Part 2: Verticalization in the Health Insurance Industry | Sherpas in Blue Shirts

Posted On December 15, 2011

In an earlier blog, M&A in the Insurance Industry: Is the party over, or yet to get started?, I talked extensively about horizontal consolidation in the health insurance industry. Now, let’s take a look at vertical integration, wherein up and down the value chain healthcare companies merge and the different business units within the resulting conglomerate type of organization become internal suppliers and buyers.

A prime example in today’s marketplace is Kaiser Permanente, which for years has been operating under this model. The company provides health insurance via Kaiser Foundation Health Plans (KFHP), and delivery of medical care through Permanente Medical Groups.

First, there is very little synergy in terms of primary value creation due to the disparate core focuses of the two businesses (risk management versus healthcare provision.) Second, an inherent conflict of profitability maximization interest arises from the two businesses  serving each other – the health insurance business unit is primarily incented to squeeze the most attractive pricing out of the medical services business unit, but in the opposite direction, there’s a 180 degree flip. Granted, industries such as oil & gas have been dealing with this internal pricing issue quite successfully for a long time, and it is not an impossible obstacle to overcome. But to succeed, there must be a clear decision on which of the two businesses will be the cost center, and which will be the profit center.

Against the backdrop of general public dissatisfaction with the overall cost of healthcare, many credible sources have mentioned Kaiser’s model as a potential alternative with positive qualities. The first is superior control over cost structure. In the Kaiser model, all delivery of healthcare services is squeezed into a fixed cost of running a chain of hospitals and physician offices  where majority of medical personnel consists of salaried employees. Even if this does not result in much lower comparative services costs (as some mega insurers can obtain equally good commercial conditions by exerting enormous pricing pressure), it at least provides considerably more cost transparency and predictability, allowing for much more accurate decisions on selective growth initiatives. Additionally, the internal nature of transactions allows elimination of costly activities such as rate negotiations, reimbursement management, pre-approvals, and litigation, as well as other processes associated with conducting business between independent entities. Finally, vertically integrated companies can exploit some economies of scale by consolidating various back-office functions such as HR and IT. And given how IT-intensive healthcare has become in recent years due to the need for implementation of various capital intensive projects to establish electronic medical records and health information exchanges, these economies of scale are especially attractive.

Not surprisingly, all these considerations have triggered some discussions and investigations of existing opportunities in the industry. Case in point: Highmark’s acquisition earlier this year of of West Penn Allegheny hospitals. This is a very aggressive, “stand out from the crowd” move, given the multi-billion dollar scale of operations of both involved parties. And it raises the question of whether we should expect a series of similar deals from other industry players  trying to optimize their cost structures in the current ambiguous business environment resulting from President’s Obama healthcare reform. Obviously, this is a difficult question to answer, in part due to the controversial nature of the model, but primarily because very few healthcare providers operate on a national level, while large health insurance businesses typically do.

Think about it: Highmark’s acquisition of West Penn Allegheny will allow it to provide healthcare services to roughly three million of its five million existing members, so it will have to maintain a dual delivery model (i.e., based on both external and internal delivery), which drives additional governance cost. To completely switch to a fully internal delivery model, most large insurance companies would have to conduct multiple acquisitions, practically one deal per region, resulting in ownership of an extremely diverse set of assets, thereby requiring enormous integration and standardization effort. This is the primary obstacle for massive replication of the Kaiser model.

I believe any vertical integration in the nearest future will remain limited to a regional type of play, wherein some locally existing benefits justify an insurer’s move down the value chain. What do you think?

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