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Will More Insurers Control Health Care Costs Better?

July 9th, 2010

A common theme among health reformers has been that the small-group and individual markets for health insurance are too concentrated and thus inadequately competitive. The proposed remedy is to have more independent insurers compete within local markets. 

Reformers left of center on the ideological spectrum – President Obama prominent among them – advanced this thesis frequently in their advocacy of a new, public health plan, or of insurance cooperatives, for Americans under age 65.

Reformers right of center appear to subscribe to the same thesis when they argue for allowing insurers to sell health insurance across state lines. An alternative interpretation, however, is that they merely wish to permit what finance people call “regulatory arbitrage” – that is, shopping by consumers among different regimens of health-insurance regulation and their associated costs.

Widgets versus health insurance. As someone who has long taught micro-economics I understand, of course, why competition among multiple producers in the market for the legendary widget will drive down the price of widgets to minimum feasible production costs, plus a small profit margin, if widget makers buy the inputs they use in similarly competitive input markets. This is the standard textbook case of perfect competition.

I have some trouble, however, grafting this model onto the market for health insurance, which is not quite like the market for the legendary widget.

To arrive at the premium a commercial health insurer will charge for a particular policy and risk class, the insurer’s actuaries will first project the expected per capita outlays (X) for the covered health care products and services that insured members in that risk class are likely to trigger over the insured period. This is by far the largest cost component embodied in the premium.

To these actuarially expected outlays on purely medical benefits (X), the insurer will then add allowances for the cost of marketing the policy (M) (advertising and broker commissions), administering it (A), and the desired profit margin (P) needed to stay in business over the long term. The sum of these components will equal the premium.

What Component Of Premiums Would Be Reduced By Increasing The Number Of Insurers?

The question then is which of these components – X, M, A and P – would be driven down by having more insurers compete for enrollees in a given market area.

The prime candidate would seem to be P, the profit margin. In practice, however, that margin is smaller than seems widely believed – typically much below 10 percent and often below 5 percent.

There might be some economies in administrative costs (A) per insured in the case of large insurers allowed to sell policies across state lines in the small-group and individual markets. However, these economies would pale compared to the savings that might be achieved in the market for medical benefits.

The marketing costs (M) would, if anything, increase with the number of insurers competing in a local market.

The same, it seems to me, applies to the largest outlay insurers make — medical benefits (X). The bulk of the medical benefits procured by an insurer for residents in a given market area are produced by providers within that market area. In general, both private and public insurers have only limited, if any, control over the volume of the medical benefits that local clinical decision makers ask insurers to purchase for the insured. Furthermore, the larger the number of insurance companies active in a local market, the smaller any insurer’s market share will be — other things being equal — and the less leverage any insurer will have in bargaining with area providers over the prices of health care.

Growing supply-side concentration. Over the past decade, the supply side of the health care sector in many localities has become ever more concentrated, as hospitals formed systems and physicians joined together in larger groups. The current nouvelle vague – so-called Accountable Care Organizations (ACOs) – will only further encourage that concentration. I find it hard to believe that, in the face of this trend, fragmenting the buy side of health care even more would serve the goal of cost containment.

Ideally, in my view, the market for health insurance would be oligopolistic, which means that only a few insurers — each with some market clout vis à vis providers — would compete for enrollees in a local market. What the ideal number would be is an interesting question on which economists can have a lively debate.

So what am I missing here? Why do so many otherwise sensible people believe that fragmenting the buy side of the health care market even more than it already is will help contain the rising cost of health care? I would argue just the opposite.

I invite readers and fellow bloggers to enlighten me.

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5 Trackbacks for “Will More Insurers Control Health Care Costs Better?”

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  4. Twitted by iPunditOfficial
    July 10th, 2010 at 3:31 am
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11 Responses to “Will More Insurers Control Health Care Costs Better?”

  1. ruthgiven Says:

    I agree that the optimal level of health insurance market concentration is an important issue that has not received the attention it deserves. It depends not only on the local market concentration of providers but on health plan economies of scale and esp. minimum efficient scale for the industry. Doug Wholey et al and I published a couple of articles on this general topic in the Journal of Health Economics (winter 1996) which, though in need of updating, are still relevant to this discussion. I haven’t done much lately on this topic but assume others have.

    Also related, I’ve worked as an antitrust expert witness on a number of HMO mergers – always on the side of those opposing the merger. My first case was the 1995 United Healthcare acquisition of MetraHealth which the state of Missouri challenged in the St. Louis area. That challenge was successful and the Metrahealth subsidiary was required to be spun off. The case is described in a book I co-edited in 1997 (Competitive Managed Care). Local employer purchasers of health benefits opposed that merger but a year later they supported the merger (in the exact same local area) of Principal and Coventry because they felt this was necessary to maintain their leverage in the consolidating hospital market, esp. with respect to the growing dominance of the Barnes Jewish Christian System. The Leapfrog Group can also attest to this specific problem in the St. Louis area.

    Interestingly the person I worked for re the United/MetraHealth merger (Jay Angoff, Director of the Missouri Dept of Insurance at the time and former FTC antitrust attorney) is now the Director of the newly created Office of Consumer Information and Insurance Oversight at DHHS. I’m sure he’s busy now with the immediate insurance related provisions of health reform, esp. the highly contentious issue of how to define the medical loss ratio and reasonable premium increases, but he’s eventually (at least by 2014 when insurance exchanges begin to operate) going to have to deal with the issue Professor Reinhardt raises, the competitive effect of health plan market concentration.

    Given the small size of many markets and economies of scale we came up with 15 years ago, I agree that oligopoly seems most efficient – but how many plans would this be and how would this relate to the HHI used by the FTC and DOJ to assess competitiveness of mergers and markets? Perhaps there’s good empirical research out there now to answer these questions but if not this seems like the ideal time to fast track a well designed research initiative in this area so we (and the policy makers and regulators) have some better guidance before 2014 arrives.

  2. gailofiowa Says:

    Professor Reinhardt,

    I’m sure you would agree that the latest round of health care reform was more about providing better access to coverage (ie, guarantee issuance of mandatory coverage with subsidies for those purchasing through the exchanges) than controlling health care costs at the provider level. Improving access to coverage may, in fact, exacerbate the cost when coupled with the weak penalty on the individual mandate and the assorted exceptions. That said, I would like to comment on the various policy proposals you mentioned and their potential impact on health care costs.

    Let’s begin with the assertion, “that the small-group and individual markets for health insurance are too concentrated and thus inadequately competitive.” Having worked in the individual market for a couple of decades, I would describe it much differently. The skill sets of the individual carriers are much different than large group carriers. To be successful, they must be good at selection of individual risks (underwriting), product distribution to individuals (which is expensive and tends to involve a lot of agents), and management of the regulatory process (more specifically, the forms and rate approval process). In many states, the most expensive element of the rate approval process is the cost of delay in the approval of rates. While I believe there is adequate competition among the specialized individual and small group carriers, they generally do not have sufficient market penetration in the overall health care market to negotiate the best deals from health care providers. Some large group carriers, such as the Blues, are able too leverage off of their large group negotiations for better deals in the small group and individual markets. However, many large group carriers have chosen not to participate in these markets.

    With the recent passage of health care reform legislation, business is going to be very different for individual carriers. In order to cope with a higher minimum loss ratio requirement, I would expect many carriers to dramatically reduce agent compensation. Taking a lesson from the standardization of Medicare supplement insurance in the early 1990’s, the market will become very competitive, prices will drop and loss ratios will increase, providing more value to the customer. Volume will be a necessary ingredient for success (to reduce administrative costs and to get the best provider deals) and I would expect many of the more marginal individual carriers to naturally drop out of the marketplace. I only hope that large carriers will choose to play. Unemployed and self-employed individuals will be buying their coverage in a new way and the personal agent may become an endangered species.

    Allowing carriers to sell across state lines will permit the large national carriers to enter and operate more efficiently in the individual marketplace. Hopefully, the large national carriers will use the volume of their large group markets to leverage better deals for their individual market customers, should they choose to play.

    I do have concerns that rate regulation will make the individual market much less inviting for the large national carriers, who now operate in an unregulated rate environment. In some states, rate regulation tends to be more of an arbitrary political process than an actuarial justification of reasonable rates. From a social perspective, the current rate regulation is justifiable because individual policyholders may become uninsurable and may need protection against excessive rate increases in their declining risk pool. In the future, if individuals are unsatisfied with a rate increase, they can simply change carriers. It is my opinion that rate regulation will be unnecessary and will be an impediment to efficient operation of the market. State insurance departments can still play an important roll with localized market conduct. I do believe there could be some further improvements by the elimination of redundant solvency and market conduct reviews where multiple states examine the same company over and over.

    With respect to a public health plan, it is certainly the industry’s fear that there will not be a level playing field between a public plan and the private sector. For example, would a public plan have to pay government taxes? Would a public plan be able to fix prices like Medicare, prompting many providers to think, “just shoot me now!” While the health care reform that was passed may slightly improve costs with the higher loss ratio requirement and competitive “regulatory arbitrage” (assuming carriers are even willing to play in the individual market), I believe, and I think you would agree, it will do little overall to tame the ravages of health care cost trends and the supply-induced demand. This can only be solved by rooting out waste and ineffective care within the health care delivery system with improvements in processes and compensation schemes that promotes efficient, effective care.

    It is much easier politically to mandate benefits than to ration health care resources. If the private sector fails to tame itself, a public sector that provides a floor of protection may be the only viable alternative, unless we want 50% of our economy to be based on the delivery of health care. We already have a health care system based on class. It should be noted that today, the poorest of our nation have a right to health care through Medicaid and our seniors enjoy free Part A coverage and heavily subsidized Part B coverage. Even with the passage of health care (financing) reform I feel that our working poor may find little relief as more workers are forced into part time or independent contractor situations and individual coverage remains unaffordable. It will be interesting to see the outcome of the economics of cost of providing health insurance versus the penalty. Will the employment based insurance system implode? Is the individual mandate penalty sufficient to induce people to buy insurance? Will there be adequate carrier participation in the exchanges? If insurance is still unaffordable will health care reform implode?

    To answer your question, will more insurers control health care costs better? Of course not—so, I guess I agree with you, Professor. In the individual market there will be winners and losers. The uninsurable will be able to buy coverage, which will degrade the morbidity of the risk pools. All other things equal, the insurable will probably have to pay more unless the government subsidy offsets the increased morbidity costs. There will also be winners and loses based on rating mandates by age. We may see some incremental benefits from better information and standardized coverage with the exchanges. And, there may be an incremental benefit if more big players choose to participate in the individual market and they exert more pressure on controlling health care prices. However, the incremental improvements that the health insurance industry may be able to deliver will not constitute “control” over increased health care utilization and intensity of services. I’m afraid that’s going to take more than a few gorillas in the insurance industry.

  3. Ryan Leslie Says:

    Thank you for your thoughtful reply. I agree with your view about the potential negotiating weakness of small insurers. However, in a system with larger cost-sharing by consumers, prices ultimately can’t be set solely through negotiations between insurers and providers. Patients will make countless small decisions at the margin based on values and beliefs, forcing providers to adjust accordingly. In my previous example (shoulder surgery vs. pain medication), it would take only a handful of patients choosing to forgo surgery due to perceived lack of cost-utility for a practice to feel the impact and react. The marginal patient communicates information about cost-utility that is lost in a system of mega-sized payors. Furthermore, without this information, how are resources efficiently allocated geographically? How do we respond to a shortage of oncologists in northern California without having to identify it three years after-the-fact with retrospective data? There’s a massive coordination problem here that we aren’t addressing.

  4. bjcefola Says:

    A off-topic meta question for consideration: Why do providers accept differing payments for the same procedures from different payers? To the extent that there is a range of payment the provider is taking extra money from the high payer to subsidize the low payer. What is the economic rationale for this practice? How would the system change if providers were required to charge level prices?

  5. acavale Says:

    Thanks for the replies, Professor. its good to see the poster respond.

    Upon re-reading Rogercollier’s comment, I find that his analysis is at best only partially correct. In most markets, it is illegal for medical societies to “collectively negotiate” with insurers. I was hoping that you would point this out. Secondly, it is a complete myth that specialists are paid any higher than generalists – usually insurers publish their “payment schedules” for CPT codes in each market, and all physicians are paid per the schedule. It is obvious to any one involved in clinical practice that Rogercollier has no idea about how medical practice really works. Its best to discuss based on facts, rather than myths.

  6. Uwe E. Reinhardt Says:

    Response to Ryan Leslie (July 15th)

    Your thesis is that more insurers in a market area will offer prospective customers a greater variety of high cost sharing via high annual deductibles, coinsurance, upper limits on coverage of certain benefits or exclusions, and that high cost sharing by patients at point of service is the most straight forward approach to controlling health spending.

    That may well be, but a price the insured will pay for this choice is that each of a multitude of insurers will have less market moxy especially vis a vis hospitals in bargaining over the prices of health services than a few larger insurers would have.

    Besides, a few large insurers in a given area also could and probably would compete for enrollees offering a variety of policies, with different combinations of premiums and cost sharing. Yet each of fewer insurers would have more clout with providers in bargaining over fees.

    Response to acavale (July 9):

    I think Roger Collier’s comment is one good response to yours.

    Furthermore, I was thinking less of physicians than hospitals in my blog post.

    You are probably right, though, that in some market areas physicians have relatively little clout in bargaining over their fees with insurers, which makes then resort to volume enhancement.

    Response to joeedh (July 14)

    First, unless it makes you feel good in a self-therapeutic sort of way, it is not really necessary to resort to language such as “so of course the esteemed author must instead babble on as if he knows nothing about it” in a discourse of this sort, especially when you can’t be sure that you are right..

    Risk adjustment is used in Europe (e.g., the Netherlands, Germany, Switzerland) solely to compensate competing insurers for the differences in the actuarial risk represented by different individuals. It is also used, for the same reason, by the U.S. Medicare in making payments to the Medicare Advantage program and, implicitly, by Medicaid managed care. It is not a “conservative” or otherwise political concept. It is a technical, actuarial concept.

    To my knowledge, risk adjustment has never been intended to compensate competing insurers for any differences in the prices they pay given provider for identical goods or services. These prices, however, were the sole focus of my comment.

    If, as joeedh proposes, insurers were compensated for such price differentials as part of risk adjustment, what incentive would insurers then have to bargain hard with providers over those prices?

    Finally, as a general observation, I wonder what prompts the resort to code names in this Health Affairs blog. Why do commentators lack the temerity to sign their full names to their statement?

  7. hteitelbaum Says:

    Dear Professor,
    Just as “P” (margin) for insurers is smaller than imagined, so too for providers. Many hospitals, and many physicians, are barely hanging on. Yes, there are some for-profit hospitals doing well, but here in New York we have seen the demise of several hospitals recently, and more will no doubt follow. On the physician side, we, like payers (and hospitals), deal with cost drivers beyond our immediate control: malpractice insurance, drugs, technology, salaries of ever more sophisticated and expensive support staff (sometimes driven by quality concerns which limit scope of practice of less skilled and less costly employees), the ever increasing demands for “more” care by patients, the ever more available and costly therapeutic options which increase cost substantially but quality or quantity of life only marginally, and defensive medicine (yes, it is very real, and very costly), driven by the public’s expectation of perfection. The proportion of physicians in “private practice” is dropping rapidly and will drop further as many physicians seek the shelter of hospital employement instead of the uncertainties of self employment in an era of cost escalaton and constrained reimbursement.

    Our ability to develop costly new therapeutic approaches has outstripped our ability or stomach to pay for them. Likewise, the public’s expectations to live ever longer and better and its demand for perfection from the healthcare system further fuels costs which American society is no longer willing or able to pay.

    Insurers are not the sole or primary culprit in the rising costs of healthcare, but neither are providers. The American people need to come to grips with what is most valuable to them, and what they want to spend their money on. The issue is not simply (and not even) that we are spending too much on health care, but that we live in a world (and country) of constrained resources. Education? Health care? “Defense?” Space Exploration? Highway infrastructure? What is most important to us?

    Finally, if we wish to limit how much we spend on health care, how do we determine what is more important: prenatal care for all, bone marrow transplants for the few, or marginally effective treatments for glioblastoma multiforme or vaccines for prostate cancer ?

    We need a new national dialogue. And we need our leaders to stop believing that the legislation that Congress approved and the President signed is real health care “REFORM.”

  8. Ryan Leslie Says:

    “So what am I missing here?”

    With all due respect, you seem to be missing the most straightforward way that cost growth would be constrained–namely through increased pressure to reduce medical benefits (your X). An increased number of insurers with an increased variety of plans (ideally that escape state minimum coverage laws) would result in a greater share in patient out-of-pocket expenditures. If you have an injured shoulder, as a patient would you choose an expensive surgery or less expensive pain medication? This is a very different decision if you are largely paying out of pocket than if your perceived cost is near equal for the two options. When patients are making cost-conscious decisions regarding their care, providers have strong incentives to make their services more appealing–through lower cost and better quality.

    I also agree with acavale’s description of the monstrous power of payors.

  9. joeedh Says:

    As the esteemed professor is no doubt perfectly aware, the answer is using a robust risk adjustment mechanism (this approach is used by the Netherlands and a number of other countries). Yet due to the peculiarities of politics in this country, this method is considered “conservative”, so of course the esteemed author must instead babble on as if he knows nothing about it.

    Risk adjustment is the basis of managed competition; once the difficult task of implementing it is accomplished, premiums will tend to reflect the cost and quality of benefits decoupled from the risk pool of an individual company. Thus insurance companies will compete for quality and cost containment, and specialized care organizations become feasible.

  10. RogerCollier Says:

    What a pleasure to read a straightforward explanation of why “more insurer competition is good” is a fallacy. I would add a couple of points:

    Liberalizing rules for market entry by insurers is senseless since, unless they are willing to expend huge premium subsidies to buy market share, the premiums of “new insurers” will always be higher than average since providers will see no reason to offer lower prices to the newcomers. (And allowing sale of insurance across state lines will lead to carriers relocating to take advantage of friendlier state insurance regulations, to the probable disadvantage of consumers.)

    While another commenter correctly points out that most physician practices are small, this is misleading for two reasons. First, many primary care practices negotiate collectively with insurers via local medical societies. Second, the highest priced providers –specialists and hospitals – typically have either a monopoly or an oligopoly, giving them the upper hand in rate negotiations. The growth of hospital chains is intensifying this effect, with chains insisting that all their facilities be included in a carrier’s network, regardless of individual rates or reputation.

  11. acavale Says:

    Dear Professor:
    Looking at it from the “provider” side, I find a significant flaw in your in your understanding that insurers have “less leverage” while negotiating with local providers. Based on extensive knowledge of oligopolistic insurers’ leverage in our market, I can safely say that public and private payers pretty much have a 100% say in their reimbursement rates with a majority of providers having zero leverage to engage in real “negotiation”. Clearly your argument demonstrates your intricate knowledge of micro-economics but virtually no knowledge about the financial dynamics of medical practice. As you are probably aware, even today about 60% of medical care is provided by physicians in practices with less than 5 physicians. Therefore, your theory of the weak insurance companies having no leverage vis a vis the providers, does not have legs.

    The only trend that can reduce consumption of health care services is to reduce the volume of services. The current system of CPT code-based billing/reimbursement based on a price-fixed system has resulted in providers using their only method of getting paid, i.e. increasing volume.

    So, the real answer to your question is not whether too many or just a few insurers will be beneficial, but rather how we as consumers value the care we receive. Adding real competition among providers, by allowing transparent pricing for services (without price-fixing), where consumers can directly purchase the type of service they find more useful, would be a remedy. Insurance is not the answer, but can be a useful tool, if used appropriately. Resurrecting the physician-patient relationship would go a long way in reducing the costs in health care.

    I hope this was an enlightening idea.

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