November 15th, 2013
Editor’s note: In addition to Shubham Singhal (photo and linked bio above), this post is authored by Rohit Kumar and Jeris Stueland. Rohit Kumar is a consultant in McKinsey’s Chicago office. Jeris Stueland, an expert in McKinsey’s Healthcare Systems and Services Practice, is also in the Chicago office. The authors would like to thank Ellen Rosen, Jim Oatman, and Michael K. Park for their contributions to this article.
This is the second in a periodic series of posts by McKinsey analysts on the landscape facing payors in the post-reform world. You can read the first post in the series here.
Whether scale brings competitive advantage to payors is a topic of hot debate. Many believe that consolidation is likely as the industry goes through the disruptive changes set in motion by reform. Some contend that anticipated margin compression and medical-loss-ratio floors will make scale efficiencies critical for achieving sustainable economics in the future. Others, however, note that managing the total cost of care is becoming central to a payor’s success, and question what advantages scale provides in such a world. If most health care is locally delivered, they argue, how much of the value created by cost-of-care management can scale drive?
Our research and experience suggest that for payors, the minimum threshold for efficient and effective scale is low. The primary rationale for scale emerges from the large fixed investments payors must make to develop the new capabilities needed to compete effectively in a rapidly changing regulatory and market environment (and to comply with evolving regulations). This rationale holds particularly true for payors that choose to build these capabilities themselves rather than through partnerships with external vendors, noncompeting plans, or other stakeholders in the value chain.
Yet, once the minimum level of scale is achieved, performance variability on administrative costs continues to be quite high. This suggests that for many payors the bigger opportunity to achieve administrative efficiencies is through operating model and organizational redesign, productivity enhancements, and application of design-to-value principles to core processes.
Minimum Efficient Scale For Payors
We used National Association of Insurance Commissioners (NAIC) filings to assess sales, general, and administrative (SG&A) costs for payors of different sizes across states. Exhibit 1 shows the industry scale curve we derived. We found that costs began to converge above 100,000 lives, a relatively modest level of aggregate scale. (Exhibits appear at the end of this post.)
Interestingly, it appears that, as scale increases, the incremental costs driven by greater complexity begin to counteract the economies of scale. As Exhibit 2 shows, payors with greater than one million covered lives tend to have more lines of business and to operate in many more states than smaller payors do, and they seem to have higher administrative costs. In our experience, smaller payors often have much greater standardization of products and processes, and are more likely to outsource IT platforms and core functions. Because their business is less complex, they often appear to be better able to make the most of the efficiencies derived from economies of scale.
In a post-reform world, the disadvantages of complexity could further increase. For example, as the public exchanges and much talked-about private exchanges take hold, large payors will have to be able to offer products and pricing in numerous different geographic ratings areas if they want to reach the consumers buying insurance on those exchanges. (California alone has 19 rating areas.) In this scenario, local and regional payors may be better positioned to capture opportunities in the various rating areas, since they may have greater flexibility to customize locally.
If significant numbers of large employers opt to move to defined contribution models, the disadvantages of complexity could become even greater. Companies that today cover all of their employees through a single national group plan or administrative-services-only product could decide instead to offer their employees a range of health coverage and supplemental insurance products at different price points; private exchanges could help the companies tailor the offerings to different geographic rating areas.
In addition, the ability to customize locally could give smaller payors an advantage in the growing Medicaid and dual-eligible businesses. Care management and provider collaboration are important for controlling the cost of care in those businesses, and understanding specific local health needs and establishing relationships with local providers can be crucial for executing these efforts well.
As a result, the pursuit of aggregate scale is unlikely to be fruitful for payors unless accompanied by material changes in operating model design.
Conduct Has Greater Impact On Administrative Costs Than Scale Does
Our analyses reveal that the impact of scale on lowering SG&A costs is even less evident within a single line of business. In the small-group segment, for example, we have found that some payors have per-member, per-month costs that are more than twice those of payors of a similar size (Exhibit 3). The conclusion is inescapable: some payors simply operate much more efficiently than other payors do, regardless of scale. In other words, conduct matters more than scale.
We have also assessed if there are differences in margins or earnings growth between payors that spend more on administrative costs and those that spend less. That is, are parsimonious payors shortchanging themselves by investing less in the key capabilities required to ensure business performance? As Exhibit 4 shows, we could find no correlation between the level of SG&A spending and either profit margins or profit growth.
In our experience, payors that operate more efficiently and perform better have put considerable thought into their operating models to ensure that the companies are optimized to deliver against the value proposition they promise to their customers and sales channels. These payors make sure that their resource allocations are ruthlessly prioritized to the capabilities that help the companies succeed against competitors. They also make careful decisions about the level of standardization or managed customization (e.g., through modular product design) in their offerings, and they ensure that their IT architecture is capable of delivering changes and new capabilities at low cost (e.g., through easy integration with standard third-party solutions).
In addition, these payors make thoughtful choices about the use of in-house versus outsourced processes and capabilities — they keep in-house those areas in which they can be distinctive or create a competitive advantage, and they outsource as much else as possible.
Benefit Of Scale
Scale does have its benefits, however. With reform, the level of uncertainty and thus the level of risk in the health insurance business have increased. Among the unknowns: likely uptake rates among the previously uninsured, the behavior of newly insured individuals and those with a change in insurance type, the composition of risk pools, the effect of risk adjusters, and the conduct of existing competitors and new entrants. We assessed the volatility in likely performance of differently sized books of business to understand the benefits of scale and found that scale does help to mitigate volatility (Exhibit 5). Smaller companies can purchase reinsurance to mitigate volatility but incur the additional cost.
An even stronger argument in favor of scale arises from the fact that today’s payors have a significant need for new capabilities if they are to compete effectively. For example, they must learn to operate in the new individual and small-group exchanges (as well as in the completely redesigned off-exchange market in those segments), cope with the emergence of private exchanges and small-group self-insurance in the employee benefits market, adjust to rate pressures and changes to revenue programs (e.g., star ratings and risk adjusters) in the Medicare market, and accommodate expanded Medicaid eligibility rules. At the same time, payors must accustom themselves to new payment models and learn how to comply with the new and often incremental regulatory mandates that some of the market changes are creating.
Each of these new capabilities requires significant investments in IT systems, new business processes, and talent. Payors that can spread the costs of these investments over more lives can often have a significant cost advantage. Furthermore, larger payors can invest in many more capability areas, thereby diversifying their risks until the uncertainty resolves. Exhibit 6 illustrates the effects of scale on two examples of one-time, fixed investments.
In sum, the value of scale is relatively small in terms of operating efficiencies, and many times those efficiencies are offset by increased complexity. However, scale can make it easier for payors to build superior capabilities and mitigate volatility. All payors, regardless of their size, should assess and consider evolving their operating models and organizational designs to unlock efficiency opportunities. Those payors that do opt to pursue scale should be thoughtful in how they undertake mergers or partnerships — the best approach to use will depend on the deal’s rationale. (More details about deal execution can be found in the white paper by Celia Huber et al, “Riding the next wave of healthcare payor M&A.” July 2013. For a copy of this paper, contact Karen_Harden@mckinsey.com.)
EXHIBITS (Click to enlarge):
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