The Evolving Economics of Health Care

When President Obama and the Democratic Congress passed the Patient Protection and Affordable Care Act last year to reform the nation’s health system, they didn’t schedule all of the transformational regulations to take effect immediately. For instance, the central innovations of the plan — a legal mandate to purchase health insurance, paired with the development of state-based insurance exchanges — were assigned full implementation dates in the year 2014.

In the meantime, though, the economics of the American health care industry aren’t just sitting idly by, waiting for the legislation to take full effect. Instead, as economic conditions evolve, organizations are making plans and taking steps to position themselves to exploit the terms of the new law.

Regrettably, from the perspective of American consumers of medical services, these steps are driving the costs of health care into the stratosphere. And if the process continues to play out in accordance with current trends, there may not be much of a competitive, free market health care system left to regulate by the year 2014.

Fewer Insurers

Let’s begin by considering the number of insurance companies that are now competing with each other to offer health care policies to consumers. Because we allow these firms to eliminate their competitors by simply acquiring them, the competitive market continues to shrink into smaller and smaller clusters of firms.

Furthermore, these insurance companies are focusing more intensively on providing services to enrollees in federal government programs. That’s why Cigna paid $3.8 billion to buy Healthspring, for instance, and why Humana acquired MD Care. In each case, a huge insurer became even larger by purchasing a potential (or actual) competitor in the field of government services.

A health care industry with very few insurers simply doesn’t function in the same manner as a competitive market place. Firms in such industries are relatively less likely to compete based on factors like quality, innovation, and superior service; instead, they are relatively more likely to focus on strategies like maximizing prices and passing along the costs of medical care to customers. With fewer competitors to challenge them on the first set of factors, firms enjoy the freedom to focus instead on the second set of factors.

Fewer Payors

Of course, if the market were to be dominated by large numbers of strong payors — such as employers or trade associations, entities that purchase health care benefits on behalf of their employees or members — one could rely on the payors themselves to compel insurers into competing on the basis of quality. Unfortunately, though, the American health insurance industry is losing payors, not adding them.

Consider Walmart, for instance. The largest employer in the United States has shaken up many industries with its mammoth purchasing power, and could conceivably play the same role in the health insurance industry. But the firm appears to be more interested in driving employees out of its health plans than aggressively purchasing health insurance policies on their behalf, as evidenced by their recent increases in employee health premiums, as well as their refusal to cover certain part time employees.

Some commentators have voiced concern that the implementation of a national network of state-based health insurance exchanges, given its ability to serve as an alternative to employer based health insurance coverage, would result in employers dumping their health benefits benefits entirely and driving their employees onto the exchanges. In fact, some believe that Walmart is planning to execute that very strategy, and is now driving up the employee costs of health care to unaffordable levels in pursuit of this goal.

On Their Own

Even the most avid supporter of a single payor program, financed and managed by the federal government, would likely concede that a truly competitive free market health care system would be highly beneficial to consumers. Imagine a city filled with thousands of insurers and payors, of every conceivable shape and size, eagerly searching for any strategic advantage that could differentiate them from their competitors and help attract new consumers.

Now that’s a fairly compelling scenario, isn’t it? With thousands of competitors occupying each segment of the market, no single party could possibly exert control over the entire system. And consumers could continuously “go shopping” for coverage, forcing each organization to compete with multitudes of others for their loyalty and premium dollars.

The contrary scenario, though, is the one that currently exists, and that is becoming more and more entrenched with every large insurance acquisition and every dramatic employer decision to shift the costs of providing access to health care onto employees. Indeed, such actions provide consumers with fewer and fewer choices of payers, who in turn must choose from fewer and fewer choices of insurers.

The results? Ultimately, the economics of the industry will inevitably dictate the outcomes. Costs will continue rising, service levels will continue shrinking, and consumers will continue to be left on their own to fend for themselves.

Health Care Consolidation: Efficiency or Monopoly?

Who (or what) should be blamed for the dramatic increase in the cost of private health insurance in the United States?

To a certain extent, of course, the aging of the population and the development of technologically complex treatment options have contributed to the burgeoning costs of insurance. Consolidation activities within certain sectors of the health care industry have impacted costs as well, with hospital mergers eliminating competition among providers and insurer mergers doing likewise among payers.

Last week, however, the city of Pittsburgh, Pennysylvania witnessed a health care consolidation transaction of a different kind. Instead of a large hospital or insurer swallowing up a rival, the insurance company Highmark decided to cross industry sectors and directly acquire West Penn Allegheny Health System and its Allegheny General Hospital subsidiary.

Why would Highmark want to do such a thing? And is the emergence of insurer / provider conglomerates a beneficial public policy development … or yet another nail in the coffin of a competitive health care system?

A Case of Vertical Integration

A producer purchase of a provider system isn’t a terribly unusual event from a macro-economic perspective. Energy production companies have owned or franchised retail consumer outlets for decades; Exxon Mobil and Chevron, for instance, simultaneously drill for oil, refine it into gasoline, and then develop franchise contracts with gasoline stations to provide it to consumers. Energy firms have even coined specialized terms to describe the dual sides of their business operations: the phrase upstream activities refers to the production process, whereas downstream activities refers to the refining, sales, and marketing processes.

Economists refer to this type of merger as vertical integration, a process by which a single firm acquires (or otherwise controls) an entire value chain of the production, sales, and distribution of a category of products or services. It is distinctly different than horizontal integration, a process by which firms merge with their competitors (or potential competitors) in order to develop larger market shares in their narrowly defined segments of their value chains.

In the private sector health insurance industry, employers generally purchase access to health care from insurance companies, which then contract with hospitals and other providers to deliver services to employees. Although patient advocates and provider lobbyists may argue that hospitals and patients occupy the very center of the health care system, from a value chain perspective, insurers can be characterized as upstream organizations and hospital networks as downstream organizations.

A Mixed Record

Clearly, vertical integration strategies have succeeded in the energy industry. But can they do so in the health care industry?

Based on recent history, the track record for such business strategies among insurers and providers is most decidedly mixed. On the one hand, Kaiser Permanente of California has remained one of the most highly respected and successful health care conglomerates in the nation by managing provider and insurer functions simultaneously. On the other hand, though, Humana — one of the largest health insurers in the United States — pulled out of the provider market in 1993 after concluding that there are too many natural conflicts of interest between the two industry segments to justify a conglomerate approach.

New York State, a geographic pillar of the national health care industry, has also experienced mixed results. On the one hand, the rise of the Catholic Church’s statewide health plan Fidelis Care did nothing to save St. Vincent’s Hospital of Manhattan, or its seven fellow Catholic hospitals in New York City, from closure. On the other hand, the New York City Health and Hospitals Corporation continues to find success with its wholly owned MetroPlus health plan subsidiary.

Efficiency vs. Competition

Interestingly, California and New York represent relatively competitive health care markets, with several hospital networks and insurance companies competing for business in each state’s major population centers. It is possible that the natural forces of free market capitalism have helped blunt the deadening anti-competitive effects of vertical integration in these regions, thereby preventing conglomerates from evolving into monopolies.

Pittsburgh, though, represents a very different type of health care market. Its hospital sector is currently dominated by the University of Pittsburgh Medical Center; thus, Highmark’s acquisition of the badly trailing second tier hospital may actually result in an increase of provider competition. Usually, merger partners argue that the beneficial cost efficiencies to be derived through consolidation justify the possible harmful effects of a loss of competitive players; in Highmark’s case, though, public policy advocates in the Steel City may enjoy the twin benefits of cost efficiencies and greater (as opposed to lesser) competition.

It is understandable why Highmark was attracted to the acquisition opportunity; after all, by strengthening the closest rival to a dominant hospital system, it may be able to improve its own contracting position with both medical providers. Although conventional wisdom stipulates that competitive markets often suffer whenever major organizations merge or acquire each other, from a public policy perspective, this particular merger might well produce a different outcome.