FORTUNE -- Running one of America's largest health insurers was never easy, but now it's a strategic challenge that will be studied in business schools for years. That's because the industry is about to be revolutionized by the new health care reform law. Yet no one is sure exactly how. At least Humana CEO Michael McCallister has the comfort of knowing his company has remade itself before. Launched 50 years ago as a nursing home operator, it later abandoned that business and became America's largest hospital company before bailing out of that industry in 1993 to focus on insurance. Humana's biggest business now is Medicare Advantage insurance -- essentially enhanced Medicare offered through private companies.
McCallister, 58, has a short résumé, having joined Humana as a finance specialist straight out of Louisiana Tech in 1974. He spent much of his career running hospitals around the country and became CEO in 2000. He talked recently with Fortune's Geoff Colvin about why Humana (HUM, Fortune 500) is getting back into the health care delivery business, why the new health care reform law won't keep costs down, what he has learned from providing coverage for Humana's own employees, and much else. Edited excerpts:
It's rare to see an entire industry get whaled on by government leaders as health insurance has been. President Obama said, "Americans are being held hostage by health insurance companies." Nancy Pelosi said health insurers are "villains" who "have been immoral all along." How do you feel when you hear that kind of thing from the leaders of the nation?
A: Personally I look at it as politics, and I don't get too bothered by it. But I hate it because it's such a downer for all our employees who wake up every day trying to do good things for people, help people get through illnesses, protect them from financial disaster, from being sick. We have a good, higher purpose to what we do, and our people feel that. So it can be hurtful when they say that. Some of it comes from a misunderstanding of what we actually do, and it sets us up to be a pretty good target.
That gets to a larger issue, which is how the public perceives the whole health care industry. In most industries, rising revenues are seen as good news -- growth and opportunity. Why is it that in this one industry, rising revenues are seen as a grave national problem?
I think it's a lack of understanding of what actually drives health care costs. Health care costs become premiums, which are our revenues. I can show you a historical chart showing that our premiums have tracked health cost increases pretty closely for many, many years. So why would health care costs be going up? And then you enter a whole new space -- the aging population, new technology and new drugs, and wonderful things we can do medically that we all want but are very expensive. It takes us into the space of our own health and wellness as individuals. We're not taking care of ourselves. We're becoming an obese nation, leading to diabetes and other chronic illnesses. A lot of medical spending is tied to five chronic illnesses [diabetes, stroke, heart disease, pulmonary conditions, and hypertension], all of which are preventable. People don't really connect the dots when they think about why in the world health care costs are going up.
What specifically can be done about those five illnesses?
Let's talk about a couple of them. Heart disease is obvious. It gets a lot of publicity, and people know a lot about it, but have we changed our diets? Are we really taking care of ourselves? Obesity leads to all these things. Diabetes is becoming an epidemic across this country. We have kids, 30% of whom are overweight or obese already, so we have another tranche of folks coming along who are going to suffer the same thing. We haven't brought the public to a point where they realize that they actually control their health and ultimately the cost of their health care. It's just tough to get people to focus on it in the short term.
There's an argument that people don't focus on it because they don't feel they're spending their own money when they get health care. Is that right, and is it going to change?
The third-party payment system does set up incentives that are driving much of what happens. Historically, if people had insurance, they had very little out-of-pocket as they used the health care system, so the power of consumers was not showing up. In the rest of the economy, consumers are very, very powerful. We do not tolerate bad services or bad products. In health care, we not only tolerate them, we pay for them every single day without knowing any better. We've got a third-party payment system where the payer's in a different room from the seller and the buyer, and it sets up a perfect storm for inflation.
Under the new health care reform act, it's the law of the land that everybody in America who can afford it has to buy what you sell. Is that fundamentally a good thing for you and for your competitors?
I would describe the bill as a mixed bag. It does some good things. You can make the policy argument that getting 30 million more people covered is a good thing -- none of us want people outside the system. The issue of preexisting conditions does scare people; the No. 1 concern of most Americans is that they'll fall through the cracks. Do we want to keep our kids on our policies until they're 26? Sure. Would you like to be able to get preventive care without having to pay for that? Why not? But all these things cost money, so the bill is loaded up with all sorts of things that set bad incentives. The biggest takeaway from the bill is, it doesn't do much fundamentally to help with the underlying problem, which is that costs are too high and are rising too fast. This turned into more of an insurance market reform bill than health care reform.
What's your bottom-line prediction of what will happen to health care costs in the next five to 10 years?
They're going to rise because we have not addressed the drivers. Nothing in this bill has done that. We have a system where we're insulated from real-world cost and quality measures, and we as consumers can't behave in the way we normally do, and we're not taking care of ourselves in an appropriate way. At our company we've focused our future on the idea of health, wellness, and well-being because we know that's where this has to go next. As large employers sit down and think about their health costs, they've run out of room from the standpoint of moving benefits around. They're really going to have to step up and address the underlying health of their employees, not only because of health care costs but also from the standpoint of productivity and absenteeism.
So what's the future of employer-funded health insurance?
Smaller employers will continue to do what they were doing, which is struggling with this. They're likely to send their people to the exchanges [that will be established under the new health care law]. All the businesspeople I know have done the math on the future. They'll have to confront decisions based on the culture of their company and the importance of this benefit to their employees. But I can tell you the pressure and the bias will be to drop it.
The law not only requires people to have health insurance but also imposes many requirements on the features of that insurance. Some analysts have concluded that the effect will be to turn health insurers into the equivalent of public utilities. Will it?
It's a shame that we're not going to have a lot of opportunity for innovation and variation. If we try to commoditize this, we're going to end up in a situation where we drive out innovation and good thinking. It's something we can probably live with, and we will find ways to differentiate ourselves, but as a policy matter and as a solution to the problem, I don't think that's it.
What's Humana's strategy now?
We have a very straightforward strategy to deal with the individual consumer in those lines of business where we're talking to an individual. So we love Medicare Advantage because it's a retail business where you talk to people directly. We love the individual health insurance market in concept -- we'll see how it plays out relative to exchanges. It will get bigger, so there's potentially an opportunity. We like that relationship with the individual. But this idea around helping people get to a better spot from the standpoint of well-being is what's going to drive us, and we think that's a business for us. We're even trying to change the language -- instead of ROI, return on well-being. We're trying to find ways to motivate behavior change. We're going to bring in incentives and rewards and a lot of things from the rest of the economy to get people to think differently -- about their interaction with the system and the way they take care of themselves.
That strategy opens up almost anything in the health care world, not just insurance. Where do you see it leading?
Clearly the core health insurance product is critical to everyone. You want to be protected. But there are other things we think we can do, whether they're going to be fitness programs or other products. If I think about my senior population, I can think about a much longer relationship relative to home health support, for example -- people are always better off in their homes than they are institutionalized. So you're right, it's very broad and leaves us a lot of opportunity.
Recently we bought a company, Concentra, which has us reentering the provider space, which we left many years ago. So now we find ourselves in work-site wellness at 200 and some locations, in urgent care, some primary care. We're beginning to think about the full integration of the relationship and how you can organize the financing and the delivery a little differently, wrap up some new economic ideas that would come from elsewhere, and get to a better place. It's a much broader way to think about it.
Many companies with so many customers have a tremendous amount of customer data, and they know they're not using it as effectively as they could be. You're doing something you call strategic analytics. What's the goal?
From our spot as a payer, we have the best view of individuals as they move around health care that exists today. There may be a day when there's an electronic health care system where everything is connected, and that would be great, and there's money in the stimulus bill to try to move that ball. But as we sit here today, I know every doctor people visit, all the drugs they take, because we're paying for all this stuff. We have a pretty good idea of what people are suffering from, whether they're taking their medications, whether they're compliant with the treatments, whether they've had eye exams and things, whether they're diabetic. So we have a wonderful opportunity to add value.
We're in the middle innings around gathering that data and making it actionable. That's the key -- it needs to be actionable for the individual and for us. We're a little late as a company and as an industry in drawing value from that, but we're in a good position to do it. So we're investing in it heavily.
Humana changed the way it handles health coverage for its own employees about a decade ago. What did you learn from that experience?
We knew that if we couldn't effectively work with our associates to get a better handle on their health and their health care spending, then we weren't going to have much of a value proposition to our customers. So we took it upon ourselves to be early utilizers of virtually everything we would innovate around. We were early adopters of everything from health savings accounts to higher deductible health plans to elimination of paper. A lot of that stuff's out there broadly today, but we started doing it in 2000 and 2001. In those days eliminating all paper from purchasing health insurance was unknown.
It's a combination of process, technology, benefit structures, information, funding mechanisms, and feedback. Virtually all Humana associates are at a computer, and they are not bashful. So if we ask them, "Tell us about this," we will get a huge percentage of people who will give us feedback. It's a great laboratory.
It sounds as if one of the themes of what you did was give individuals more control and more incentive to exercise control. Is that right?
I'll give you the principle that started the whole thing. I basically said to the associates of Humana a decade ago, "Listen, I can't solve this problem for you. You're going to have to get engaged here. We're in this together. This is not something that Humana as an employer is going to just take care of forever, because that's not sustainable."
Every business has that problem. So you start by treating everyone like they're adults, and you say, "This is the problem." We laid out everything that was going on with cost trends and said, "We are going to work on this together." They had some accountability and responsibility, and we had some. We've been very transparent about what's happened all along the way, what's working and what's not. We changed things; we stopped things we started; we tested a lot.
When it comes to this subject I would argue I probably have one of the most engaged populations you'd find anywhere in the country in a big business. And yet we still have a lot of work to do. I study my own population in terms of their body mass index, their weight, smoking rates, and all that. We still have a lot of work to do. This is hard work because it really, fundamentally, requires a change in how people think.