk-adjusted payments, so the sick will become financially attractive enrollees and patients. With today's pricing—the same for the sick and the well—insurers and providers lose money with the sick.

· The resulting competition for consumers with differentiated products will control costs by increasing quality of care—e.g., integrated teams for congestive heart failure have reduced costs by $8,000 per year per enrollee. This higher-quality effect is especially important for the sick.

The risks of consumer-driven health care:

· Overall, relative to the current system, the risk of consumer-driven health care is low. After all, the current system has led to quality problems, double-digit cost increases, little information, and dispirited providers.

· The risks [brought by] undercapitalized, incompetent insurance entrants will be reduced by competition and regulation by state regulatory bodies.

Q: In your new article in Harvard Business Review, you write, "The current health insurance system in the United States has its share of defenders—people and institutions that would stand to lose money or power should the status quo be overturned." What kind of money and power stands to be lost, and by whom? How did we get to this homogenized pricing of the present insurance system in the first place?

A: Homogenized prices and benefits in insurance policies arose with the best of intentions. Uniform prices were thought to enable the sick to buy insurance, and uniform benefits would simplify shopping. But the unintended effect was to shackle competition and to make sick enrollees unprofitable.

The architects of the present system, status quo insurers, stand to lose in a consumer-driven health care system if they do not innovate. But, as indicated in the complimentary letters from Aetna's president and Wellpoint's CEO received by the Harvard Business Review, some of the insurers are not barriers to change.

The community of health policy experts, most of whom favor a system of standardized benefits selected by experts like them, are likely to be the most vocal opponents.

Q: Your article mentions several "scare stories" that are told to frighten people away from a consumer-driven model. These scare stories include the idea that health care will cater to the rich at the expense of the poor, and to the healthy at the expense of the sick. How would you like to reassure employees that your idea is in their best interests?

A: Consumer-driven health care will improve health care quality by inducing competition among providers that respond to consumers' needs; risk-adjustment of payment will make the sick much more attractive enrollees than the present uniform pricing system.

All boats rise in a rising sea. Other consumer-driven markets demonstrate that suppliers innovate to reach all income classes with cost-effective products. For example, automobiles that once cost more than a house are now cheaper, better, and available to all income classes. Indeed, the word "Toyota" is now used as shorthand to identify low-cost, high-quality goods and services.

Q: Your article draws a parallel between consumer-driven health care and the now-fairly-common American practice of employees getting more control of their own retirement allocations. You assert that the switch to employee control vis-à-vis retirement plans has been successful. Given the current economic jitters, do you think the timing is good to introduce a different health care model?

A: Employers that currently provide insurance benefits advocate consumer-driven health care because it cannot be worse than the present managed care system, whose costs escalate at double-digit [rates] while quality concerns and employee unhappiness escalate. Employers that would like to provide health insurance, but who cannot afford it, will find new, lower-cost consumer-driven health care policies, such as those offered by California's Wellpoint, that help them achieve their goal.

Employees in defined-contribution pension plans have shown their mettle. They earned a better rate of return than those in defined benefit plans. A similar effect will take place in health care. People do better when they shop for themselves than when a professional shops on their behalf.

Where the analogy between consumer-driven health care and pension plans is not appropriate is in the funding. While employers will likely maintain their present funding for health insurance, consumer-driven pension plans have been primarily self-funded since 1999.

Q: What steps are you taking to move your idea forward, and what has been the reception from business and government?

A: I held a large conference at Harvard Business School on consumer-driven health care to discuss the topic. The conference was attended by CEOs and other leading thinkers. I have published and lectured on the topic since then.

The reception from business and providers has been far stronger than the one from government. Many businesses see consumer-driven health care as a way of relieving high costs and employee discontent, while providers see it as a way of relieving themselves from the strictures of managed care.

But the receptivity of governments has been virtually nil. I have long advocated the creation of a new government agency to require disclosure of performance metrics of insurers and providers and to regulate their probity and solvency. People cannot shop in the absence of information and, in my view, performance data will not be disclosed in the absence of governmental requirements. My urgings have fallen on deaf ears to date, unfortunately.

Excerpted with permission from "Let's Put Consumers in Charge of Health Care," Harvard Business Review, Vol. 80, No. 7, July 2002.

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Regina E. Herzlinger is the Nancy R. McPherson Professor of Business Administration at Harvard Business School in Boston. She is the author of Market-Driven Health Care (Perseus, 1997) and the forthcoming Consumer-Driven Health Care (Jossey-Bass, 2002). She chaired Harvard Business School's Consumer-Driven Health Care Conference in 1999.