Last month Oscar Health Insurance raised a $375M strategic investment from Alphabet, uncovered in an incredibly thorough interview. This immediately raised questions about the round size, valuation, sustainability, and growth strategy.
Naturally, Oscar’s round size and corresponding valuation (and lack thereof) received the most attention.
First, the round size. Oscar’s business model and strategy necessitated massive capitalization for two reasons:
- Nature of the business: As an insurance company, Oscar has to follow state regulations that mandate that insurers maintain a minimum cash pool to cover their internal operations (to avoid leaving people uninsured if they shut down). Given the size of their latest round, continuing to maintain cash reserves from venture financing is likely unsustainable and will require that they turn an operating profit by next year.
- Strategy: Oscar deployed significant capex building their in-house claims processing infrastructure, which likely ran near-term free cash flow into the ground with the goal of reducing long-term SG&A.
Second, valuation. Making a few assumptions below:
- After the latest funding round, the company is valued at ~$4B.
- Oscar meets its 2018 revenue target of $1B.
- Ends the year with an MLR of 80% (74% as of July 2018, which will increase as their members spend through their deductibles for the second half of the year).
- SG&A of 15% (assume lower than the industry average of 18% because of the company’s in-house claims processing unit, lowering labor spend).
Oscar would turn an EBITDA of $50M and have a P/E ratio of 80x. In comparison, Anthem, Cigna, Aetna, and UnitedHealth are all currently trading at 16–24x P/E ratios.
However, like many of the above insurers, Oscar has been thinking beyond traditional health insurance and towards vertical integration. As an insurer built as a technology company with rapid user growth and exceptional customer experience, Oscar has the ability to backwards integrate into the supply (provider) side without the burden of traditional fixed costs and completely dominate an otherwise crowded next-generation primary care market.
Three converging industry trends make winner-take-all market dynamics in primary care uniquely possible:
- Hospitals are shuttering and competition for patients vs. urgent care, retail clinics, and microhospitals is becoming more fierce.
- A higher percentage of employers and insurers are opting for narrow, selective provider networks due to rising premium expenses.
- Consumers are becoming increasingly comfortable with virtual interactions with the health care system, giving Oscar a frictionless distribution channel for health services and ownership of the front door to health care.
Will Oscar’s membership continue to grow 2–3x year over year? Will their technology bring health care costs down? Is it enough to compete with incumbent M&A activity? I looked into Oscar’s technology stack as part of the health insurance value chain, their corporate strategy, and why, in the face of current provider market forces, a vertical integration model could create tech-industry-type aggregation theory dynamics in an otherwise overcapitalized and well-distributed next-generation primary care market.
TABLE OF CONTENTS:
- The Value Chain in Health Insurance
- Overcapitalization of Health Services
- Scaling Virtual Primary Care
- Aggregation Theory
- Cash Flow?
The Value Chain of Health Insurance:
Let’s start with defining the value chain for the health care services industry. Like a traditional consumer market, the chain is divided into three parts:
- Suppliers (health care organizations, providers)
- Distributors (insurance companies, self-insured employers)
- Consumers (members, patients)
The road to outsized profitability in health care is forked: either build a horizontal monopoly (i.e. hospital consolidation, insurer M&A), or integrate forward or backward to control two of the three elements of the value chain (e.g. integrated delivery networks).
In 2011, the Affordable Care Act’s medical loss ratio (MLR) requirement—that insurers must spend between 80–85% of their revenue on medical services — squeezed margins for insurance companies, which began to balloon revenue for providers (It’s the prices, stupid).
Because this creates a perverse incentive where higher hospital prices result in higher total profits for insurers via higher premiums passed down to consumers, insurance companies have no true financial incentive to keep costs down.
Insurers are instead working to capture revenue by integrating backwards into the provider side, where revenue has expanded. Insurers can either sell services or technology products to providers or become providers themselves. UnitedHealth and Humana have been actively buying up independent physician practices and networks.
Oscar has been quickly aggregating demand to compete, with membership growth between 2–3x per year since 2014.
Important to note that their numbers are still incredibly small relative to UnitedHealth and Anthem, which have tens of millions of members each. That being said, Oscar’s serviceable market continues to grow as more employers either opt for selective, narrow networks or self-insure (ASO). Oscar’s tech stack can make the case that the company can, in given markets, make more intelligent, data-driven decisions about which high-value providers and services to include per geographic area relative to employers considering self-insurance — more on that process in the next section.
Given the speed of Oscar’s growth rate and their relative nascence in the health insurance market, what’s amazing about the business is the way the company’s margins have changed as their membership has increased.
As an insurance business, Oscar’s operating profit, which is based entirely on effective calculation of premiums, showed higher gross margins as its number of members increased. Either Oscar was incredibly lucky with their member selection OR their data scientists are effectively steering patients towards the right care and building selective networks that reduce high costs. Their engagement numbers make me think it’s the latter.
Overcapitalization of Health Services
Health services in 2018 is an incredibly frothy market. One Medical recently raised $350M from the Carlyle Group, which includes Carlyle buying out approximately $130M worth of shares from existing investors. Paladina Health raised $165M from New Enterprise Associates after the fund bought the company’s network of 53 primary care practices for $100M earlier this year, and Iora Health raised $100M in follow-on financing earlier this year.
However, despite consumer and market trends in health care shifting dramatically towards decentralization and unbundling of services, user experience, and higher out-of-pocket costs, most next-generation primary care startups have not fundamentally changed their model of care in the last five years, and their unit economics don’t scale to what venture-backed businesses need.
First, a benchmark: 2016 primary care spend data from Oregon shows a commercial spend of $44 PMPM. In contrast, Medicare Advantage primary care spend was $83 PMPM.
Based on some assumptions on traditional fixed costs in primary care clinics and a patient volume of 4,500, the juice might not be worth the squeeze for next-generation primary care models, which have an estimated PMPM cost of $54.19 just to break even.
Scaling Virtual Primary Care
Oscar, like Sherpaa Health, designed a virtualist model to deliver primary care services. Virtualists are primary care physicians who interact with Oscar members primarily through video or asynchronous messaging. As per Oscar’s marketing materials, their virtualists currently do the following:
- View health histories and answer questions about plan benefits.
- Instantly schedule appointments on members’ behalf with our direct scheduling integrations.
- View drug formularies in member plans and prescribe drugs.
- Refer members to specialists.
63% of Oscar member’s interactions with the health care system are virtual, i.e. they happen without an in-person visit. 41% of members are monthly active users. Compare that with telemedicine market leader Teladoc, where only 2–3% of its members use the service annually (~1.1M total Teladoc visits in 2017). 25% of Oscar members use telemedicine (vs. 3% for employer-sponsored insurance). These engagement numbers allow Oscar to maintain the same type of customer experience that a patient might have with a next-generation Primary Care clinic like One Medical, but with potential stronger unit economics, i.e. lower fixed costs, positive margins, and a larger panel size per provider.
Most importantly, 43% of member’s first visits to the doctor are routed algorithmically through Oscar’s Care Router. Their own strategy makes it obvious:
Due to our high member engagement, Oscar is best positioned to drive higher utilization of lower-cost virtual care as a substitute for visits to doctor’s offices, emergency rooms, and urgent care clinics.
Virtual primary care as a front door to health care also offers less friction for users versus visiting either a retail clinic (CVS, Walgreens) or urgent care (UnitedHealth).
A next step for Oscar would be backwards integration into the supply-side by expanding their brick and mortar presence, but altering their operating model to augment their virtual primary care offering. They currently have a single clinic in Brooklyn, which to date has traditional primary care unit economics. Consumer survey data illustrates a synergistic relationship of user experience between virtual and in-person visits. Expanding their physician presence will help Oscar both capture patients that do need care in an office and make the virtual PCP offering more attractive to potential members, while transitioning to larger panel sizes per PCP given the company’s existing Concierge infrastructure.
Oscar’s user experience and engagement has allowed them to aggregate loyal customers (members) and use their utilization data to figure out which suppliers (providers) they want to retain in their selective narrow networks, akin to Ben Thompson’s aggregation theory.
As hospitals continue to struggle with emerging competition at retail clinics and urgent care centers, they view Oscar (aggregator) as an entrypoint to capture users with whom Oscar has an ‘exclusive’ relationship due to their virtual primary care offering. For example, Oscar’s “Provider Partner Program” incentivizes providers to become Oscar brand ambassadors. In return, the percentage of a doctor’s panel occupied by Oscar members increases.
Oscar aggregates hospital specialty services and selectively chooses the best-value offerings for its own network — applying the Walmart Centers of Excellence self-insurance model at scale. This in turn improves their member experience, stimulating a cycle of member and subsequent supplier growth. It’s a classic network effects business that competes on user experience. This is the same dynamic that made Facebook, Netflix, Uber, and Google quickly valuable.
Whoever owns the front door (entrypoint) to health care has leverage over providers (suppliers), who depend on insurance as a distributional force to bring business to health services. Oscar’s bet is that virtual primary care will outcompete both traditional primary care and emerging trends in retail and urgent care in competing for customers. As a technology company built on providing a consumer friendly brand, excellent user experience, and an innate incentive to optimize for customer lifetime value, they could, once their consumer volume becomes dominant, effectively compete with incumbent insurers in new markets. Suddenly the P/E ratio closer to Amazon or Netflix rather than traditional health insurance ratios makes a little more sense.
Will they have the capital to make this happen?
As mentioned near the top, insurance is highly capital intensive and prone to easy, but drastic, missteps. Constant venture funding is distracting to corporate leadership, highly variable, and can steer company strategy in different directions given fund timelines and investor liquidation needs.
That being said, there are a few reasons why I think Oscar might be able to swing positive cash flows from operations in the next few years:
- Medicare Advantage (MA):
No question that their plan to sell MA plans starting in 2020 bolsters the company financially. MA plans pay out more per-member-per-month vs. traditional insurance, there will be 10,000 baby boomers turning 65 every day for the next ten years, and there’s more freedom to experiment with plan design with new CMS reimbursements for supplemental benefits.This makes a higher fraction of spending and attention on primary care under MA plans both a more compelling investment for insurers and a better opportunity to show reductions in long-term costs.
Oscar has already proved that they can leverage their tech stack to steer patients towards lower-cost care. This is amplified by the MA population’s needs and CMMI’s rollout of value-based insurance design (VBID) models nationwide. As I’ve written before:
VBID plans could be modified to target individuals with specific diagnoses (e.g. reduced copayments for beta-blockers for CHF patients) or those living in particular geographic regions. In theory, this could also function to reduce long-term costs by incentivizing people to use the care most likely to improve their long-term health.
These systems will be more costly to implement due to the need for cooperation and transfer of eligibility data between payers and the point of care. This is why existing VBID initiatives have been limited to conditions like diabetes, where it’s easier to ascertain condition status simply from medications taken. Obtaining integrated claims data would be ideal here and help create in-house VBID plans across different disease areas.
The bottleneck and solution bolded above is exactly why Oscar’s entrance into the health care value chain as a payer has poised them to capture this market. Their customer-facing concierge support and routing towards higher value care informed by an in-house claims processing unit not only reduces immediate health care spending via rerouting, but also intelligently informs future benefits design.
2. The Flatiron Strategy
Both Oscar’s Concierge service and virtual PCP system contain communications and triage data absent from every other stakeholder in the value chain.
Oscar is playing the Flatiron Health game. Meticulously structured insurance claims data correlated to patient-reported behavior, biometrics, and communications with providers could be a gold mine for both pharma and tech companies breaking into health care (e.g. Apple, Verily, Amazon) and an alternative revenue stream and/or joint venture opportunity for Oscar. In particular, while the scale is small at the moment, that combination would be awfully useful to augment Google/Verily’s Project Baseline.
By scaling virtual primary care and Concierge services over a system built on excellent UX, Oscar has fundamentally designed the same gatekeeper model and narrow networks that made HMO’s successful at cost control in the 1990s without the corresponding consumer backlash that sunk them.
If Oscar continues to gain market share at current rates, incumbents may soon face the danger that they’ll have to compete on quality and user experience over price alone, and if Oscar’s tech stack can already figure out which network is optimally-priced to a region or group of employees, that dynamic might already be here.
As always, hoping to continue the conversation with interested readers. Reach out on twitter @nxpatel. I’d love to hear your thoughts.
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