JUNE 2014 How US healthcare companies can thrive amid disruption

The healthcare industry is undergoing sweeping change. To emerge as winners, incumbents should learn from other industries that have faced similar upheaval.

Disruptive change is now a fact of life for in­dustry leaders with broader and more Brendan Buescher many industries. Healthcare is no excep- compelling business models to emerge. and Patrick Viguerie tion. Although healthcare has been chang- ing for decades—think about the introduc- The promise of opportunity creation and tion of diagnosis-related groups (DRGs) upside is far from certain. In fact, the or the initial push toward managed care in historical record is unambiguous: incum- the 1980s—the Affordable Care Act (ACA) bent companies are often unseated by promises to accelerate both the rate of industry disruption. Thus, we expect that change and the level of uncertainty con- many payors could be unseated in the fronting the industry. Payors face navigating years ahead. However, our research a difficult transition: from an industry in reveals two key insights for payors that which the customer is often a corporation want to thrive despite disruption: or small company and the business is paying claims to one in which consumers • There are three strategic paths that make healthcare purchasing decisions, companies in other industries have used the direct provision of care may be neces- successfully to thrive during and after sary for success, and consumer and retail disruptive change. capabilities really matter. Furthermore, payors must make this transition amid • Regardless of which path they took, these regulatory and consumer uncertainty and companies built the organizational capac- in a fairly short time frame. This industry ity and agility required to lead during the and business-model shift is on a scale disruption. They made big shifts in leader- that few companies and few sectors in ship focus and major changes to resource the economy have been through. allocation, and they developed a faster organizational clock speed and leaner Over time, however, the transition should cost structure. create new opportunities with significant upside. The entrance into the market of Understanding more than 30 million new consumers, disruptive change many of whom have never bought health- care products before, may ultimately trigger Industries change for different reasons. changes that drive real productivity im- Sometimes, the cause is a crisis. The provements in an industry that has lagged subprime mortgage meltdown, for example, in this regard. It may also allow new rocked the financial-services industry. 2

Payor Book — January 2014

Exhibit title: Industry leadership volatility has risen steeply

Exhibit 1 of 6

EXHIBIT 1 Industry leadership volatility has risen steeply.

% of companies that fell out 5-year topple rate1 of the S&P 500 during the years shown (n = 1,320 companies in 35 industries)

29 0.35 0.30

0.25 2.5X 0.20

0.15 11 Includes toppling due to M&A 0.10

0.05 Excludes toppling due to M&A

0.00 1989–1994 2004–09 75–80 80–85 85–90 90–95 95–00

1 The “topple rate” is the likelihood that an industry leader will lose its dominant position during the next five years. The graph includes data through 2002. Source: S&P 500; McKinsey analysis

Insti­tutions that had existed in some form for more than doubled during the past 25 years a century or more, such as Lehman Brothers, (Exhibit 1). And the odds that an industry disappeared rapidly. More commonly, com- leader will lose its position during the subse- petitive dynamics (anchored in a variety of quent five years—what we call the “topple drivers, including product quality, performance, rate”—tripled during the 25 years from and cost) produce big changes in the com- 1977 through 2002.1 petitive landscape over time—think about how Japanese competitors gained share When an industry faces disruption, compa- in the US automobile industry over several nies often fail to appreciate quickly enough decades. In some cases, a distinct catalyst the nature, extent, and velocity of the triggers a discontinuous change. The iPod, changes taking place. A number of reasons for example, transformed the music industry, explain this failure. Often, disruptions start just as the iPhone and its applications changed at an industry’s periphery, among compa- the game in mobile handsets, demonstrating nies that provide specialized value proposi- the power of creative destruction. Healthcare tions to different customer segments. In is facing such a discontinuous change. these cases, market penetration begins slowly, with barely perceptible impact. The healthcare industry’s disruption is tak- However, change can occur much more ing place at a time when the overall pace quickly when the “rules of the game” are of change in the economy continues to in- altered. McKinsey research has identified

1Caroline Thompson and Patrick crease. Two measures highlight this long- eight characteristics that are commonly Viguerie, “The faster they fall,” term trend of increasing “industry leadership found during industry disruptions, particu- Harvard Business Review, March 2005, hbr.org. volatility”: the churn rate in the S&P 500 has larly those triggered by significant regula- 3

tory shifts.2 Healthcare executives can ex- only on competitive advantage but also on pect to see most or all of these in the next operational efficiency. Many of the airlines few years: that survived deregulation did so in large part because of continuous productivity Competitors churn. Lots of new players en- improvements and organizational restruc­ ter the market, but most fail. (For example, at turing. As a result, they fly considerably one point after the US telecommunications more passengers now than they did a couple industry was deregulated, there were more of decades ago and at a significantly lower than 50 different long-distance fiber networks cost per seat mile, even though fuel prices in the country. Almost all of them are gone.) have more than doubled. However, churn is not limited to new entrants. Although a few incumbents are able to gain New value propositions reveal new cus- stronger posi­tions, many shrink, are ac- tomer segments. Few people knew they quired, or disappear. wanted smartphones until smartphones were invented. In healthcare, new customer Battles occur on two fronts. During indus- segments will emerge as innovative products try disruptions, companies often face regula- are introduced into the market and consum- tory as well as competitive challenges. (In the ers become more aware of the diversity of first few years after telephone deregulation, their choices. more battles were fought in the courts than in the marketplace.) This is apt to be true in Profit pools often shift. During disruptions, healthcare. Not only are the political battles the most attractive industry segments often over the ACA likely to continue for a while, become the least attractive, and vice versa, but numerous negotiations may be required as new entrants flock to the more attractive to settle finer points of implementation. segments and compete away profits.

Structural advantage prevails. When market The volume of mergers and acquisitions forces become more important than regula- rises. Deal activity tends to increase during tory rules, real competitive advantage deter- industry disruptions, but it often comes in mines the winners. Understanding and exploit­ waves as competitors attempt to keep up ing the future points of advantage can enable with one another. A few decades ago, the 2These observations are based on both direct industry experi- companies to thrive despite disruption. introduction of DRGs led to a large wave ence and McKinsey research— of provider consolidations. ACA enactment in particular, analysis of a wave of deregulating industries in the Performance differences widen. As the has already resulted in a high volume of both United States. See Joel A. Bleeke, 3 “Strategic choices for newly level of competition increases and the basis payor and provider deals. opened markets,” Harvard of competition shifts to true sources of Business Review, September– October 1990, hbr.org. advantage, the difference in the financial The net result of disruption is usually a mas- 3For more information about per­formance of top and bottom players in- sive reshaping of the affected industry and recent payor M&A activity, see Ankur Agrawal, Celia Huber, creases—and the gap often persists for years. its key segments—where the profit pools lie, and Bryony Winn, “Riding the next wave of payor M&A,” who gets them, and through which business Beyond reform: How payors Productivity and innovation increase. models. Entire parts of the value chain may can thrive in the new world, January 2014, healthcare Strong financial performance depends not be unseated or change in importance. .mckinsey.com. 4

Disruptive change in disruptions, for many reasons. Many the healthcare industry incumbents focus on the status quo; have incentives that encourage profit-and-loss Even before the ACA was enacted, health- leaders to concentrate on near-term, “Horizon care had the hallmarks of an industry vul- 1” performance across existing businesses; nerable to disruption. For more than half and are hobbled by significant organizational a century, healthcare expenditures have complexity that makes major adaptations risen considerably faster than GDP growth. difficult. For most companies, it is also quite Furthermore, healthcare has not achieved hard to create an effective strategic response the types of productivity increases that to disruption. A robust strategic response most other industries have experienced. requires an incumbent to navigate a change in In fact, healthcare ranks near the bottom business models—to strike the right balance in terms of productivity improvements between the new and the old at the right since 1990 (Exhibit 2). time—something an attacker does not need to worry about. For an incumbent, the scope For decades, rising healthcare expendi- of change typically requires transformation, tures have triggered industry changes (for and historically only 30 percent of example, managed care, ongoing cost shift- organizational transformations succeed.4 ing to employees). Nevertheless, cost and Classic cases of disruption (when a company productivity pressures have continued to faces a competitor with a superior business mount and have created enormous impetus model that results in markedly lower costs) for inno­vations that drive better outcomes ultimately call for a significant boost in the at lower costs. Many such innovations are incumbent’s competitiveness, which can be now possible. For example, technological difficult to impossible to achieve, depending developments (universal mobile “end on the circumstances. points” or handsets, cloud computing, big data, and so on) make it feasible to manage The existing payor business model is now chronic diseases more efficiently. being disrupted in several ways. Because the traditional model of employer-spon- On their own, the cost and productivity sored insurance is shifting toward individual 4For more detailed information about the dynamics of success- pressures would probably have been suf- offerings in an exchange setting, payors ful corporate transformation, ficient to produce major structural shifts need to build a new set of consumer- and see Scott Keller and Colin Price, Beyond Performance: within the healthcare industry. However, the retail-focused capabilities.5 They are also How Great Organizations Build Ultimate Competitive added pressure from ACA implementation facing new competitors for their chosen Advantage, Hoboken, NJ: John provides the catalyst for even more changes segments and geographies. Integrated Wiley & Sons, 2011. 5For more details about the to occur, and to occur more quickly. offerings that bundle care and payment capabilities payors will need, see Jenny Cordina, Ali Keshavarz, are threatening classic payment-focused Rohit Kumar, and Shubham Consumers may well benefit from the approaches. In addition, a raft of innova- Singhal, “Winning with con- sumers: What payors can learn innovations that healthcare disruption is apt tions that promise to do a better job helping from ‘consumer’ companies,” Beyond reform: How payors to unleash—consumers typically do when companies and consumers manage their can thrive in the new world, disruptive changes arise. Incumbents, on healthcare spending is likely to put pressure January 2014, healthcare .mckinsey.com. the other hand, often falter during on existing payor value pools. 5

Payor Book — January 2014

Exhibit title: Healthcare is vulnerable to disruption (independent of reform)

Exhibit 2 (top) of 6

EXHIBIT 2 Healthcare is vulnerable to disruption (independent of reform).

Cumulative real per capita growth in national health expenditures vs GDP, % growth since 1960

900 National health expenditures 818 800

700

600 Payor Book — January 2014 500 5X Exhibit400 title: Healthcare is vulnerable to disruption (independent of reform) 300 Exhibit 2 (bottom) of 6 200 GDP 168 100

0 1960 1970 1980 1990 2000 2010

Productivity improvement Average growth in rates,1990–2007, % employment, % Computers and semiconductors 7.6 –2.3 Internet and data processing 7.2 1.4 Telecom services and broadcasting 6.0 0.8 Retail trade 4.0 1.0 Information, other 3.8 0.9 Wholesale trade 3.5 0.5 Utilities 3.5 –1.6 Finance 3.0 1.0 Manufacturing (excluding computers) 2.5 –1.3 Transportation 2.3 1.7 Real estate and leasing 1.2 1.4 Professional and business services 0.6 2.7 Recreation, hotels, and restaurants 0.2 2.4 Mining –0.3 0.2 Other services –0.6 1.2 Education –0.7 3.0

Healthcare –0.8 3.0 Construction –2.3 2.1

Source: Bureau of Economic Analysis; Centers for Medicare and Medicaid Services; Haver Analytics; McKinsey analysis 6

If the experience of other industries that have A refocused portfolio can produce rapid re- undergone disruption is a guide, the health- sults. About 15 years ago, disruption in the care industry will see many new entrants. consumer products industry—a result of Few are likely to survive, but some of those the rise of big-box retailers, online shopping, that do may become new industry leaders if and private-label products, among other they can couple innovative business models factors—led P&G to conclude that it needed with strong operational efficiency (as South- a new strategy. The company shifted away west Airlines managed to do in the airline from commodity categories (for example, industry). Who these winners will be in food) and toward higher-margin areas that healthcare remains to be seen, but potential were more insulated from private-label prod- candidates include companies that are us- ucts, such as health and beauty. The com- ing information and insights to help patients pany knew that it had greater pricing power make more value-conscious care decisions in the latter categories, could use its innova- and companies that are making more close- tion expertise to develop new products for ly coordinated care delivery possible. those categories, and could leverage its size to bring products to market faster. P&G then Three strategies that can made several major organizational and op- help incumbents thrive erational improvements to support its new strategy. The result, over the next five years, Our research into previous industry disrup- was a 20-percent year-on-year increase in its tions suggests three broad approaches for return to shareholders. navigating disruptive change. Two challenges are inherent in this approach, Refocus your portfolio however. The most straightforward way to avoid the negative consequences of industry disrup- First, when deciding where to concentrate, tion is to shift the company’s emphasis to companies must be able to gauge the likely the customers or products that will benefit future attractiveness of various industry seg- from the disruption (or at least be insulated ments, not their current attractiveness. This from it) and to de-emphasize the areas of is a challenge many companies have gotten business that are most vulnerable. This ap- wrong. For example, when the airlines were proach can work well for a multibusiness/ deregulated, many incumbents focused on multisegment payor if the core of the com- long-haul flights (their most profitable routes) pany is still competitive, even though pieces and scaled back service to second-tier cities of it are under challenge. For example, a (service that had been subsidized under reg- payor could scale back its exposure to the ulation). However, profit margins on long-haul small-group markets that will face increased routes shrank after new entrants introduced pressure and further build its capabilities significant price competition (for example, $99 in the individual markets. Although this coast-to-coast flights). In contrast, the entrants strategy is not without risk, it could enable that focused on commuter service to second- the payor to refocus its portfolio in line with tier cities found themselves as sole providers broad market trends. on these routes and flourished economically. 7

Second, companies must be realistic able to launch its online trading site about their capabilities, because the likeli- within about a month; it also cut its prices, hood of succeeding with a refocused port­ although it charged a significant premium folio is far higher when an organization can over online-only brokers. Schwab was able build on existing strengths. This fact alone to maintain its profitability and margins makes it clear that there is no one-size- because of the added volume it obtained fits-all answer to how a payor should reshape through its new business model, the its portfolio. premium it charged relative to other online brokers, and the overall growth in the Internet For payors, greater emphasis on growth seg- brokerage market. ments in Medicare Advantage and Managed Medicaid are clear examples of refocused The biggest challenge a company that wants portfolios. Indeed, the national carriers to transform its business model faces is that appear to have placed bets on this approach new entrants often offer a “better mouse- by making major acquisitions to capture trap”—some combination of superior benefits portfolio momentum and acquire new capa- and lower cost. It is usually hard for an estab- bilities. However, many questions remain, lished organization to transform itself to the including how the nationals will develop extent and with the speed necessary to thrive these new potential profit pools and where (think about print magazines in an age of these acquisitions leave the Blues plans. digital media). The odds of success are high- er if the company can identify and exploit Transform your business model competitive advantages that others cannot A second option is to make fundamental— replicate (Schwab’s offline presence was and potentially radical—changes in the com- particularly powerful in this regard). Finally, pany’s core activities to meet the disruptive the pricing model and approach selected challenge head-on. Charles Schwab used are critical, because few decisions flow more this approach after a wave of lower-priced, quickly to the bottom line than pricing changes. Internet-only stock brokerages gained signifi- Understanding the relationships among pricing, cant market share in the late 1990s. Schwab, overall demand, and market-share changes the first major discount brokerage, had ini- is therefore crucial. In Schwab’s case, lower tially succeeded by undercutting the prices prices worked because volume was growing of traditional brick-and-mortar brokers, but rapidly, and the incremental cost of servicing the arrival of E*TRADE and other online bro- the increased volume was lower online than kers put its value proposition in jeopardy. through the company’s traditional model. In deciding how to respond, Schwab knew it had some advantages that online brokers For payors, it is not yet clear what the win- would find difficult to match. If it could rapidly ning business model(s) will be in the future develop online trading capabilities for cus- or how the transition can best be made. tomers, it could offer consumers both online Some payors are taking (or, at least, experi- and branch-network services, as well as its menting with) a “do it yourself” model by reputation for superior customer service. teaming with physicians and building new Through massive effort, the company was capabilities to manage care. Others are 8

developing more exclusive partnerships Over the past two decades, IBM has trans- with health systems or pursuing vertical formed itself in other ways. For example, it integration. Still others are implementing refocused its hardware business on high-end and refining new payment models that sup- PCs rather than mainframes; it then sold off port and reward providers for reducing the its PC business to concentrate on corporate- total cost of care. However, past experience software solutions. IBM’s ability to keep makes one thing very clear: indecision is transforming itself has enabled it to keep not an acceptable path when industries pace with several waves of change in the are undergoing disruption. A good decision rapidly evolving IT market. about a new path is required if a company wants to thrive. What is the lesson for payors that want to build a major new business? Probably the Build a major new business most important one is to follow Wayne The third option is to acquire or build a new Gretzky’s advice to “skate where the puck business that can leverage the company’s is going, not where it has been.” That is, core capabilities and grow large enough payors should develop a worldview—by to replace earnings lost from its existing understanding and developing insight around business. This may be the most challenging the key trends and uncertainties—and move of the three options. toward that future state, with real clarity around the business(es) they choose to be in. As part One company that was able to succeed with of this process, companies must decide the this approach faced a situation analogous to primary role they will play in areas such as the one confronting payors today. The advent claims processing, risk selection, underwriting of the personal computer undermined IBM’s and management, and data analytics. primary business model (one that integrated hardware, software, and intensive sales and What is needed to succeed support capabilities). In the new world, cus- tomers were using technologies from many Responding rapidly to industry disruptions different vendors, which disrupted Big Blue’s is hard. At most companies, the economic vaunted end-to-end approach. At the same constraints of operating a business at scale time, these customers found themselves hamper the ability to make changes “in having to cope with much greater complexity flight.” Many organizations are also prisoners as the number of computers and computing of their past—and the more successful that platforms within their organizations prolifer- past, the harder it usually is to make changes. ated. New CEO Lou Gerstner ignored pundits’ Furthermore, rapid responses may be suggestions to break IBM into pieces and especially challenging for healthcare compa- instead decided that the company’s best nies. Many parts of the industry are heavily move would be to build a large computer- regulated. Interactions among stakeholders services business to help customers better (payors, providers, patients, employers, and deal with the increased complexity. Within so on) are often complex. Proud professionals a decade or so, half of IBM’s revenues were everywhere have deeply grooved operating coming from that new business. models and successful track records. 9

However, the market does not care about However, the vision of the future must also the past or about any of these constraints. be grounded in an accurate understanding of Thus, payors that want to navigate disruption which market factors the company can control successfully must get in front of it quickly. and which ones are inevitable. The executives Navigating disruption effectively requires can then attempt to shape to their advantage a healthy organization,6 a solid governance the factors within their control and avoid model, and—especially—leadership. In wasting time and money on inevitabilities. each of the three corporate transformations described above, the CEO was at the center: Reallocate resources A.G. Lafley drove the strategic and organi­ Senior executives should also be willing to zational changes at P&G, Charles Schwab make significant changes in how and where personally led the charge at his company, resources are allocated. After all, a strategy and Lou Gerstner came in from the outside is only a theory until resources are allocated (RJR Nabisco) to save IBM. to it. In making the allocation, the executives should take care to ensure that they are not We believe that senior payor executives should underresourcing the new strategy. undertake four sets of actions if they want to get in front of the coming disruption. The first There is also a second danger the executives three will enable them to select and imple- should guard against: at many companies, ment a strategy. The fourth will give them the budget processes favor existing businesses economic breathing room they need to imple- over new ventures. Our research into more ment that strategy and compete effectively. than 1,600 US companies shows, for example, that about 90 percent of all capital-expenditure Shift focus allocations can be explained by the previous First, senior executives should shift their own year’s capital-expenditure allocations.8 focus. In essence, they need to take on two Although all of the companies had detailed jobs: they must run today’s business while planning and capital-expenditure-allocation creating the business of tomorrow. To do this, processes, those processes were inadver- 6For more information about how they should have a clear vision, based on tently reinforcing the status quo. to ensure organizational health, solid insights, of the future. This vision should see Gretchen Berlin, Aaron De Smet, Shubham Singhal, and include the key present and potential market Increase speed and Bryony Winn, “Health-focused redesign: Creating a payor orga- segments. Which of these segments do the capacity for change nization for the future,” Beyond executives believe will grow rapidly or become If a company is to survive industry disruption, reform: How payors can thrive in the new world, January 2014, more profitable? Which ones will shrink? senior executives must increase its speed healthcare.mckinsey.com. 7 Questions like these are crucial, because and capacity for transformation and innovation. For more information about the importance of growth, see healthy institutions need growth—growth Their ability to accomplish this will be much Mehrdad Baghai, Sven Smit, and Patrick Viguerie, The Granular- drives value, creates opportunity, and enables greater if they have a clear picture of what the ity of Growth, Hoboken, NJ: distinctiveness. Our research across sectors organization is good at and what assets can John Wiley & Sons, 2008. 8For more details about this shows that without growth, large companies be leveraged in other areas. Thus, before they research, see Stephen Hall, Dan Lovallo, and Reinier find it hard to create value after ten years finalize their decision about which strategy Musters, “How to put your and are six times more likely to exit their (or strategies) to follow, the executives should money where your strategy is,” McKinsey Quarterly, March 7 industries than other large companies are. make sure that they have a realistic under- 2012, mckinsey.com. 10

standing of their organization’s capabilities. Remember: cost reduction is not a recipe Otherwise, they risk overvaluing business for success. But in the postreform world, it building at the expense of other options. will most likely be a prerequisite for success.

The executives should also think long and . . . hard about where their existing assets can make a difference in the new world. For ex- The coming disruption is likely to significantly ample, scale may be beneficial for payors reshape the healthcare industry. Payors have that need to manage volatility or make large occupied a large and critical—but relatively investments in an IT systems migration.9 focused—role in the industry’s value chain. As the full effects of the ACA take hold, Get lean disruptive forces will begin to attack payor In the postreform world, administrative business models. Winning payors will get in efficiency will be a must-have, not a nice-to- front of these forces by aggressively moving have—and not merely because of regu­lations to refocus their portfolios around the most governing medical-loss ratios. If history is a attractive segments, successfully transform- guide, many new entrants will be much more ing their business models, and/or building efficient than incumbents are and will have significant new businesses. The opportuni- more favorable cost structures. Incumbents are ties are many, but to take advantage of them, likely to find it difficult to compete with them senior payor executives must make clear unless they have “leaned out” their operations. strategy choices and exercise the leadership required to ensure that the necessary organi- Furthermore, performance differences typi- zational changes are made. cally become much more exposed during industry disruptions. Until now, the fact that Brendan Buescher is a director in McKinsey’s there is no correlation between a payor’s Cleveland office, and Patrick Viguerie is a director in the Atlanta office. Copyright © 2014 size (by measures such as the number of McKinsey & Company. All rights reserved. lives covered) and its administrative costs has not received much scrutiny, but this situ- ation is not likely to persist.

9For more information about the benefits that scale may (or may not) offer payors, see Rohit Kumar, Shubham Singhal, and Jeris Stueland, “Bigger may not be better: Does scale matter for payors?,” Beyond reform: How payors can thrive in the new world, January 2014, healthcare .mckinsey.com.