The quirky incentives that have made US healthcare sick

And how we can innovate in spite of them.

The first step to fixing the healthcare system in the United States is fixing the underlying incentives. As Charlie Munger said, “Show me an incentive and I will show you an outcome.” And the outcome in the United States is expensive healthcare.

In 2014, the US spent 17.1% of the GDP on healthcare, the most out of any country in the world and 43% more than the 2nd industrialized country on the list. Even with these exorbitant costs, the US has the lowest life expectancy, the highest infant mortality and the highest obesity rate out of 13 similarly industrialized countries. Clearly, we have a problem. But that’s not news to anyone. What is news is illuminating the opaque incentives that got us here.

The financial incentives in healthcare should reward companies that can provide the highest quality of care[1] at the lowest cost. Unfortunately, that’s just not happening. In fact, there’s an entire cemetery of great products that improve patient care, but die off because they can’t get the financials to make sense.

Incentives are the culprit, but health insurance companies are the enforcers. In other industries, consumers have direct purchasing power. This makes certain that the consumers’ needs are met. In healthcare, consumers relinquish most of their purchasing power to insurance companies. This allows insurance companies to put their needs before those of the consumer. (See side note 1.)

After aggregating purchasing power from consumers, insurance companies have overwhelming control of the healthcare system. Instead of the consumer, it’s now insurers that negotiate prices with providers for existing health services. And it’s insurers that now determine which novel health services consumers should have access to.

Now, this would not be a serious problem if the incentives of the insurer and consumer were the same. Intuitively, it seems they both want affordable, quality care [1]. However, insurers have significant competing incentives to offer the exact opposite.

Insurers are incentivized to increase the cost of medical care over time. To understand the state of today’s healthcare system, we have to understand these quirky incentives. Let’s dig into them.

1. The 80/20 Rule

The 80/20 rule (or medical-loss ratio) is a government regulation that limits insurers’ profits. This sounds good, until we take a deeper look. With the 80/20 rule, insurers can at most keep 20% of the money they collect from consumer premiums for profit and administrative costs (e.g. salaries). So, if insurers want to increase profits, they need to increase the total amount of premiums collected. However, they cannot just increase premiums since insurers need to maintain competitive premium rates as compared to other insurance companies.

The solution is allowing the cost of care to increase. If the cost of care increases similarly for all insurers (as it will), then all insurers can raise premiums, and still remain competitive. To sum it up, medical care costs go up, premiums go up, and profits go up (since insurer’s keep 20% of a bigger pie). (See side note 2.)

This is a low-risk way for insurers to make more money, and insurers are low risk! In fact, they are so low risk that every time I have had a meeting with an insurance company, they give me a pamphlet outlining their building’s evacuation procedures in case something happens while I’m in there.

2. Insurers Are Investment Funds

As soon as you pay your premium, insurers will invest most of the money into stocks and bonds. They are an investment fund, and make a significant portion of their profits from the interest earned on investing. As the medical costs increase, insurers can amass a larger war chest to invest. The interest made through these investments do not count towards 80/20 rule. Insurers are free to make as much as they can through investments.

3. Fees from Self-Insured Employers

Today, many companies insure their employees’ themselves. These are called self-insured employers, and they do not pay premiums to insurers — they just cover the cost of care for their employees themselves. In 2014, 61% of all insured workers were in a self-insured plan. That percentage grows every year. Private insurance companies manage the paperwork for these self-insured employers on the back-end, and receive a percentage in fees based on the employer’s total medical cost. So, once again, the higher the cost of medical care, the more money the insurance company makes.

It’s a pattern! And the pattern is that insurers are consistently incentivized to increase the cost of medical care. Since insurers wield the purchasing and decision-making power on behalf of consumers, medical costs do consistently increase over time. In fact, we have seen hyperinflation of healthcare costs in the United States, more than 100% faster than general inflation (based on the consumer price index).

To be clear, all the people I have met working at insurance companies are good people with good intentions. They are not making conscious decisions to increase the cost of care. They don’t have to. The incentives are making those decisions for them.

The issue with all this is that current incentives make it incredibly difficult to fix some of the most important problems in healthcare. Two of these problems are the high cost and poor quality of care. With the wrong incentives, even the most brilliant innovators, dedicating their lives to improving healthcare only really succeed in optimizing the existing system.[3]

It’s noble to strive to improve the quality of care while pushing down the cost. But, the incentives are stacked against you. And, incentives are king.

So, how can you work on the most important problems in healthcare?[4] The key is to break free from the rule of the existing incentive structures. Here are 3 ways to get incentives more aligned.

1. Build Your Own Insurance Company

Build an insurance company from the ground up that proactively aligns its incentives to delivering affordable, quality care. Now, that’s easy to say and hard to do, especially after the whole monologue about incentives. But, it can be done. The way to accomplish this is to maximize profits not by increasing premiums but by attracting the most consumers. And you do this by delivering the most affordable, quality care.

Here’s the breakdown. Insurers can only keep 20% of premiums, so they maximize profits by maximizing the total premiums they collect. To do this, insurers either need to increase premiums paid by each customer or increase the total number of customers. The key is being laser focused on increasing the number of customers over just increasing premiums. The benefit is that by focusing on attracting more customers the insurance company can focus on 1) low premiums and 2) high quality care. That’s what customers actually care about. By focusing on increasing the total number of customers, the new insurance company’s incentives are better aligned with the customer.

Incumbent insurance companies haven’t aggressively pursued this strategy many reasons, including: 1) they are risk averse (see note 3), 2) they have an easier way to increase profits by increasing cost-of-care, 3) they are behemoth organizations that don’t have innovation in their DNA, etc.

It will be difficult for the new insurer to improve on cost/quality immediately because the cost/quality of much of the care is determined by providers outside of the insurer’s control. So, to deliver on its promises, the new insurer will need to provide care directly to its customers. For instance, they can provide preventative services (like health coaches) that reduces cost and experience services (like health concierges) that improve satisfaction. Of course, these care services needed to be technology-enabled to make them cost effective for the insurer.

The best starting point for the new insurer is with consumers that have Medicare Advantage. Since Medicare Advantage covers people 65+, they are on-average sicker, with more chronic issues.

As a new-age insurer, caring for sicker customers actually give them an advantage because: 1) the patients provide more data faster (e.g. letting the insurer develop algorithms to identify and treat people sooner), 2) they interact more often with the healthcare system, so there is a better feedback loop from quality outcomes and experiences to other potential customers, 3) a large portion have chronic disease, which can be treated with new age digital health tools and behavior change. Huge shout out to Devoted Health; they seem to be going for this approach!

This option has some serious obstacles, though. First, the approach requires significant capital. Second, even if the capital is acquired by the startup, there is significant risk in the execution: from actually being able to deliver on reduced premiums to actually attracting enough customers. Just because a new insurance company tries, doesn’t mean that it will be able to shake off the old incentives and patterns. But, they will have a much better chance than today’s behemoths.

2. Direct-to-Consumer

Bypass the insurer completely, and sell your services directly to the consumer. Consumers want high quality care at an affordable price, so your incentives as a startup are aligned. Certain demographics are more willing to pay out-of-pocket for their healthcare (think the financially-secure and health-conscious demographic). Direct-to-consumer works best for companies focused on conditions more prevalent within this demographic, like fertility, pregnancy, IBS, general prevention, etc. Unfortunately, some of the most important problems in healthcare are prevalent in the demographics least likely to pay out-of-pocket: financially insecure individuals with chronic health conditions. If you are focusing on those problems, explore having the family/friends of the patient as the economic buyer of your product.

Another option is to sell to consumers directly outside of the US healthcare ecosystem. For example, in India, the consumer holds much move of the purchasing power than in the United States, and so the direct-to-consumer approach can be easier.

3. Self-Insured Employers

Self-insured employers are actually mini-insurance companies that also pay their own premiums. Since self-insured employers directly pay for their employees’ healthcare, they are incentivized to provide quality care at a low cost (including investing in preventative healthcare).

Over the past years, the self-insurer trend has only been growing, even moving towards smaller and smaller companies. An advantage for innovators is being able to sell their value-added services to many nimble organizations instead of a single behemoth healthcare organization (like UnitedHealth or Aetna).

Today, self-insured employers hire major insurance companies to manage the back-end paper-work. I think there’s still opportunities for startups to cut out the insurers completely by providing a service that: 1) handles the back-end paper-work, and 2) provides vetted care services to the employer, reducing their healthcare costs (e.g. Collective Health).

Misaligned incentives stifle innovation in healthcare. By correctly aligning incentives, healthcare startups will be finally empowered to focus on some of the biggest problems in healthcare[5]. Companies that have the right incentives in healthcare will become healthcare powerhouses as the market adjusts to recognize these companies’ tangible value, especially within today’s gigantic void. More importantly, these companies will gradually pull the entire healthcare system in the United States towards better, more affordable healthcare. Let’s get started.

Side Note 1: Don’t consumers hold real power in the healthcare system by picking the insurer that best represents their needs?

Not really. Theoretically, consumers (either individuals or employers) pick insurers based on the insurers ability to provide affordable, quality care. If this were true, insurers would be more incentivized to provide affordable, quality care. Practically, consumers are not able to make an effective decision based on the affordability and quality of care because 1) insurers are too opaque, 2) the feedback loops are too slow, 3) the offerings between insurers are too similar, etc. Thus, insurers still set the incentives for the healthcare system on behalf of the consumer.

Side Note 2: Can’t insurance companies maximize profit by increasing the total amount of premiums they collect by insuring more people?

In the ideal world, yes. That is one of the goals of the 80/20 rule, and it’s one of my proposed solutions. However, today’s insurers have not stepped up to compete by providing better services at lower costs. To accomplish this, they really would need to innovate: innovate to revamp their customer experience, innovate improve health outcomes and innovate reduce healthcare costs. And, innovation is not in their DNA — see side note 3.

Side Note 3: Why are insurance companies so risk averse, and decide to not innovate more/faster?

Many reasons. Here is one important reason. Insurers need to accurately estimate the aggregate health costs of their customers. This is a critical part of the insurance business. Actuaries accomplish this risk analysis based on the data from previous years. To get the best estimates, actuaries want as much consistency from year to year as possible. Adding in a novel treatment introduces a novel variable that has a less predictable cost/benefit trade-off. This is one of the reasons insurance companies are risk-averse, and less incentivized to innovate. Of course, if there is a predictable cost increase, that’s completely fine.

Side Note 4: Why focus on insurance companies? They are not the only issue in healthcare.

Insurers are not the only issue, but they have the most power to push healthcare in the right direction. The 3 major stakeholders in healthcare are payers, providers and patients. All the stakeholders contribute to the state of today’s healthcare system. However, insurers have the most direct power to actually influence the state of the healthcare system. And, insurers are the mediators between the provider and patient. So, it’s easy to see insurers on top of the pyramid, and focus our attention on them. With that said, the issues in healthcare are too complex and interrelated for a single stakeholder to be the solution to all problems.

[1] For the purpose of this article, quality of care is measured in patient outcomes and patient experience.

[2] For the purpose of this article, quality of care is measured in patient outcomes and patient experience.

[3] To be clear, optimizing the efficiency of today’s healthcare system is both worthwhile and necessary (in many cases). However, there are some significant and fundamental issues in healthcare that cannot be fixed by just improving the efficiency of today’s system. We should try to achieve a more global optimum instead of just local optima.

[4] The US government can change the incentives for private insurance companies, and can also change the entire incentive structure for healthcare. Unfortunately, we cannot always count on the government.

[5] In fact, many of the successful healthcare startups of recent years use the above incentives: from Omada to Pill Pack to One Medical.