A Conversation With Regina E. Herzlinger, PhD: A New Individual Market on the Horizon

Health care reform sets the stage for employers to bow out of health care, creating an insurance market driven by individual choice, according to Harvard’s Professor Herzlinger

It is inevitable that employers will enable employees to cash out the value of their health insurance rather than having employers buy it. The Patient Protection and Affordable Care Act’s exchanges, coupled with the individual mandate, means that employees could be making their own decisions and demanding a variety of coverage options, says Professor Regina E. Herzlinger, PhD, of the Harvard Business School, an expert on innovation in health care.

“For insurers, the good news is that it’s very likely we will have a much larger insurance system, with people from the employer-based pools and Medicaid shopping in exchanges,” she says. “The bad news is that there is going to be a lot more competition.” The health care system in the United States will evolve into one that looks much like Switzerland’s, where competition keeps administrative costs low, but it will not work unless people have good information on quality and outcomes, predicts Herzlinger, who is the Nancy R. McPherson Professor of Business Administration at the Harvard Business School.

Herzlinger has written seven books, including 2007’s Who Killed Health Care? America’s $2 Trillion Medical Problem — and The Consumer-Driven Cure, and dozens of articles on the health care market. She has testified before Congress and served on the Scientific Advisory Group to the U.S. Secretary of the Air Force. She has also served on the boards of private and publicly traded consumer-directed health care companies. An economist, she earned her bachelor’s degree from the Massachusetts Institute of Technology and her doctorate from Harvard Business School. She spoke recently with MANAGED CARE Editor John Marcille.

Managed Care: The Affordable Care Act moves us toward universal coverage. Can we afford it?

Regina E. Herzlinger, PhD: I have always supported universal coverage for personal and economic reasons. There are 40 million people who are uninsured. Typically, in any pool, 20 percent are sick. That’s 8 million people. How are we going to cover these 8 million sick people? The only way we can pay for them is to raise taxes — which is not going to happen — or to have universal coverage. Universal coverage is in many ways much more acceptable than a tax in which the well subsidize the sick. So it’s great we have it. It’s not great that it costs so much. The net present value of our future Medicare liabilities is already $90 trillion. That’s the amount we would need to have in the bank right now to pay for extending Medicare as far out as it would likely go. PPACA will just add to that cost.

MC: Are the penalties in the Affordable Care Act sufficient to get us close to universal coverage?

Herzlinger: They are sufficient to ensure that the governmental costs of the law will be higher. If health insurance costs around $16,000 for a family, you really don’t need to be an actuary to figure out that an employer should drop health insurance and pay the fine of $2,000 to $3,000. And what happens then? The subsidies on the exchanges are very generous. They go up to $88,000 in income for a family. (To calibrate that sum, the median household income in the United States is around $50,000.) The budget for the subsidies is based on estimates of 30 to 40 million people. If those numbers are in the hundreds of millions, which would happen if employers en masse dropped health insurance coverage, the costs of the Affordable Care Act will be significantly higher. It’s cost, cost, cost. Universal coverage is terrific, but not when we are bankrupting our children and grandchildren.

MC: Are we headed toward a single-payer system?

Herzlinger: I wouldn’t say that. I think we are going to a Swiss system. Employers will drop their health insurance coverage, not solely for reasons of cost. Many employers find buying health insurance onerous, and they would rather it be a consumer purchase.

MC: How does the Swiss system work?

Herzlinger: Let’s say Harvard University enables me to cash out of my ESI. After all, it has always been an element of my income and not a gift from my employer. I would take them up on that offer and get around $20,000, which is what the university spends on my health insurance, and then I go shopping. That is the genesis of a Swiss style of universal coverage. The Swiss have no Medicare, and they have no Medicaid. Everybody buys their own insurance. If you are poor in Switzerland, the government gives you enough money so that you can buy as much insurance as the average Swiss. The fact that they have no public insurance means that they don’t have unfunded liability, so right away that’s a big plus. The Swiss children are not burdened by the mammoth unfunded liabilities of the Medicare system.

MC: What are the results?

Herzlinger: The rate of growth of health care expenses is far lower than the rate of growth of the GDP, and they have a great health care system.

MC: It sounds idyllic.

Herzlinger: It’s idyllic for the poor. When they use health care services, they are indistinguishable from other people. No wonder Switzerland has such high equality between the poor and others in access to health care. It is good for consumers. They can buy pretty much the kind of policy they want. It is good for employers. They are not burdened with the thankless job of selecting health insurance. It is good for the mobility of labor in the Swiss economy. People aren’t locked into jobs just because the job offers health insurance. It is pretty good for insurers, too, because it is run entirely by private health insurance companies.

MC: And it’s the competition that keeps costs down?

Herzlinger: Correct. Their administrative costs are less than 5 percent, and that is the key to the whole system. The administrative costs of our health insurers are between 12 and 20 percent.

MC: Are there similarities in the way their system has evolved and the way ours is changing?

Herzlinger: In 1994, the Swiss held a referendum to get rid of employer-based health insurance. Employers liked the idea because it was onerous for them to buy the benefits, and unions liked it because it freed employees from job lock. So this odd coalition got together and they passed it. It squeaked by. In 2007, they held a referendum on repealing the system in favor of single payer. That proposal was widely rejected. More than 70 percent of the Swiss wanted to keep what they have.

MC: What are the criticisms of the Swiss system?

Herzlinger: Some people mistakenly say that insurers in Switzerland are non-profit, but that is not true. Virtually all of them are for-profit companies; they are just forced to offer their basic insurance, the minimum insurance, at zero profit. They make their profits from supplemental insurance. The insurers are profitable, but not excessively, because it is a consumer-driven system. They compete in terms of service and by keeping a tight rein on their administrative expenses. Another criticism is that the Swiss spend 11 percent of their GDP on health insurance, while the Canadians and Brits spend about 9.5 percent of GDP. That criticism is a little naïve. The last silly criticism is that the Swiss achieve their results because the system is so regulated, not because it is market driven; but highly regulated health care systems, such as in the United Kingdom and Germany, do not achieve comparable cost control. The main difference between them and Switzerland is that they are not consumer-driven. In the United Kingdom and German system, an intermediary, not the consumer, directly pays for the health insurance.

MC: How so?

Herzlinger: The Swiss could spend substantially less if they chose to do so. A third of them buy high-deductible plans, but if all of them bought high-deductible plans, the percentage of expenses would go down substantially. A quarter of them buy HMOs. If all of them bought HMOs, the expenses would dip below those of other developed countries as a percentage of GDP. But it’s a consumer-driven market, so 40 to 50 percent of them prefer to buy full coverage with free choice of network. The market has spoken. That’s the way it goes.

MC: Who is choosing high-deductible plans?

Herzlinger: The people who should choose them: Relatively affluent and healthy people.

MC: How do you define consumer-driven health care?

Herzlinger: What I mean by consumer-driven health care is that consumers drive the health care system, and they choose what they want. The Swiss, to my knowledge, were among the first to introduce high deductibles, which are mistakenly equated with consumer-driven health care. If I were in Switzerland, I would urge the insurance companies there to introduce another kind of health insurance policy, one that pays people who are sick to maintain their health. They have this in South Africa, and Humana recently adopted it in the United States with a product called Vitality. It’s a great health insurance policy, and it’s something that insurers can do.

MC: What do we need to do to create an environment in which insurers are innovating and consumers are getting what they want here?

Herzlinger: You cannot have a well-functioning consumer-driven market without a lot of information. And the areas where information is most sorely lacking are in the quality of medical care. People always say, “I have a great doctor,” and I say, “Yeah? How do you know?” The reply: “My friend Carol told me he is a great doctor.” That is really outrageous. I know more about my yogurt than I might know about a doctor who is going to do a mastectomy on me or a prostatectomy on my husband.

MC: What’s the answer?

Herzlinger: I was the senior author of a recent article with Peter Pronovost, MD, PhD, about the need to create a body like the Securities and Exchange Commission for health care. It is an idea I came up with in 1996, and Peter independently thought about it, so we co-wrote this paper. In the 1930s, the financial markets were like health care, in terms of no information. People bought stock because their friend told them it was a great stock. They had no basis on which to make an informed judgment. And Franklin Roosevelt brilliantly brought in the SEC, which has been a miserable failure as a regulatory agency but a huge success in bringing transparency to the financial markets. A health care SEC is absolutely essential.

MC: The level of information we have today is not very good, and yet organizations like the NCQA have been in existence for a while.

Herzlinger: Yes. It doesn’t seem to work; I think they would agree with that themselves. What’s missing is an incentive to have good information. Let’s say that I’m an insurer and I offer a cheap narrow network policy. I need to convince customers that my network is terrific, that even though it’s cheap, it’s high quality. How do I do that? Right now, I can tell them whether the doctor told some patients to stop smoking or gave others a beta-blocker. But customers don’t care about those things. Customers want outcomes data. They want to know, If I go to this surgeon, given my risk class, and have the following things done, what is my likelihood of emerging alive, having the surgery done at the right location, and not getting an infection? Those are very compelling data, and insurers will need that type of data to compete in a consumer-driven health care system.

MC: An individual would be able to judge the quality of a network and the quality of a hospital or doctor?

Herzlinger: A lot of people in health care are tremendously elitist about consumers. They think they are dumb. Somehow these dumb consumers do all right in the rest of their lives, but when it comes to health care, they are dumb. But if the people who are running the health care system right now, who are not the consumers, are so smart, why are we in this terrible financial, unknown quality situation?

MC: Consumers will create something better if given the chance?

Herzlinger: There is a wonderful book called the Wisdom of Crowds by James Surowiecki that restates mountains of empirical economic evidence that says a crowd is smarter than the individuals within it. That’s how a market works. You and I might not be so smart, but when you take a whole big group of us collectively, we are going to be smart. That’s how Toyota got to be the number one selling car in America — not because every automobile buyer is a genius about automobiles. Because we have very good data with which to evaluate automobiles, we collectively went away from American cars of inferior quality to the those of the Japanese at that time, even though few of us are automotive gurus.

MC: What role would insurers play in the health care SEC?

Herzlinger: One of the problems with measurement right now is that it is overwhelmed by interest groups. As I noted in, Who Killed Health Care? everybody, except the patient, is jockeying for his self interest. Right now, measurement is shaped by primary care doctors, surgeons, nurses, dentists, insurance companies, governments — all wanting to manipulate the measurement to put themselves in the best light. That’s understandable, but it doesn’t mean it’s good. Financial statements, in contrast, are shaped primarily by the accounting profession whose interest is in the quality of measurement. So I think the way to do a health care SEC is to have people who are primarily interested in health care quality — such as biostatisticians, epidemiologists, and health economists — comment on proposed rules. They should be professionals whose main interest is perfecting measurement, not in catering to any one interest group.

MC: Let me ask you about some other ideas. Accountable care organizations — does this concept have any legs?

Herzlinger: It’s like the Affordable Care Act itself — great idea, poorly thought through. Fee-for-service payment is perverse because it penalizes integration. The classic example is when Duke Medical Center integrated the care for congestive heart failure and lowered the cost by $8,000. So what happened to Duke? It lost $8,000 in admission revenue per patient. ACOs would stop that because they would stop fee-for-service payment. Duke would get some sort of integrated price, and if it managed the care so the cost was less than the price, it would keep the difference. That’s good. They lower the price and make more money. Everybody wins. The problem is the scope of the ACO, which is not just one disease or one condition, but everything for everybody. It’s not feasible to excel in managing every kind of care. It’s too complicated.

MC: So ACOs won’t catch on?

Herzlinger: Generally in our economy, if someone has a good idea, it disseminates very widely. So why don’t we have a Kaiser in every state, in every city? Many of Kaiser’s attempts to expand were abandoned. It’s a nice idea, but it’s hopelessly academic. We need to integrate care, but let’s keep it real. Let’s keep it on a scale that is viable — for example, bundling care for high-cost diseases, such as congestive heart failure, and for certain types of procedures, such as bariatric procedures. That seems to me very feasible, and we would save tens of billions of dollars.

MC: How do you feel about monopolies in health care?

Herzlinger: That’s another thing about ACOs: They will prove to be anti-competitive. It’s very difficult to foster competition if the competitors are gigantic. There is solid economic evidence to show that when hospitals merge, prices go up. So another worrisome aspect of a landscape dominated by giant ACOs is that they will increase prices rather than decrease them. Many people in the government are worried about ACOs’ effect on competition, but they are not going to move until they see how that landscape falls out.

MC: Will the consumer model make its way to Medicare?

Herzlinger: Consumer-driven health care started in the commercially-insured population. I would hope it would go to Medicaid so that the poor aren’t stuck in this terrible program. And eventually it will go to Medicare because we have to solve the Medicare problem.

MC: The Congressional Budget Office thinks that senior citizens will be worse off under a voucher system from Medicare, which is Rep. Ryan’s plan.

Herzlinger: What the CBO failed to think about is, if 50 million seniors go out in the insurance market, is that market going to remain the same, or is it going to become more competitive in ways the Swiss insurers are competitive, by reducing administrative costs? The CBO’s mistake was assuming that nothing would change. If 50 million seniors show up in the insurance market, they are going to force insurers to become more competitive.

MC: It hasn’t worked in the individual market as it exists today.

Herzlinger: No. The numbers in the individual market are too small to drive that market. Small markets in every sector of the economy are noted for their efficiency.

MC: Providers talk about the difficulty of dealing with so many insurance companies. Is it going to get worse for them as more health plans enter a consumer-driven market?

Herzlinger: Well, either you are going to have a lot of insurers breathing down your neck, or it’s going to be single payer. Our last gasp is consumer-driven health care. Take your choice.

MC: Either way, though, employers are going to get out of the business?

Herzlinger: Most employers will drop their health insurance and cash out their employees. Right now, Harvard takes $20,000 of my income and uses it to buy my health insurance. The only reason I let them do it is because I don’t get taxed on that money. I don’t like what they buy for me. I would buy something very different and lower cost, but if they gave me the money right now, I would be taxed on it. So I put up with the extravagant health insurance policy because it costs me less than it would if I were to get the money and be taxed on it. So I have proposed — and I believe this will happen — that I could get that $20,000 tax-free, and the amount I spend on health insurance would remain tax-free. It’s a complex tax proposal, but it will actually raise federal tax revenues. So if I get my $20,000 and I spend $16,000 on insurance, that’s $4,000 left of taxable income. I think most people will not spend as much as their employers have spent on their behalf for health insurance.

MC: Under the Affordable Care Act, though, you would have to buy a minimum level of coverage.

Herzlinger: Yes, and that’s a very good thing. I couldn’t get $20,000 and buy a policy with a million-dollar deductible. That’s not acceptable. But in a consumer-driven market with this tax-free status, people will buy less health insurance, preferring more after-tax income to more health insurance. I am in favor of commercial health insurance. I certainly prefer it to single-payer insurance. But it’s an industry that will need to become more competitive and consumer-focused to survive.

MC: Thank you.

The problem is the scope of the ACOs. It’s not feasible to excel in managing every kind of care.

Most employers will drop their health insurance coverage and cash out their employees.