And Now for the Real Health-Care Reform

Are you ready for private health-insurance exchanges?

Some of the biggest employers in the U.S.? AT&T, DuPont, General Electric, IBM, Time Warner, and Walgreen ?have started to shift the management of health-care costs onto their employees. Increasingly, workers must use so-called private health-care exchanges, self-directed marketplaces in which they can select their coverage and pay for it via a contribution from their employer. While small and midsize companies have used such exchanges for years, the giants of Corporate America have only begun to embrace the model in the past year or so as health-care reform has taken hold.

Scott Pollack for Barron's

"Health insurance in the U.S. is at the cusp of a major transition from an employer-driven payor model to a model directly involving many more employees and consumers," according to Booz & Co. consultants.

About half of all Americans, roughly 165 million people, receive health insurance sponsored by their employers. Shifting workers and their families to private exchanges amounts to the biggest change in the delivery and purchase of health benefits in the post-World War II era.

ASIDE FROM TRYING TO control spiraling health-care costs, other factors are driving big companies' interest in private health-insurance exchanges. Looming government tax penalties on high-cost "Cadillac" plans, as imposed by President Obama's Patient Protection and Affordable Care Act of 2010, are a big impetus: Come 2018, companies will be taxed at a 40% rate for benefits paid to individuals in excess of $10,200 and for families, above a threshold of $27,500. Online technologies are also making private exchanges more feasible. Moreover, high unemployment is proving to be a catalyst, as companies have more clout to make such decisions and less worry about pushback from employees and unions.

One in four employers is considering switching to a private exchange in the next three to five years, according to management consultant Accenture. It is expected that by 2017, one in five Americans, or 18% of the population, will be buying benefits in this way. From the one million to two million employees estimated to be using private health-care exchanges today, consultants forecast the number could jump to 30 million to 40 million by 2018. Employees will get more choices under these plans, but they are also likely to pay more and receive fewer overall benefits.

Although the transition is still in its early stages, benefits consultants have by far the most to gain from the shift to private exchanges. Firms like Aon Hewitt, a unit of Aon (ticker: AON) and Towers Watson (TW), among others, already have well-established relationships with the human-relations departments at many big companies; they could see their businesses greatly expand as millions more people move onto the exchanges they design and manage.

Long-term earnings growth for benefits consultants is estimated at about 11%, but the advent of private exchanges "will increase that dramatically," predicts Quoc Tran, a managing director and portfolio manager at Lateef Investment Management in Greenbrae, Calif. "The genie is out of the bottle," he declares.

On the other hand, incumbents of the existing system, such as pharmacy-benefit manager Express Scripts Holding (ESRX) and CVS Caremark (CVS) and managed-care companies such as Aetna (AET) and UnitedHealth Group (UNH) will experience more competition.

LARGELY OVERSHADOWED BY all the political haggling about public exchanges and insuring the uninsured (in the news again last week when the March 31 deadline for open enrollment in Obamacare was extended), private exchanges promise an even bigger transformation of health care, akin to the switch from defined-benefit retirement plans to defined-contribution retirement plans, such as 401(k)s, in the 1980s and early 1990s.

"It's not as well-known [as the public exchanges] because it's an employer-sponsored event and not as visible, day to day," says Richard Birhanzel, a consultant at Accenture.

For years, companies have attempted to hold down health-care costs by whittling away the amount of benefits they offer and requiring employees to pay a bigger chunk. Many new hires don't qualify for retirement benefits, and benefits are capped for those that do. But the new system will be different: Companies will no longer administer the plans, engaging instead with third-party consultants like Aon or Towers Watson to design and manage the exchanges, which will offer coverage options from a variety of insurers.

Typically, in an exchange model, companies make a cash contribution to their employees, who then choose among plans and options on an electronic exchange. As with 401(k)s, it becomes the responsibility of the employee to make the best choices and, in many instances, to cope with increases in premiums. It's a far cry from the traditional system in which a company administers group coverage by selecting an insurance carrier, determines the types of plans that will be offered, and then negotiates rates for a defined package of medical benefits for its employees, establishing deductibles and co-payment fees.

CALL THE OPPORTUNITY for benefits consultants large but uncharted. Morgan Stanley analysts are among those who find parallels with the development of 401(k)s in the early 1980s: Within five years of their debut, these plans accounted for 16% of the retirement market.

Benefits consultants typically receive a fee of, say, $200 to $250 per employee, plus a payment for administering the exchange. Those fees are sure to rise as interest rates climb. And the sheer number of people expected to be enrolled will lead to dramatic growth at these companies.

Aside from Aon and Towers Watson, the other leading competitor is Mercer, part of Marsh & McLennan (MMC). Towers Watson is the purest play and, as the smallest of the pack, with an $8 billion valuation, is the most highly leveraged to the trend (Aon has a market value of $25 billion, and Marsh & McLennan, $26 billion). Each of the top three?Towers, Aon, and Marsh?boast about a one-third share of the market. As a result, the growth of enrollees will have the biggest effect on Towers Watson. A fourth rival is Buck Consultants, a unit of Xerox (XRX).

Investors are starting to notice. Since September, when IBM, the nation's fourth-largest employer, announced that it would place its Medicare-eligible retirees on a private-health exchange, a wave of similar announcements has come from big companies. And the stocks of the benefits consultants have outperformed the overall market.

In contrast, the advent of private exchanges has weighed on pharmacy-benefit managers such as

Express Scripts Holding and CVS Caremark, and managed-care providers, including not just Aetna, but UnitedHealth Group, and Cigna (CI). In addition to added competition from private exchanges, they will have to cope with a new environment in which health care is no longer a business-t-business transaction, but rather a business-to-consumer one. There could be pressure on prices and margins, as well as increased administrative costs. The change will also affect these companies' relationship with customers.

In February, to combat the threat, Cigna launched its own proprietary private exchanges, available in certain cities to workers at companies for which it already provides insurance benefits and for which the only carrier option will be Cigna. The insurer, however, is providing more medicalcoverage choices than is typical in a traditional employer-sponsored plan.

Life insurers, including the likes of MetLife (MET) and Unum Group (UNM), could gain by selling ancillary benefits?supplemental health, disability, and even pet insurance?to employees who opt for lower coverage levels and lower premiums that leave them with extra money in their accounts. Indeed, this highlights one of the risks inherent in this new model: Employees might make poor choices that will leave them vulnerable.

DESPITE THE POWERFUL momentum driving the private-exchange model, widespread adoption by companies is not a given. Companies want to be assured that any savings from switching platforms outweigh the costs. There are advantages to the current model because spending on insurance premiums reaps tax benefits for employers. Also, medical benefits are still seen as a key tool in recruiting talent, and many companies want to retain a role in managing that benefit. They still can keep costs down by increasing co-pay amounts and raising deductibles.

As a result, most companies are tiptoeing into this brave new world of private exchanges by transferring their Medicare-eligible retiree populations first, testing the waters before moving their active employees. Some retirees are unaware they're being rolled onto a private exchange, only that their former employer is modifying their program again.

Walter Reed, a 71-year-old DuPont retiree now living in Deer Isle, Maine, received a notice that Extend Health, a Towers Watson exchange for retirees, would be managing his medical benefits. He worked with its representatives to try to duplicate his former coverage for about the same price. To achieve that goal, he was switched to Blue Cross/Blue Shield from Aetna, pays a slightly higher premium, and lost his dental coverage.

He had no idea that he was now on a private exchange. DuPont makes a contribution to Extend Health on his behalf, and he also is billed by Extend every month. "When I first retired, it was all free," says the former agricultural chemist. "Every year, they pay a little less and I pay a little more.

But as long as I have decent health care at a reasonable price, I am happy."

Other companies, particularly retailers with lower-paid workforces and high employee turnover rates, have jumped in with both feet, transferring active workers, as well as retirees, to private exchanges. Drugstore chain giant Walgreen (WAG) is the biggest company to do so, but Sears Holdings (SHLD) and Darden Restaurants (DRI) have also gone this route.

Walgreen, based in Deerfield, Ill., decided to move all its employees to a private health exchange as a way to combat health-care inflation and to offer more choice in coverage to its diverse workforce of 250,000, of whom 160,000 are eligible for medical benefits. Of that group, 36% are single and under age 30. They have different coverage requirements than those married with families.

"WHILE WE DO ANTICIPATE health-care costs continuing to increase in the future, we believe that one of the advantages of moving to an exchange is that costs will increase at a slower rate," says Michael Polzin, a Walgreen spokesman. "We anticipate spending the same on health care this year as we did last year. But had we not made the move to an exchange, we would have seen a cost increase this year. However, our intent is to continue paying the same ratio of total health-care costs going forward, so, as overall costs increase, we would expect our contribution to our employees to also go up."

Walgreen previously had self-insured its health coverage, and offered its employees two plans provided by two different carriers. In its new private exchange, managed by Aon Hewitt, Walgreen moves to a fully insured model for the first time, paying the broker a per-employee premium and transferring the risk to the insurer. Employees in each of Walgreen's 21 geographic regions will have access to five plan options provided by five carriers. Walgreen says the majority of its workers like being able to choose their carrier.

Bryce Williams, a co-founder of Extend Health, the leader in managing exchanges for Medicareeligible retirees that was acquired by Towers Watson in 2012, says that in the early days of these private exchanges, many assumed they were for struggling companies. That was particularly true after Chrysler, Ford Motor (F), and General Motors (GM), faced with solvency issues, moved their retirees onto the exchanges during the credit crisis.

Now the exchanges are viewed as a tool for financially fit companies to stay that way.

"You can see why exchanges for active employees are the next big thing," says Williams. The investors who have driven up the shares of the benefit providers already have.?

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