A decade before Americans first heard the term “Obamacare,” health insurance premiums were steadily climbing and the insurance industry was busily consolidating, but few raised concerns about the potential relationship between the two trends.

Instead, there was widespread belief that the health insurance market was competitive and that market forces would protect U.S. workers from price gouging by insurers. One indicator of that faulty assumption was a rapid increase in the outsourcing of public insurance to the private sector. Another was a 2004 Federal Trade Commission/Department of Justice report saying that most experts at the time held fast to the “competitive” assumption. Fortunately, Kellogg economist Leemore Dafny was not one of them.

Instead, the associate professor of management and strategy had decided to get to the bottom of the competitiveness question herself, and one day happened to tune into a National Public Radio report that touched on the idea. That early 2000s radio segment described the very different fates, post–9/11, of aviation giants United Airlines and Boeing: Boeing was booming, taking in mega-contracts, while United Airlines faced bankruptcy in a new apocalyptic landscape where consumers suddenly had a fear of flying. “Listening to the NPR stories on these two companies, whose fortunes varied so much,” Dafny remembers, “made me think, ‘I bet that United is getting a great deal on its health insurance policies, and Boeing is not,’ owing to its profit surge.”

In the early 2000s, there was widespread belief that the health insurance market was competitive.

“This in turn led to the realization that health insurance is a prime setting for what economists call ‘perfect price discrimination,’ when a seller charges different prices to different buyers so as to extract the great possible profits from each transaction.”

Uncovering Evidence
Over the succeeding years, Dafny would prove her hypothesis of perfect price discrimination, especially in smaller insurance markets. As she wrote in the American Economic Review: “I find [that] firms with positive profit shocks subsequently face larger premium increases, even for the same health plans. Moreover, within a given firm, those sites located in concentrated insurance markets experience the greatest premium increases”—particularly where there are six or fewer carriers.

In short: The companies Dafny examined that were doing well were actually penalized for their profits in the form of higher premiums. So insurers, not customers, controlled the market.

That finding was fairly revelatory. “At the time I began the research there was very little concern, apart from expected opposition voiced by the American Medical Association, about the potential role of the health insurance industry in contributing to rising health-care costs,” Dafny says. “So the very basic question I wanted to ask was, ‘How well are these markets functioning? How can we diagnose whether health insurance is a fairly competitive industry or isn’t?’ ”

Other researchers had made efforts in the same direction but were stymied by incomplete and unreliable data. What helped Dafny test her theory was a treasure trove of data she luckily stumbled upon. “I was discussing my general research interests with a businessperson, a family friend,” she says. “He kept telling me, ‘You know what? We have some really terrific data; we’re a large benefits consultancy.’ ” Such offers are few and far between, Dafny knew; proprietary data is rarely made available to researchers. Yet here was a businessperson “interested in gaining a new perspective” and willing to facilitate a data-sharing agreement in order to contribute to academic research.

What a gift that database was, describing as it did the health insurance plans of large U.S. employers between 1998 and 2005. Included were 776 large, multi-site corporations spread across 139 different geographic markets and a range of industries, from financial institutions to manufacturers to consumer products companies. In total, these companies insured 4.8 million active workers and more than double that many people, adding in their dependents. “There are very few data sources that tell you anything about private insurance,” Dafny says, of the database’s value. “We have a lot of data on the public health programs, but these were contracts struck between private insurance companies and employers.”

Dafny documented a steep rise in the number of highly-concentrated insurance markets: In 1998 only 7 percent of employees in her sample were receiving their coverage in locations with six or fewer major, full-insurance carriers; by 2005, that percentage was up to 23 percent. As of 2009, the percentage was a staggering 41 percent. “This is becoming a more important phenomenon over time,” Dafny comments, “and the phenomenon that is most important in my view is not price discrimination per se but the fact that insurers have that ability to raise premiums.”

“It’s difficult with this analysis to estimate how uncompetitive things are, but it is a first step in my view at debunking the assumption that the industry was pretty competitive. I tried hard to find anybody besides the American Medical Association raising the possibility that the industry wasn’t very competitive and robust back when I embarked on this project, and I couldn’t find it.”

Dafny then matched the public companies in the database—some 77 percent of her sample—to a financial database that included various measures of profit margins. She included all categories of health plans offered by these employers, from health maintenance organizations to indemnity plans, but excluded self-insured plans as employers rather than insurers actually set the premiums for these plans.

What the economist found was that a company with an increase in profit margins subsequently faced higher insurance premiums (and vice versa), but only for plans offered in locations with a small number of insurance carriers. The effect was significant in areas with ten or fewer major carriers and particularly pronounced with six or fewer carriers. In the latter areas, a profit increase of 10 percent was associated with an increase in health insurance premiums of 1.2 percent.

Unexpected Answers
So why would employers tolerate price increases in the wake of a good profit year? Dafny went into the field to find out, interviewing insurance brokers. They told her that switching plans is a “tough sell” to employees, who are loath to deal with the myriad changes required when one’s health plan changes. Not only is the paperwork significant, but many patients have to change providers if their current providers are out of network in the new plan. 

Workers do tolerate switches in bad times—“taking one for the team,” Dafny calls it—but are less tolerant in good times. Dafny then turned to the data, which corroborated this line of reasoning: Firms with increased profit margins were less likely to make changes in the set of health plans they made available the following year. Conversely, companies with decreased profit margins were more likely to make changes to their health plan offerings, in particular removing some plans to save money.

Dafny’s findings do not bode well for a future of affordable health insurance. “Although advocates of the private insurance system usually appeal to the virtues of competition,” Dafny wrote, “there is little empirical evidence to support the assumption of robust competition among insurance carriers.”

Today, legislators and regulators in Washington share her concern. Dafny describes “a lot of conversations” she has had with high-level administration officials and congressional committee members trying to get a handle on “whether these markets are sufficiently competitive to support the expansion of coverage”—health reform’s central aim—“through the private industry.”

The current level of competition is far from ideal, Dafny says she tells them. She also tells them that the solution is to come up with ways to facilitate new entry into the insurance industry. The key, Dafny notes, is to help these entrants access provider discounts so that their networks can be competitively priced.

That is a continuing dialogue. Meanwhile, implementation of the Patient Protection and Affordable Care Act that President Obama signed into law in March 2010 continues apace, and Dafny has embarked on further research into the effects of consolidation on premiums and the value to consumers of having greater choice in health plans. That treasure trove of data is still paying off.

Since health-care reform relies on the private insurance industry for fully half of the expected increase in the number of insured Americans, “It’s critically important,” Dafny says, “to look at the industry, assess where and when it functions well, and try to promote competition through well-designed regulatory reforms.” The question is how closely lawmakers are paying attention.

Editor’s note: Dafny’s paper “Are Health Insurance Markets Competitive?” was awarded the 2012 Stanley Reiter Best Paper Award, an honor bestowed by Kellogg School faculty upon a research paper judged to be the “best” of those published between 2008 and 2011.

Related reading on Kellogg Insight

Games Hospitals Play: How hospitals cope with competition

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The Effects of Health On Wealth: Major illness leads to financial catastrophe for the uninsured

Congenital Defect: Systemic hospital cost inflation