Consolidation and the Transformation of Competition in Health Insurance

James C. Robinson


Health Affairs. 2004;23(6) 

In This Article

Pressures on Profitability

The correlation between the structure of an industry, measured in terms of the share distribution of competing firms, and its long-term profitability, is patchy at best, because of the important role of other determinants of revenues and costs. It would not be appropriate, for example, to infer that the high levels of consolidation documented in Table 2 caused the high levels of profitability documented in Table 3 without considering the role of other determinants. The consolidation among firms already in the industry is only one of five factors typically highlighted in discussions of corporate strategy. The others include barriers that prevent entry by competing firms from other markets, substitute products from other industries, bargaining power among suppliers, and bargaining power among purchasers. Generally, the profit potential is lower in industries with low barriers to entry by firms from adjacent markets, easy replacement by substitute products, and pressure from consolidated suppliers and consolidated purchasers.[16]

For two decades the most important source of competitive pressure in health insurance has been the availability of new entrants, including start-up HMOs and carriers from adjacent geographic regions willing to fight for enrollment through lower prices. Today, start-ups are rare because there have been no major innovations in technology, product design, or organizational structure that new firms could use to offset the scale advantages enjoyed by incumbents. Even large and successful firms are cautious as to the ease of extending into new markets. Today a national plan will make a serious entry into a new regional market only through the purchase of a large local firm. If the national plan already has a presence in the local market where it makes the acquisition (as it almost invariably the case), market expansion increases rather than decreases consolidation at the local level.

The most radical form of competition comes from substitute products rather than from new purveyors of existing products, as when the personal computer replaced the typewriter. Health insurance had seen no meaningfully different substitute products since the HMO was introduced thirty years ago. However, the recent experimentation with "consumer-directed" health plans combining a tax-sheltered health savings account with a high-deductible PPO, represents a potential substitute, replacing much of third-party (insurer) payment by consumer out-of-pocket payment.[17] The advent of these plans stimulated the formation of several new firms (for example, Definity and Lumenos) and the entry by firms from adjacent product niches (for example, Great West, Fortis, and Mutual of Omaha). For the moment, however, the consumer-directed plan seems more an incremental change to the PPO than an actual substitute and can be offered by large incumbent firms such as Aetna and Humana.

The consolidation of the health insurance industry has been accompanied in many markets by the consolidation of the hospital sector, which has permitted hospital systems to raise the rates charged to insurers.[18] Rising costs for clinical products and services are not incompatible with insurance industry profitability, however, if plans retain the discipline to raise their premiums at a rate commensurate with expected increases in underlying medical costs. Over the past several years, as hospital and other provider costs have surged, the major health plans (including those in Table 3 ) have not only maintained but reduced their medical cost ratios, from an average of 85.1 percent in 2000 to 82.1 percent in 2003.[19]

Despite the prominent role of the corporate purchaser of health benefits in the theory of managed care and managed competition, purchasers have proved ineffective in restraining premiums and profits in markets where consolidation has reduced the number of competing health plans. In the short term, health plans are moderating the rate at which they are increasing premiums relative to costs, but this is primarily attributable to an interest in growing (profitable) enrollment rather than to any consolidated purchasing power among employers. The longer-term risk to insurance industry profitability could be an abandonment by employers of health insurance as a fringe benefit and any resulting growth in publicly provided insurance (especially Medicaid expansions).