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For the past decade, Leemore S. Dafny, an associate professor of management and strategy at the Kellogg School of Management, has been seeking to elucidate the anomaly that is the U.S. health care system. Her work has addressed various issues like competition among hospitals (it is remarkably similar to other industries), the impact of tort reform on health costs (it is surprisingly small), and the state of competition in the health insurance industry (there is relatively little). It is on this last point that Dafny has now dug deeper. Along with co-authors Mark Duggan, a professor at the University of Maryland, and Subramaniam Ramanarayanan, an assistant professor at UCLA, she sussed out the specifics of how consolidation in the U.S. health insurance industry has affected insurance premiums.

Until recently, the health insurance industry had not been seen as playing a major role in driving up health costs. “Many excellent researchers have pointed—and I think correctly—to the interaction of innovative technology and generous health insurance as the primary source of that increase,” Dafny says. “But I wanted to see whether and to what extent our health insurance industry could be responsible for some of the surge in health insurance premiums.”

Specifically, Dafny and her colleagues were interested in what role the “market structure and conduct of the insurers” played in the story. In other words, how does the oligopolistic structure of the health insurance industry, where there are too few firms to spur strong competition, allow companies to raise prices indiscriminately? Testing that can be difficult, though. There is no way to manipulate the entire insurance industry for the purposes of answering a question. So researchers like Dafny and her colleagues rely on “natural” experiments, where some event produces conditions that satisfy the requirements of a real experiment. The event in this case was the 1999 merger of Aetna and Prudential Healthcare.

Vagaries of Geography

Although Aetna and Prudential were national companies that offered plans in many states and regions, they had widely varying shares in different local markets. For example, the two had relatively similar shares in Jacksonville, Florida—19 percent for Aetna and 24 percent for Prudential—but disparate shares in Las Vegas—11 percent for Aetna compared with only 1 percent for Prudential. That meant that the combined company would control over 40 percent of the market in Jacksonville, but only 12 percent in Las Vegas. Similar differences played out in the other 137 geographic markets the researchers studied.

Dafny and her colleagues used the differences in the degree of overlapping pre-merger market shares to test whether reduced competition was, in fact, responsible for driving up premiums. If premiums rose similarly in markets like Las Vegas, where competition was little affected, and markets like Jacksonville, where it was greatly affected, then consolidation would have little to do with it. But if premiums skyrocketed in Jacksonville but only nudged up slightly in Las Vegas, then the merger may be at fault.

To make doubly sure, the researchers also included a control, or placebo, treatment—Texas. “Texas is a place where the Department of Justice acted so as to block the effects of the merger,” Dafny says. “They had Aetna divest plans from a firm they had acquired the year prior.” This “consent decree” effectively made the combined Aetna-Prudential Healthcare cede customers to its rivals. In essence, the merger took place in Texas, but none of the competition-reducing effects were felt.

Dafny and her colleagues used a modified version of the Herfindahl-Hirschman index (HHI) as their measure of consolidation and competition in the market. HHI “is the most commonly used metric of market structure, and it is explicitly named often in the antitrust agencies’ horizontal merger guidelines,” Dafny points out. The researchers calculated the HHI of the two companies before the merger, the combined company after the merger, and the projected change if the companies had remained separate. That last statistic is the key to the experiment, because it allowed Dafny and her colleagues to filter out confounding effects that occurred after the merger, like shifts in consumer sentiment, for example. By comparing the before-merger HHI with the after-merger projected HHI, they could measure how much the merger alone had impacted premiums.

As might be expected, HHI shot through the roof in many markets (Figure 1). By 2006—just seven years after the merger—HHI rose by 100 points or more in 78 percent of the markets and by 500 points or more in 53 percent of the markets. To put that in perspective, at that time the U.S. Department of Justice worried about antitrust effects if HHI had risen by more than 100 points in markets where it already exceeded 1800 (which in most health insurance markets it did).

Figure 1. Change in local health insurance market Herfindahl-Hirschman index (HHI) between 1998 and 2006.

Dafny and her colleagues found that premiums rose the most in markets where the merger was predicted to have the greatest impact. That is, the combined company enjoyed greater market power and used it to raise premiums. By extrapolating their results to predict the effects of consolidation in all markets between 1998 and 2007, Dafny and her colleagues found that, in the average geographic market, consolidation drove premiums up by 7 percent. That is $34 billion in additional premiums. While that is a lot of money in real terms, they are careful to point out that consolidation accounted for only one-eighth of the average premium increase between 1998 and 2007. In other words, consolidation was responsible for some of the increase in premiums, but not the majority.

Supply-Side Side Effects

Premiums were not the only place the merger’s effects were felt. Physicians’ pay dropped by 3 percent in merger-affected markets during the study period, Dafny and her colleagues estimate, while nurse pay rose a modest 0.6 percent. On top of that, Dafny and her colleagues reported that more nurses were hired in those markets. “It’s consistent with insurers’ efforts to substitute nurses for physicians,” Dafny says. “The evidence suggests that when insurers have more power, they facilitate the substitution toward lower-priced labor.”

Despite better pricing power and more leverage over labor, the merger was not a great success. In the years that followed, Aetna did a poor job managing its new market share. Slowly, the effects of the merger wore off as more businesses moved their coverage to other insurers. Though the company lost its gains in market share, the higher premiums remained. “In this particular case, Aetna and Prudential lost all the share that they had gained,” Dafny notes. “We were thinking, well, maybe the increase in premiums will reverse?” she adds. “But it didn’t.”

Countering Consolidation

Consolidation and the lack of competition that accompanies it are likely here to stay. The American Medical Association reports in 2011 that 83 percent of health insurance markets are “highly concentrated” according to new, higher guidelines set out in 2010 by the U.S. Department of Justice (HHI of 2,500 or more). Furthermore, in 47 percent of metropolitan areas, one insurer controls the majority of the market.

So far, businesses have responded by shifting to cheaper plans and requiring employees to shoulder a greater share of costs. But those tactics will only work for so long. Plans can only become so cheap before they cease to provide much insurance at all.

To counter continued consolidation, Dafny recommends enticing new entrants into insurance by encouraging or requiring health care providers to give them discounted rates for a period of time, allowing new companies to gain a foothold in the market. This could help counter “the chicken and egg problem thwarting new entrants, who cannot obtain provider discounts without large enrollments, and cannot achieve large enrollments without discounts,” she says.

Related reading on Kellogg Insight

An Unhealthy Market for Competition: Health insurance companies in the U.S., not consumers, control the market

Games Hospitals Play: How hospitals cope with competition

Tort Reform No Miracle Cure: Limiting liability has limited impact on healthcare costs