Why Health Insurers Don't Control Costs

In my prior two posts on health care reform, I described the debate now raging over whether establishing a new public health insurance option open to everyone should be expected to stimulate or kill competition and assessed the extent of competition in health insurance and health-care provider markets.

On the latter topic, the verdict was quite clear: In both insurance and provider markets, there is little evidence of anything like healthy competition. Instead, in most parts of the U.S., the two markets appear to be oligopolistic: A small number of firms dominate, wielding price-making power.

All this leads us, then, to the question posed in the title: Why, exactly, are health insurers so bad at controlling costs?

There are several components to a full answer to that question, of course. Among the most important:

• The great market power wielded by insurers, as discussed in my last post;
• “Shadow pricing” by smaller insurers (setting their prices based on the prices of larger, market-power-wielding insurers, instead of seeking to compete through offering lower prices);
• Barriers to entry in both insurance and provider markets;
• Our “fee for service” payment system (which creates incentives for provision of more, and more expensive, services, rather than for effectiveness and efficiency);
• The lack of comparative effectiveness research and standards, and more generally the “public good” characteristics of information about health care practices and outcomes (making private insurers unlikely to invest in generating such information);
• The great information-gathering challenges buyers of health insurance face; and
• The high administrative and marketing costs of private (compared to public) insurers (six times the average administrative costs per capita in wealthy countries, according to a recent McKinsey & Company report).

But here I want to focus on a less frequently discussed factor contributing to the runaway inflation of health care costs: market power among providers. This factor is especially important to understand, I think, for the current debate over whether to include a public plan (and one permitted to use its bargaining power when negotiating rates with providers) in a reformed health care system.

The Importance Of Providers’ Market Power

Here's a quick summary of my argument in this post: even if we were to assume that private insurers act as beneficent seekers of the public good, it is hard to see how they would effectively bargain for lower premiums by forcing providers to accept lower payments, given the market power now wielded by the top providers in most local markets.

Let me explain.

All else being equal, providers prefer higher over lower rates of compensation for the health care services they provide. (To be clear: when I say "providers," I'm not referring to the doctors, nurses, nurses' aides, etc. who take care of us but to the increasingly-consolidated hospital companies for which most of them work.) More pay—whether it goes to shareholders, employees, new investments, or some combination among these—is a self-evidently good thing, if it can be achieved. When providers enter negotiations with insurers, they seek—for perfectly respectable, ordinary reasons—to maximize the payments they receive.

The insurers' position is actually more ambiguous. They're situated in between the sellers and buyers of health care services. They provide insurance to the buyers and purchase services from the sellers, to deliver those services to the buyers they insure. If there was no market power on either side of the insurers—if the bargaining power of both providers and payers was close to zero, with provider markets functioning competitively—then insurers would seek to increase their market share by competing to provide the highest quality coverage, the lowest prices, or some especially desirable combination of price and quality.

Unfortunately, health care provider markets operate nothing like that. On one side of the (highly consolidated, oligopolistic) insurers are the consumers of health care—all of us lucky enough to still have insurance - operating for the most part as employees of a firm or as individuals. On the other side sit the providers, who in many local markets are more consolidated than even the insurers. Under those circumstances, it would be foolhardy for a profit-maximizing insurer to seek to do anything other than accept price increases demanded by providers, at the expense of consumers. A market-power-wielding provider's threat to not work with an insurer (if the insurer tries to insist on cost control) must be taken very seriously.

And on the other side, patients lack the alternative options ("if you don't rein in the growth of premium prices, we're going to….."), access to information, and collective voice necessary to make any countervailing demands on insurers. For an insurer situated between these two sides—even if you suspend disbelief for a minute and assume them to be concerned primarily about the health of the people they insure—it's a no-brainer: concede to what the providers demand, and pass the higher premiums along to consumers.

Why should the insurers fear providers' threats of pulling out? Because most patients, and most employers who provide insurance to their workers, expect to have some choice among local hospitals. In fact, it's one of the very few things about health insurance plans that patients and employers have access to clear information on and are in a position to compare. If, for example, two out of the three major insurers operating in a local market cover care from all the major local providers, and the third insurer does not, then that insurer will lose business until it wises up.

Insurance companies simply size up the bargaining power on either side of them and make the logical choice: meet the providers' demands, and pass along payment increases to health care consumers. As long as they're not forced to restrain price inflation by some kind of countervailing bargaining power on the patients' side, it's hard to see why anything about this dynamic would change.

So-called "flagship hospitals" have always exercised a degree of market power in local provider markets. Everyone wants access to the famous medical center with the genius doctors as part of their insurance plan, if they live in a place where such a provider exists—giving that provider a degree of monopoly pricing power when it negotiates with insurers. What has changed over the last 20 years—beyond the general trend of consolidation among hospitals, which has increased oligopoly market power—is that those flagship institutions have increasingly become part of multi-hospital consortia. A consolidated group of hospitals that includes a flagship institution wields not just the market power of constituting a large percentage of the local market but also the market power of including a provider that buyers of insurance value above others. Whoever came up with this idea—of letting lots of other providers "piggyback" on a flagship, vastly expanding the consortium's pricing power—richly deserves the early retirement on some Caribbean isle I imagine they're enjoying.

Many of the health care providers with the greatest market power plow a large percentage of their annual surpluses into construction projects and new technologies, after taking out a relatively small percentage of their surplus as profits (or none, if they're nonprofits). Such investments have led to a kind of "medical arms race" in which "new medical facilities generate their own demand, because when there is more treatment available, doctors order more care for their patients." Such spending exacerbates the market failures (of oligopoly and monopoly power) already discussed. Excessive spending due to reliance on expensive but not necessarily better technologies is one of the inefficiencies in the U.S. health system most commonly noted by scholars comparing it to other countries' health systems.

Low Transparency, High Prices

For example, to prove the effects of provider consolidation, it would be great to be able to look at insurers' pricing practices. But "health plan pricing data is proprietary", so such an analysis is something "only the federal government can undertake through exercising its subpoena power." Since "contracts between insurers and hospitals typically include confidentiality agreements" it is very difficult for the public to determine whether insurers pay rates to providers based on anti-competitive price-coordination rather than the kind of cost-minimization competitive markets are supposed to generate.

Fortunately—as long as a couple of them continue to exist, anyway—newspapers can sometimes step in when regulators are asleep at the wheel: in late 2008, the Boston Globe published a series of investigative articles on Partners HealthCare, a multi-hospital consortium founded in 1994 through a merger between Boston's prestigious Brigham and Massachusetts General hospitals. Each of these two hospitals already exercised significant "flagship" bargaining power prior to the merger.

Globe reporters discovered that in 2000 the CEOs of Partners and the state's largest insurer, Blue Cross Blue Shield (BCBS) of Massachusetts, agreed to a major payment increase for Partners. In return for receiving higher payments from BCBS, Partners "promised to push for the same or bigger payment increases" from other insurers. The Partners CEO's attorneys warned him at the time "that a written agreement between the state's biggest hospital company and its biggest health insurer that would make insurance more expensive might raise legal questions about anticompetitive behavior," according to the Globe. So the deal was sealed not with a contract but a handshake. BCBS called it a "market covenant."

Partners is the state's largest private employer, and it appears to have had little trouble convincing other insurers to go along with the higher prices the dominant insurance player agreed to. BCBS, meanwhile, saw its largest-ever increase in enrollment in 2000—the year of the "covenant" with Partners—and its profits have topped $200 million for five consecutive years.

It seems reasonable to assume that Boston is not the only place in the country where market-power-wielding insurers and market-power-wielding providers have reached such gentlemen's agreements, given the basic principles of economics. Absent some bargaining power on the purchaser side, it's perfectly natural that consolidated, poorly regulated insurers and consolidated, poorly regulated providers preside over a rapid increase in health insurance prices. Why would they do anything else?

A Final Note

What's funny about this whole discussion is that all the arguments I've been making—not just about providers' market power, but in the list of other factors contributing to cost inflation mentioned at the beginning—are drawn from elementary microeconomics. They're about the virtues of competition, and standard ideas of what you can do to generate more of those virtues in situations where you find oligopolies and other kinds of market failure.

Isn't the other side in this debate—the opponents of a public plan—supposed to be the one championing markets, competition, and the whole microeconomics "self-interest" creed? Aren't progressives supposed to be the ones who don't care about costs, who waste everyone's hard-earned money on do-gooder schemes?

Lest we forget, while focusing so much on cost control (on which the pro-public plan side's arguments are indeed both more persuasive and better informed by economics than are those of the public plan's opponents), I want to remind you in closing that comprehensive health care reform that includes a public plan would do considerably more than rein in cost inflation. It would, in fact, help us to remedy what Martin Luther King, Jr. called "the most shocking and inhumane….of all the forms of inequality": inequality in people's access to the basic human right of good health care.

Views expressed on this page are those of the authors and not necessarily those of Campaign for America's Future or Institute for America's Future