Now that the Medicare Modernization and Improvement Act of 2003 is in force, large US health insurers are eagerly competing to sign up current retirees for new Medicare products, including the Part D drug benefit and a revamped Medicare Advantage program.¹ The market is a sizable one: in 2006, Medicare products sold to current retirees could generate $150 billion in revenues and as much as $8 billion in profits for health insurers. The annual profits will probably at least double by 2014. But there's an even more promising opportunity for insurers: future retirees—notably a large number of aging baby boomers—face drastically increased out-of-pocket health care bills because of a significant reduction in employer-funded benefits, greater longevity, and ever-rising medical expenses (Exhibit 1).

Products to help retirees plan for and manage that spending could generate an estimated $80 billion in revenues and $12 billion in profits for health insurers and other financial institutions by 2014 (Exhibit 2). That might lift the revenues and profits of a single leading health insurer by as much as $10 billion and $1 billion a year, respectively. And this kind of retiree business has the advantage of being relatively independent of government-funded programs such as Medicare, for which elected officials can reimburse insurers at lower rates and therefore shrink their profits.

In part because the evolving needs of future retirees are new to health insurers, few of them have so far moved to grasp this new opportunity. They must now do so—and urgently. The baby boomers will soon have to start making decisions about how to pay for their health care in retirement, since many of them won't have the luxury of company-funded health care plans to supplement Medicare. McKinsey research shows that preretirees worry about how to pay for their health care and that these concerns will drive them to solidify their financial plans five to ten years before they actually retire. So far, however, they have been stymied by a dearth of quality advice about how to plan for health care in retirement—including realistic estimates of the total costs they might face. Our research indicates that preretirees are three times as likely as people who are already retired to seek out financial advice and twice as likely to express interest in purchasing products that mitigate risks related to health care costs. The largest number of baby boomers will reach 65 (the age when the retiree businesses of health insurers typically focus on consumers) in 2012 and 2013. But these boomers could begin to lock in their purchase decisions as early as 2007.

Given the insurance and managed-care experience of leading health insurers, they should be in a strong position to tap into the demand for retirement health care advice and solutions—particularly if they have invested heavily in new Medicare programs. Nevertheless, many health insurers lack the product, consumer advice, and distribution capabilities needed to get the most from this market. They should be concerned that financial-services companies have taken an early lead in establishing themselves as retirement specialists in the minds of consumers.² To repel the competition and make the most of this growth opportunity, health insurers can't be complacent. They must move urgently to design thoughtful new products that help baby boomers pay for health care in retirement and then build customer service and distribution systems to reach the market effectively.

The challenge

One of the top three concerns that preretirees cite is the management of risks related to health care expenses (Exhibit 3). Although awareness of this issue is rising, many preretirees don't fully understand the risks and their potential financial consequences. Two-thirds of preretirees believe, for example, that employers will provide health care coverage in retirement. In reality, only 30 percent of all retirees now have employer-provided health care coverage, and most employers plan to cut back or eliminate these programs in the near future.

Other baby boomers preparing for retirement assume that Medicare will cover nearly all of their medical expenses. But seniors on Medicare now pay 18 percent of their total health care costs out of their own pockets, and the level will rise to more than 20 percent over the next decade. Average annual out-of-pocket expenses for retirees who experience a catastrophic illness exceed $33,000, and this sum is projected to rise to nearly $50,000 by 2014. Fewer than one in five seniors can afford the expense without cutting back on essentials such as food and housing, and the government isn't likely to help.

Some consumers and financial advisers are now looking to new Medicare programs and health savings accounts (HSAs) to solve these financial problems.³ Although HSAs do offer tax advantages on savings for future health care expenses, not everyone is eligible to enroll. In addition, limits on the contribution levels and tax benefits of HSAs mean that even a 55-year-old who saved aggressively would accumulate only $30,000 before reaching age 65. In 2014 this sum will amount to less than 15 percent of what will be needed to cover an average retiree's out-of-pocket expenses.

What about drugs? As of January 2006, Medicare Part D provides drug coverage for retirees who enroll. Despite premiums of about $375 a year, on average, the benefits are limited. Retirees who spend several hundred dollars a year on prescription medications may get no relief. Although many health insurers have enhanced everyday coverage, average retirees, with $2,600 in annual drug expenses, could pay up to half of the bill themselves.

Most health insurers, like their clients, suffer from misconceptions about retirement. Perhaps the most serious of them is a tendency to treat people who are currently employed and those who are already retired, or people under and over 65 years of age, as different, unrelated groups. For the former, insurers view employers as the primary decision makers on health care coverage; for the latter, the government. Currently, insurers have limited insight into the behavior of individual consumers and are therefore ill equipped to design innovative products or deliver useful advice to people who are approaching retirement.

Today simple indemnity products—long-term-care and critical-illness insurance, for example—are offered mostly to help people manage their health care risks in retirement. These products come with limits on how and when consumers can buy them and are of little value for managing the delivery of care and for helping to stretch the consumer's health care dollars. What's more, most of the leading health insurers are not yet capable of providing advice or selling products directly to consumers.

How health insurers can respond

To help people pay for their health care during retirement, insurers must build new capabilities and enhance long-established ones, such as managed-care expertise and relationships with employers and current retirees. Building brand awareness among consumers and adjusting operations and the IT infrastructure to serve individuals will certainly represent formidable challenges. To realize the new opportunity's full profit potential, however, insurers must excel in two critical areas: product innovation and advice-based marketing and distribution to consumers.

Product innovation

Effective retirement health care products must combine several elements: savings and investments, risk protection, network access and discounts, and disease and case management. To create products that consumers will buy, health insurers must understand three issues in much greater depth than they do today.

How consumers want to pay. Consumers don't want to pay insurance premiums for products such as long-term-care and critical-illness policies over many years before retirement. Our research shows that not only the rigidity of the payment plans but also unclear value propositions discourage most consumers from buying these simple indemnity products. Many people prefer to save money and earn investment returns on it and then pay a lump sum to buy insurance as they approach retirement. Health insurers can attract such consumers by offering products that combine investments with health risk protection—for example, health-related riders on annuities and life cycle funds whose investment allocation changes automatically as a consumer approaches retirement, at which time they roll over into long-term-care and critical-illness policies.

Health-specific savings accounts may hold significant tax benefits for eligible consumers—notably, people who have high-deductible health plans or work for employers that open a voluntary employee beneficiary association (VEBA).⁴ Aetna and Fidelity Investments, for instance, have joined forces to offer employees of academic institutions a defined-contribution savings plan to pay for health care in retirement. Under Emeriti Retirement Health Solutions, the plan launched in 2005, the participant makes after-tax contributions, and the employer makes tax-free contributions (typically of $1,000 or less each year), to a VEBA account. These savings are invested in Fidelity funds. Earnings withdrawn after retirement to pay for insurance premiums or qualified medical expenses (including vision products, dental and nursing care, and hearing aids) are exempt from the capital gains tax. Emeriti participants also enjoy group rates for Aetna health insurance plans and don't have to requalify upon retirement, even in poor health.

Insurers should note that more than 30 million preretirees have the bulk of their assets tied up in home equity or life insurance policies and will need recourse to those funds to pay for their health expenses in retirement. We expect consumer demand, now in its early stages, to increase for reverse mortgages, viatical settlements,⁵ and senior settlements.⁶ Given this market's size and potential, it's critical for insurers, either alone or through partnerships, to offer a wide range of products and payment options to help consumers pay for their health care when they retire.

Financial exposure. To determine whether an insurance- or savings-based product should be used to target a customer, insurers must differentiate between infrequent but catastrophic out-of-pocket expenses and more frequent and routine ones (Exhibit 4). Catastrophic events such as cancer, heart attacks, and slips and falls will likely account for more than 40 percent of all retiree out-of-pocket spending by 2014. To mitigate the financial risk associated with such events, health insurers should offer critical-illness, accident, and long-term-care insurance products that include elements of managed care and more flexible payment options. To help consumers pay for the smaller, routine out-of-pocket expenses, insurers should encourage employers to open retirement health VEBAs and individuals to open HSAs and to use prepaid cards⁷ with network discounts to stretch savings.

Specific diseases and conditions. Dental services and prescription drugs dominate out-of-pocket expenses for most seniors who escape catastrophic illness, even if they enroll in Medicare Part D. For seniors who do have a catastrophic illness, nursing home care will account for roughly 43 percent of out-of-pocket health care spending in 2014 (Exhibit 5). Insurers that know which maladies drive most of the out-of-pocket expenses of retirees can offer them retirement health products with a strong element of managed care. These offerings, such as core medical-insurance plans, must evolve from simple indemnity products into managed-care products to better serve retirees. A managed-care version of long-term-care insurance, for example, would include network discounts at assisted-living centers and skilled-nursing facilities, disease-management services focused on key underlying conditions or diseases, and case-management services to ensure that the most cost-effective treatment protocols are followed. Such innovations will make the products more affordable while delivering greater value to consumers.

To develop these types of products, health insurers will need new capabilities. Most insurers, for example, will need to improve their understanding of consumer needs and behaviors significantly as well as their ability to segment and target prospective customers thoughtfully. Many insurers will have to mine their medical-claims data to develop more sophisticated actuarial models and thereby improve the pricing of insurance policies. Others may have to develop new provider networks, such as those for long-term care, or bolster their disease- and case-management approach that most health insurers use to control the costs of employers. In the future, insurers will need a consumer advisory service to help retirees manage their out-of-pocket costs. Insurers will have to decide whether to build such capabilities in house or to look elsewhere. Likely partners include asset managers to offer the savings and investment components of retirement health products and life insurers to provide the capital to cover risks of a longer duration.

Advice-based marketing and distribution

If a health insurer is to help persuade consumers to move from a general concern about paying for health care in their retirement to the actual purchase of specific products, it will need a face-to-face advisory sales force. Most people planning for retirement prefer to get their advice in person, and more than half of the preretirees we surveyed prefer to receive it in the workplace. Health insurers have a deep understanding of health care issues and of the related expenses that retirees commonly face, and this knowledge should help these companies generate the insight needed to give quality advice. In addition, their extensive relationships with employers and their access to employees put them in a strong position to reach large numbers of preretirees—a competitive advantage that is difficult to replicate.

Health insurers then need to create an effective approach to marketing and distribution. Five should be considered.

1. Work site marketing and distribution. Work site distribution requires a two-stage sales process. First, employers must grant access to health insurers who want to get in touch with employees at work. Access usually isn't a problem. Most employers trust their current health insurers and 401(k) administrators, and McKinsey surveys indicate that for supplemental health coverage (such as long-term-care and critical-illness insurance) employees are likely to trust their present health insurers.
   
   In the second stage—reaching consumers and closing sales with them—a health insurer must build an advisory sales force at work sites. These enrollers commonly use a hard-sell approach, but McKinsey research suggests that it won't work when they try to sell retirement products. The credibility of enrollers is further undermined by the high up-front commissions they typically receive. A more consumer-friendly technique is needed to deliver meaningful advice and to build a positive brand image with preretirees.
   
   Cleary Gull, an investment advisory firm, is a case in point: it recruited a group of former airline pilots to offer retirement advice to current pilots. Cleary Gull charges pilots a flat service fee rather than a sales commission on retirement products. Like the professional background of the advisers, this approach makes their sales advice more credible. Furthermore, the advisers have a deep understanding of the benefits airlines offer and are well placed to offer tailored advice about which products would be likely to help pilots pay for gaps in their health care coverage. Given the financial state of most US airlines today, many pilots have already lost their retirement health benefits or will in the near future. Pilots reached by Cleary Gull have therefore enthusiastically welcomed its advice on how to make ends meet in retirement.
2. A specialized retirement health advisory sales force. Although it's too early to gauge success rates, a few health insurers have already experimented with a specialized retirement sales force. PacifiCare, for instance, seeks out retirees during their morning walks in malls. Other companies, such as Humana, employ advisers who travel from city to city offering retirees advice about new Medicare products.
3. Direct-to-consumer marketing. For simple retirement products such as discount cards, a direct-to-consumer sales model—with targeted mailings, telemarketers, Web sites, or retail alliances—could give health insurers a low-cost distribution channel. But this type of direct channel will likely prove more effective for educating consumers and creating an awareness of products and brands than for selling. Faced with the challenge of a large- scale effort to educate consumers on the new Medicare drug benefit, numerous health insurers have recently formed partnerships with retail pharmacies to educate seniors about their Part D products.
4. Affinity marketing. Health insurers could reach new groups of consumers through marketing relationships with assisted-living facilities, specialty medical associations, and condominium developers and associations in popular retirement spots, such as Florida. Through a partnership with the American Association of Retired Persons (AARP), for example, UnitedHealthcare offers Medicare supplemental insurance, hospital indemnity insurance, and comprehensive insurance for seniors not yet eligible for Medicare, as well as health advice through a nurse line for the AARP's 35 million members. In 2004 this partnership generated $4.5 billion in revenues for UnitedHealthcare, and beginning next year the company will also profit from a deal under which the AARP will exclusively distribute UnitedHealthcare's Part D plan in return for a share of the revenues and for discounts that AARP members receive.
5. A partnership with a financial-advisory sales force. Financial advisers of all shapes and sizes are making the transition from advice that focuses solely on building wealth to advice about generating income, preserving assets, and mitigating risks. In a 2004 survey of financial advisers, McKinsey found that only 38 percent were prepared to deliver advice about health- related risks, compared with more than 82 percent who were comfortable offering advice about risks associated with inflation, market performance, or the possibility that clients might outlive their assets. Some financial- services players (such as Fidelity) and health insurers (such as Aetna) are trying to build the ability to offer health advice. As compared with health insurers, financial advisers may have a good understanding of a consumer's finances, but they lack deep insight into health risks— insight required for comprehensive planning. Financial advisers and health insurers should thus consider partnerships. The insurers could provide resources such as health care cost estimators, specialist support, and the health-related part of the plan that financial advisers would sell. In return, the health insurers would gain a key consumer distribution channel for their products.

The way health insurers allocate investments across these five channels should depend on two factors. First, the insurers must decide how much emphasis to place on cross-selling to existing customers and how much on acquiring new ones. Work site distribution, for instance, focuses largely on cross-sales to current health plan members; partnerships with financial advisers could help insurers acquire new customers. Second, insurers must acknowledge that certain sales channels are best for particular kinds of products. More complex products, such as annuities with health care riders, are likely to require face-to-face selling.

Health insurers face significant challenges in adapting their organizations and mind-sets to focus on individual consumers and on the development of innovative products and new distribution capabilities for the retirement market. As with any major shift in business strategy, CEOs must lead the charge by helping senior managers in their retirement and commercial businesses to understand that Medicare is only the starting point for a far larger opportunity. The hurdles are bound to be many, but for leading health insurers the revenues and earnings from retirement businesses may rival those of core commercial businesses over the next decade. The prize for getting retirement health strategy right is too lucrative to ignore.