The Health Insurance Industry

1. The Health Insurance Industry A health insurer pays all or a portion of medical bills in return for a fixed premium Consumers are willing to pay premiums because insurance reduces risk The presence of health insurance affects the use and price of medical services When more of the cost is covered by the insurance plan, consumers will use more services and devote less effort to finding low-price providers and to staying healthy in general Insurers recognize this and attempt to design policies that provide appropriate incentives to consumers; such polices include the use of deductibles, contracts between insurers and medical providers and review of the medical necessity of some services Up until the early 1980s, insurers largely ignored their adverse impacts on medical costs; more recently the insurance market has become more competitive and cost-containment efforts have increased

2. Pre-1980: Traditional Insurance Firms In the U.S., both public and private firms provide health insurance The public providers are Medicare (federal health insurance for the elderly) and Medicaid (federal and state insurance for the poor and disabled) Prior to 1980, two types of firms sold private insurance: commercial insurers and nonprofits In 1975, about half the private insurance market was covered by commercial insurers and the other half was covered by the mostly nonprofit Blue Cross and Blue Shield; over time, the share of Blue Cross and Blue Shield has fallen to around 1/3 The commercial market was populated by hundreds of firms, none of which had a market share over 2% Entry and exit were easy and occurred often

3. The Commercial Market vs. the Nonprofits Over 85% of individuals insured for hospital expenses were covered under group policies; it seems likely that informed buyers dominated the market Commercial insurers would provide a menu consisting of price-insurance combinations; these were essentially competitively provided and a union or employer representative would choose from this menu Thus, the commercial market taken by itself was close to perfectly competitive However, competitive conditions varied across geographic regions depending on the strength of Blue Cross and Blue Shield The Blue Cross plans were organized by hospitals to provide hospital insurance; the Blue Shield plans were organized by physicians to provide physician services insurance Typically, the Blues were organized under special enabling acts so that additional entry was not allowed; this contributed to their market power

4. The Blues There were two sources of market power for the Blues: • They were regulated and taxed more favorably than their competitors • They could often obtain discounts from doctors and hospitals that were greater than those of their competitors Given this, why didn’t the Blues monopolize insurance markets? Two reasons: • It was more convenient for employers to deal with one insurance firm for all of their needs; this gave an advantage to commercial firms who would usually sell many kinds of insurance • The Blues were relatively inefficient and given the lack of profit incentives had no incentive to become more efficient • The Blues offered fewer menu options than the commercial firms (all-or-nothing insurance with no co-payments)

5. The Impact of the Blues on Medical Costs Why did the Blues prefer more complete insurance with fewer co-payments, deductibles, and so on? • More complete insurance raises the demand for medical care, and the providers of the Blue plans (hospitals and doctors) had incentives to raise demand • A belief that there should be no financial barriers to medical care The Blues’ practice of offering policies with minimal cost sharing led to a lower level of cost sharing in the overall market Many consumers ended up purchasing more complete plans than they would have otherwise because the Blues were able to offer attractive premiums for plans with full coverage

6. Moral Hazard When consumers have complete insurance, they may demand care that has less value to them than it costs to provide; this is inefficient This moral hazard problem is a problem for all types of insurance, but is particularly problematic for health insurance Most insurance offers a fixed payment based on the value of the loss, and that value is typically relatively easy to measure (a totaled automobile, a burned-down house); the consumer is then free to use the payment however he chooses Health insurance is different because there is no objective way to measure the “value of the loss”; consumers will consumer care excessively because they do not have to pay for it at the margin Given the moral hazard problem, the optimal amount of coverage is less than 100%

7. Moral Hazard and Inefficiencies There are two major distortions pushing consumers in the direction of full coverage: • Employer payments for health insurance are deductible as a cost but are not taxable as employee income. Thus, there is an effective tax subsidy toward purchasing health insurance equal to the sum of the federal and state marginal income tax rates (which varies between 28 and 50%) • The Blues use their market power to encourage complete insurance Phelps (1992) states that the health sector could be about 10 to 20% smaller without the tax subsidy, which is equivalent to 1 to 2% of GNP Estimates of the welfare losses associated with excessive insurance run into the billions of dollars

8. Insurance Raises Prices Health insurance reduces the incentives for consumers to search for lower prices; more complete coverage reduces incentives more The moral hazard effect is still strong with a 20% coinsurance plan (where the consumers pays 20% of health care costs); in this plan, for every $100 the consumers saves, the consumer keeps only $20 One type of insurance that overcomes this problem is sometimes called indemnity insurance In indemnity insurance, the benefit is a fixed payment to the consumer per unit of services; if the consumer finds a relatively cheap provider, the consumer keeps the entire amount saved When consumers have more complete coverage, providers have lower incentives to compete on price because lower prices do not lead to substantial increases in demand; this is one reason why health care is so costly

9. Trends Since 1980 In the mid-1970s, traditional insurance covered about 93% of consumers who were privately insured Almost all of the remaining 7% were covered by health maintenance organizations (HMOs) and preferred provider organizations (PPOs) By 1994, the HMO and PPO plans covered almost 40% of privately insured consumers, and by 2000 they covered almost 90%; between the two of them their shares are roughly equal, with PPOs’ being slightly higher Another change is that most large employers are now “self-insured”; the employer hires an insurance firm to process claims, but the insurance risks are borne by the employer; by 1990, about 58% of all group coverage was through self-insured plans Self-insurance is a means of avoiding costly state regulations on private insurance; many states mandate coverage and conditions for private insurers Self-insurance also allows the employer more direct access to cost controls

10. Rising Costs Most of the non-elderly population is insured through employment-based group policies, which means that firms pay when medical costs rise Between 1970 and 1980, the amount of insurance premiums paid by U.S. firms for group policies rose 352%; firms began to pay more attention to ways of decreasing medical costs During the mid 1980s, premium increases averaged 6 to 8% annually, but by 1990, they again reached double-digit levels In order to slow rising costs, firms have shifted employees from traditional insurance into managed care plans, which have premiums that are 9 to 12% lower Most employers still offer traditional insurance as an option Also, employers have increased the share of the premium paid by employees and raised coinsurance and deductibles

11. Managed Care Managed care plans get more involved in determining which health care procedures should be followed One common technique is to determine whether a hospital stay is required before admission occurs Cases may be reviewed during the hospital stay as well to limit time in the hospital Some plans require second opinions for surgery These cost-containment methods along with increased cost sharing have helped stabilize national health care expenditures at around 13% of GDP since 1994; prior to that time expenditures as a percentage of GDP were rising steadily from 5% in 1960 Traditional insurance firms have responded by introducing their own managed care plans (the Blues had 78.7 million enrollees in such plans in 2000)

12. Health Maintenance Organizations HMOs combine the insurer with the doctor and hospitals to eliminate the incentive to overuse medical care that is inherent in traditional insurance plans HMO profits are higher if fewer services are provided because revenues come primarily from premiums paid in advance HMOs typically use non-price rationing to discourage use; competition for members ensures that HMOs do not provide too few services Empirical evidence from as early as 1987 establishes that firms whose employees choose HMOs pay lower premiums and that there is a lower profit margin on HMO insurance; both facts suggest that HMOs were a significant pro-competitive force by the late 1980s Insurers have responded by developing PPOs and introducing managed care into traditional policies, and some have simply entered the HMO business

13. Preferred Provider Organizations PPOs are contacts among insurers, providers, and consumers The providers agree to serve PPO consumers on preferential terms, offering a lower price and agreeing to cooperate with utilization review restrictions Consumers are given financial incentives such as reduced coinsurance to favor PPO providers PPOs differ from HMOs in that services from providers outside the preferred panel are still covered (with higher cost sharing) and providers are not at risk for the volume of services used by patients Of course, nothing prevents HMOs from offering similar plans and they may do so in the future

14. The Blues Governments have been eroding the tax advantages of the Blues A few Blue plans have concluded that the costs of public service activities they are expected to undertake exceed the benefits of tax advantages and have reincorporated as commercial insurers Antitrust efforts at the state level have increased competition between Blue Cross and Blue Shield plans

15. Antitrust Enforcement Prior to 1963, national hospital accreditation standards conferred great economic power on local medical societies To be accredited, hospitals could employ only members of their local medical societies A local society could hinder the development of an HMO by ejecting HMO physicians from the local society In 1963 a court decision eliminated the membership requirement for hospital access Over the years, groups of physicians have attempted to boycott plans in response to utilization controls; antitrust authorities have played a role in stopping these boycotts through cease and desist orders