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Policy Strategy Economics Dec 1, 2011

Paying a Premium on Your Premium

Effects of consolidation in the health insurance industry

Based on the research of

Leemore S. Dafny

Mark Duggan

Subramaniam Ramanarayanan

The rising cost of health care is on the minds of many Americans. Since 1999, increases in health insurance premiums have consistently far outpaced inflation. Americans spend far and away more money per capita on health care than any other country in the world, and while many of us live to a ripe old age, our health outcomes are not commensurate with our additional spending. Out-of-control costs threaten to gobble up ever-greater portions of the U.S. gross domestic product, diverting resources from all other sectors of the economy.

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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.”

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.

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).

Dafny2011_Fig1a.gifFig­ure 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

Featured Faculty

Leemore S. Dafny

Member of the Department of Strategy from 2002-2016

About the Writer

Tim De Chant was science writer and editor of Kellogg Insight between 2009 and 2012.

About the Research

Dafny, Leemore S., Mark Duggan, and Subramaniam Ramanarayanan. 2012. Paying a Premium on Your Premium? Consolidation in the Health Insurance Industry, American Economic Review, 102(2): 1161-1185.

Read the original

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