Are Health Insurance Markets Competitive? By Leemore Dafny*

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1 Ar Halth Insuranc Markts Comptitiv? By Lmor Dafny* To gaug th comptitivnss of th group halth insuranc industry, I invstigat whthr halth insurrs charg highr prmiums, ctris paribus, to mor profitabl firms. Such dirct pric discrimination is only fasibl in imprfctly comptitiv sttings. Using a propritary national databas of halthplans offrd by a sampl of larg, multisit firms from , I find firms with positiv profit shocks subsquntly fac highr prmium growth, vn for th sam halthplans. Morovr, within a givn firm, thos sits locatd in concntratd insuranc markts xprinc th gratst prmium incrass. Th findings suggst halthcar insurrs ar xrcising markt powr in an incrasing numbr of gographic markts. Th U.S. stands virtually alon among lading industrializd nations in its havy and incrasing rlianc on th privat insuranc sctor to intrmdiat halthcar for its rsidnts. 1 Th assumption undrlying this systm is that firc comptition among privat insurrs yilds mor fficint outcoms, broadly writ (Alain C. Enthovn 1978). Howvr, a comprhnsiv survy on th stat of comptition in halthcar apparing in th 1999 Journal of Economic Prspctivs concluds thr is littl mpirical vidnc on comptitiv conduct by halth insuranc firms (Martin S. Gaynor and Dborah Haas-Wilson 1999). A 2004 rport on th sam by th Fdral Trad Commission and th Dpartmnt of Justic finds most xprts bliv th markt is highly comptitiv (with th vocal xcption of groups rprsnting physicians), *Northwstrn Univrsity, Kllogg School of Managmnt, Jacobs Cntr Suit 607, 2001 Shridan Rd., Evanston, IL, 60201, and NBER (-mail: I am gratful for hlpful suggstions by th ditor, thr anonymous rfrs, and William Collins, David Cutlr, Jams Dana, David Dranov, Mark Duggan, Vivian Ho, Kathrin Ho, Julian Jamison, Ilyana Kuzimko, Mara Ldrman, Jin Li, Niko Matouschk, San Nicholson, Mark Pauly, Scott Schafr, Kosali Ilaypruma Simon, Alln Stinbrg, Scott Strn, John Tatom, Robrt Town, Dal Yamamoto, and sminar participants at Columbia, Duk, Univrsity of Chicago, Univrsity of Maryland, Wharton, th NBER Summr Institut, th Amrican Economic Association Annual Confrnc, th Northwstrn Univrsity Law School, and th Sarl Cntr Rsarch Symposium on Insuranc Markts and Rgulation. Michal Loqurcio, Tamara Hayford, and Subramaniam Ramanarayanan providd xcllnt rsarch assistanc. Funding from Th Sarl Cntr on Law, Rgulation, and Economic Growth at th Northwstrn Univrsity School of Law is gratfully acknowldgd. 1 Othr notabl xcptions includ th Nthrlands and Switzrland. Both countris rquir individuals to purchas an approvd halthplan from a privat insurr. 1

2 although nw rsarch on th subjct is scarc and plagud by data and idntification issus (s Dnnis P. Scanlon, Michal E. Chrnw and Woolton L 2006 for a thorough rviw). 2 Manwhil, continud faith in comptitiv markts is manifst in th rapid incras in outsourcing of public insuranc to th privat sctor (Mark G. Duggan 2004; Duggan and Fiona M. Scott Morton 2008), as wll as lax antitrust nforcmnt during two dcads of xtnsiv insurr consolidation. Only thr combinations hav bn challngd by th Dpartmnt of Justic, and ths only in slct markts. 3 This study valuats whthr and whr local insuranc markts ar comptitiv by tsting for vidnc of conduct that can only occur in imprfctly comptitiv markts. I invstigat whthr firms with highr profits pay highr halth insuranc prmiums, controlling as bst as possibl for diffrncs in th plans slctd, mploy populations, and markt conditions. Th xtnt to which carrirs ar abl to xtract mployr-spcific rnts offrs a glimps into comptitiv intractions in this important sctor, as a comptitiv industry would b charactrizd by uniform pricing at (mployr-spcific) cost. Although a markt conduct paramtr (i.. a masur ranging from 0 to 1, with 0 rprsnting prfct comptition and 1 monopoly) cannot b drivd from stimats of rnt xtraction, diffrncs in rnt xtraction across markts provid a usful indicator of th rlativ comptitivnss of ths markts. Using a propritary panl databas on fully-insurd halthplans offrd by a sampl of larg, multi-sit mployrs btwn 1998 and 2005, I find firms with positiv profit shocks subsquntly fac largr prmium incrass, vn for th sam halthplans. Morovr, this incras is gratst in markts with th fwst insuranc carrirs (particularly 6 or fwr). Thus, a multi-sit firm with high profits in a givn yar will subsquntly fac significantly highr halth insuranc prmiums, but only at sits srvd by a concntratd insuranc markt. This 2 Improving Halth Car: A Dos of Comptition, A Rport by th Fdral Trad Commission and th Dpartmnt of Justic (July 2004). 3 Ths challngs wr satisfid through consnt dcrs rquiring divstitur in th markts with substantial ovrlap (Tucson and Bouldr in th cas of th UnitdHalth-PacifiCar mrgr in 2005; Houston and Dallas in th cas of th Atna-Prudntial mrgr in 1999; and Las Vgas (Mdicar Advantag plans only) in th cas of th pnding UnitdHalth-Sirra mrgr in 2008). Complaint, Unitd Stats v. Atna Inc., N0.3-99CV 1398-H, par. 19 and 20 (N.D. Tx. Jun 21, 1999); Final Consnt Ordr, Unitd Stats v. Atna Inc., No.3-99CV 1398-H (N.D. Tx. Dc. 7, 1999); Complaint, Unitd Stats v. UnitdHalth Group Incorporatd & PacifiCar Halth Systms, Inc., No. 1:05CV02436 (Dc. 19, 2005); Final Judgmnt, Unitd Stats v. UnitdHalth Group Incorporatd & PacifiCar Halth Systms, Inc., No. 1:05CV02436 (May 23, 2006). Final Judgmnt, Unitd Stats V. UnitdHalth Group Incorporatd and Sirra Halth Srvics, Inc. No. 1:08CV

3 rsult contradicts th lading altrnativ mpirical xplanation for my finding, namly that firms with high profits fac highr prmium incrass bcaus thy incras bnfits in dimnsions I do not obsrv. (If this is th xplanation, it should occur uniformly across all sits.) To dtrmin why insuranc carrirs ar abl to xtract highr prics from profitabl firms in concntratd insuranc markts, I combin insights from fild intrviws with a modl of bilatral bargaining, as larg mployrs and insurrs bargain annually ovr insuranc contracts. Th vidnc suggsts mployrs ar rluctant to switch halthplans during good tims, i.. profits incras willingnss-to-pay for incumbnt halthplans. Th fact that, conditional on th sam profit shock, prmiums incras th most in markts srvd by a concntratd insuranc industry could b xplaind by a) largr profit-inducd incrass in switching costs in concntratd insuranc markts (i.. thr is mor nw rnt to xtract in ths markts), b) gratr bargaining (or markt) powr of insurrs in ths markts, or both. Rturning to th data, I find no support for a): conditional on th sam profit shock, firms in markts with fwr insuranc carrirs ar mor likly to switch carrirs, suggsting switching costs do not incras mor for profitabl mployrs in ths markts. Rathr, it appars that th strong bargaining position of insurrs in concntratd markts nabls thm to captur mor of th xtra surplus gnratd by profit shocks. (Bcaus prics ar ultimatly th rsult of bargaining btwn mployrs and carrirs, I gnrally us th trm rnt xtraction in plac of pric discrimination, which is typically rsrvd for sttings in which th sllr has commitmnt powr, i.., maks a singl tak it or lav it offr. This tchnicality notwithstanding, th practic I invstigat is akin to first-dgr pric discrimination, in which th sllr sts individual prics to xtract th surplus of ach buyr. In th cas of a monopoly supplir, consumr surplus is wholly xtractd. 4 Howvr, consumrs rtain som of th surplus in oligopoly sttings (Danil F. Spulbr 1979; Mark Armstrong 2006). 5 4 Th trm pric discrimination is typically rsrvd for sttings in which th sllr has commitmnt powr, i.., maks a singl tak it or lav it offr. For this rason, I us th trm rnt xtraction in its stad, although th outcoms ar th sam. 5 Spulbr s modl assums ach firm facs a downward-sloping rsidual dmand curv and has th ability to prfctly discriminat. Th pur-stratgy Nash quilibrium is charactrizd by marginal-cost pricing; social surplus is thrfor maximizd. Th rsidual dmand curvs bcom mor lastic as comptition incrass, nabling consumrs to captur an incrasing shar of surplus. 3

4 Th rsults offr th strongst vidnc to dat linking privat halth insuranc prmiums to th markt powr of insurrs. Th data also indicat that an incrasing shar of th population is purchasing covrag in th last comptitiv markts. As of 2005, 23 prcnt of mploys in my sampl (which is rprsntativ of Amricans covrd by larg firms, who account for roughly on-third of th insurd nonldrly) rcivd covrag in markts with 6 or fwr major carrirs (in which rnt xtraction is most pronouncd), up from 7 prcnt in Du to rcnt consolidations, this figur is crtainly gratr today. Th findings complmnt rcnt work by Kathrin Ho (2009) on th upstram bargaining btwn insurrs and hospitals. Ho finds insurrs in som markts succssfully xtract th rnts of hospitals in thir ntworks, and hospitals in turn diffrntiat thmslvs to avrt this. Collctivly, th rsults imply th full bnfits of a comptitiv marktplac ar not bing ralizd by a larg sgmnt of th privatly-insurd. Gratr scrutiny of proposd consolidations in this sctor may also b warrantd, with particular attntion to consolidations in markts with 6 or fwr major insuranc carrirs, and whr switching costs of customrs ar high (.g. if carrirs ar highly diffrntiatd). Th papr procds in six sctions. Sction I provids background on th privat halth insuranc industry and summarizs prior rsarch. Sction II dscribs th data in dtail. Sction III prsnts th main mpirical analysis of rnt xtraction, togthr with ky robustnss chcks and xtnsions. Th modl is dscribd in Sction IV, and analyss of halthplan switching ar prsntd in Sction V. Sction VI concluds. I. Th U.S. Halth Insuranc Industry A. Ky Facts Figur 1 graphs th prcntag of nonldrly Amricans covrd by privat insuranc from , sparatd by whthr th covrag was mploymnt-sponsord or individually- 6 Th stimat of th numbr of insurd nonldrly Amricans covrd by larg firms (1000+ mploys) was constructd by th author using stimats from th MEPS-IC (gnrously providd by Kosali Simon) and th Employ Bnfits Rsarch Institut ( pdf). 4

5 purchasd. Covrag from both sourcs dclind slightly during th study priod, but rmaind high, with 70 prcnt of th nonldrly obtaining insuranc through th privat sctor in Ths figurs undrstat th fraction of th nonldrly nrolld in privat plans, as th majority of Mdicaid bnficiaris ar also nrolld in such plans (61 prcnt in 2005). Among th ldrly, 95 prcnt ar nrolld in Mdicar, and narly 13 prcnt of ths rcivd thir car in 2005 through a privat-sctor Mdicar Advantag plan. An additional 59 prcnt of th ldrly had privat supplmntary covrag in FIGURE 1 ABOUT HERE National statistics on privat halthplans ar availabl from th annual Employr Halth Bnfits survy, sponsord jointly by th Kaisr Family Foundation (KFF) and th Halth Rsarch and Educational Trust (HRET). 8 This survy documnts two ky trnds that ar corroboratd in my data. Th first is th rapid incras in halth insuranc prmiums. Figur 2 illustrats ths incrass for , basd on figurs for a family of four. Annual growth (for slf and full-insurd plans) pakd at 13.9 prcnt in 2003, dclining to a still-imprssiv 9.3 prcnt in Ths figurs likly undrstat th trnd as mployrs hav adjustd to rising costs by rducing th gnrosity of bnfits providd. FIGURE 2 ABOUT HERE Th scond trnd is th growth in th shar of mploys covrd by slf-insurd rathr than fully-insurd plans (Figur 3). Many larg mployrs choos to slf-insur, outsourcing 7 Sourc: Ths figurs do not rflct Mdicar Part D, th prscription drug program introducd in Mdicar Part D is administrd ntirly by th privat sctor and currntly covrs ovr 90 prcnt of Mdicar bnficiaris. Many providrs ar pharmacy bnfit managmnt firms rathr than halth insuranc carrirs. 8 Th KFF/HRET survy randomly slcts public and privat mployrs to obtain national data about mployrsponsord halth insuranc; approximatly 2000 mployrs rspond ach yar. Th data ar not publicly availabl, nor is th sampl dsignd to provid stimats at th markt lvl. (KFF/HRET Employr Halth Bnfits 2006 Summary of Findings, documnt 7528). Sinc 1996, th Agncy for Halthcar Rsarch and Quality (AHRQ), a division of th Dpartmnt of Halth and Human Srvics, has also conductd an annual survy of mployrs in conjunction with th Mdical Expnditur Panl Survy (MEPS). MEPS follows housholds ovr tim, and th Insuranc Componnt survys mployrs of houshold mmbrs to gathr data on halthplans. Th micro data ar availabl on-sit at Cnsus Rsarch Cntrs to thos with appropriat claranc, but thy do not constitut an mployr-plan-lvl panl. Th most rcnt data availabl is for

6 bnfits managmnt and/or claims administration but paying ralizd costs of car. Such mployrs can sprad risk across larg pools of nrolls, and may purchas stop-loss insuranc to limit thir rmaining xposur. Pr ERISA (th Employ Rtirmnt Act of 1974), ths plans ar also xmpt from stat rgulations and stat insuranc prmium taxs. According to th KFF/HRET survy, th shar of larg-firm mploys nrolld in slf-insurd (as opposd to fully-insurd) plans incrasd from 65 prcnt in 1998 to 82 prcnt in Th incras among mploys in all firms was much smallr: 50 to 54 prcnt. 9 FIGURE 3 ABOUT HERE My primary study sampl includs only fully-insurd plans. Rportd prmiums for slf-insurd plans ar actually th mployr s stimat of outlays for th avrag nroll in th plan-yar. Ths forcasts ar usd for budgting purposs and to mak dcisions about nroll contributions and stop-loss covrag. Thy ar not dirctly comparabl to prmiums for fullyinsurd plans, which ar st prospctivly and always includ risk prmiums. Slf-insurd projctions may includ a partial risk prmium if th mployr purchass stop-loss covrag; whthr stop-loss covrag is purchasd is not capturd in th data. I mak us of th slfinsurd sampl, howvr, for a numbr of supplmntal analyss. Prmiums for fully-insurd plans dpnd on th actuarial halth risk of mploys, dtails of plan dsign (.g., copays, covrd bnfits, disas managmnt programs), and gnral carrir charactristics (.g., providr ntwork, spd and accuracy of claims procssing, rputation). Th mployrs rprsntd in my sampl typically solicit bids vry yar from on or mor halthplans in all of th markts in which thy oprat. Many us bnfits consultants to srv as brokrs in this procss. According to th brokrs I intrviwd, aftr som back-andforth on plan dtails (.g. copays, drug formularis, tc.), a final round of ngotiation ovr th prmium for a fixd plan dsign may tak plac. Th nt rsult is that pricing of fully-insurd halthplans is anything but transparnt, rndring th stting rip for diffrntial pricing across mployr groups. 9 Th ris in slf-insuranc, though byond th scop of this papr, is an intrsting subjct for furthr rsarch. Early work by Coopr and Simon (2007) rvals that firms ar mor likly to slf-insur if thy hav multipl locations, a larg numbr of workrs, and high avrag wags. 6

7 Contracts ar signd 3 to 6 months prior to th start of th bnfit yar, which is gnrally th calndar yar. Thus, an mployr will typically bgin slcting 2010 plans and rats arly in To th xtnt that firm profits affct ths agrmnts, th rlvant profit figur will rflct data for 2008 (assuming data is availabl annually). 10 B. Prior Rsarch A 2006 survy by Scanlon, Chrnw and L finds 35 studis that invstigat th impact of comptition among halth insurrs on halthcar outcoms. Of ths, 7 us som masur of prmiums as an outcom. Most find a ngativ association btwn comptition and prmiums, but ths studis suffr from considrabl data problms and idntification issus. For xampl, on of th most carful studis (Douglas R. Wholy, Rogr D. Fldman, and Jon B. Christianson 1995) rlis on annual HMO-lvl data from Prmiums ar stimatd using avrag rvnu pr mmbr pr month, and th dgr of comptition facd by ach HMO is stimatd as a wightd avrag of th HMO pntration rat (th prcnt of insurd individuals nrolld in an HMO) in all of th countis in which th HMO oprats. PPOs ar not considrd, although in rcnt yars courts hav found HMOs and PPOs (as wll as th variants in btwn) to b in th sam product markt. 11 Summarizing th shortcomings in this litratur at larg, Scanlon, Chrnw and L mphasiz a poor corrspondnc btwn masurs of markt comptition and actual comptitiv conditions. No studis addrss ndognity of th concntration masurs. Two rcnt studis by Jami C. Robinson (2004, 2006) dscrib th high and incrasing lvl of concntration in local insuranc markts. Th first study uss a databas of stat rgulatory filings to study stat-lvl markt structur ovr By th nd of this study priod, narly 40 stats had a dominant carrir srving ovr on-third of th privat markt. Robinson also documnts incrass in prmium rvnus and oprating margins during th sam 10 Ginsburg t al. (2006) find vidnc of a similar lag (18 months) btwn prmiums rportd by KFF/HRET and th cost of halthcar srvics (.g., providr chargs). 11 Th cas law is summarizd in Improving Halth Car: A Dos of Comptition, ibid. Som cass in which sparat markts for HMOs and PPOs hav bn rjctd includ Blu Cross & Blu Shild v. Marshfild Clinic (65 F.3d 1406 (7 th Cir. 1995)) and Ball Mmorial Hospital v. Mutual Hospital Ins., Inc.(784 F.2 nd 1325 (7 th Cir. 1986)). 7

8 priod. Of cours, a causal link btwn concntration and prmiums cannot b stablishd through th coincidnc of ths trnds. In addition, a commntary publishd alongsid th pic highlights concrns ovr th markt dfinition: an ntir stat is not a rlvant gographic markt, [hnc] th xistnc of high HHIs in that stat has no comptitiv (or probativ significanc) (David A. Hyman and William E. Kovacic 2004). Robinson (2006) documnts still highr stat-lvl concntration figurs. H also rports many insurrs ar targting th public rathr than th privat sctor for futur growth. Th following sction offrs dtails on th high-quality, micro panl data that affords m th uniqu opportunity to xamin th pricing of individual insuranc contracts in th gographic markts actually utilizd by insurrs whn ngotiating rats. Importantly, th idntification stratgy rlis on shocks to individual mployrs rathr than shocks to markt concntration. I. Data A. Th LEHID Data Th primary datast was providd on a confidntial, limitd-us basis by a major bnfits consulting firm. 12 Th unit of obsrvation is th plan-yar. A plan is dfind as a uniqu combination of an mployr, gographic markt, insuranc carrir, and plan typ (HMO, POS, PPO, and indmnity),.g., Worldwid Widgts CIGNA HMO in Phonix, Arizona. Th panl covrs (inclusiv), and is unbalancd, with mployrs ntring and xiting basd on thir rlationship with th consulting firm, and spcific halthplans apparing or disapparing whn addd or trminatd, rspctivly. Not that participation is complt for any yar in which an mployr is includd in th sampl (i.., all plans offrd by that mployr ar prsnt) Employrs of all sizs rly on xtrnal consultants whn dsigning or purchasing bnfits. Using a 1997 survy of 21,545 privat mployrs, Marquis and Long (2000) find xtrnal consultants wr mployd by narly half of th smallst firms (<25 workrs), and narly two-thirds of th largst firms (>500 workrs). Ths findings suggst th firms ngaging th srvics of my sourc ar not unusual in this rgard, strngthning th cas for th gnralizability of th rsults. 13 Som data scrubbing was ncssary to nsur that th sam ID was assignd to th sam mployr in vry yar. In th cas of mrgrs, I crat a nw mployr ID post-mrgr if both partis to th mrgr appar in th data sparatly in a prior yar. 8

9 Th full datast includs obsrvations from 776 mployrs and 139 gographic markts in th Unitd Stats. Th mployrs span a wid rang of industris. Th top 3 ar manufacturing and financial institutions (tid for 13 prcnt of mployrs ach), and consumr products (9 prcnt of mployrs). On avrag, 241 mployrs appar in th sampl ach yar. Th mdian mployr oprats in 47 gographic markts and insurs 9,670 activ mploys (rtirs ar not includd in th data). Th total numbr of mploys rprsntd in th sampl avrags 4.8 million pr yar. This figur dos not includ dpndnts, so th numbr of insurd individuals rprsntd by th survy is at last twic as larg. Th gographic markts ar dfind by my sourc, and thy rprsnt th markts usd by carrirs and mployrs whn ngotiating rats. 14 Th markts ar somtims dfind by stat boundaris (.g., Dlawar), but mor commonly by mtropolitan aras (.g., Kansas City (in Missouri and Kansas); Kntucky Louisvill, Lxington; Kntucky xcpt Louisvill, Lxington). Figur 4 dpicts th distribution of covrd mploys across th gographic markts. This distribution closly matchs th distribution of privatly-insurd mploys in ths markts (stimatd using county-lvl data from th Currnt Population Survy of March 2000). I will rfr to th ntir datast by th acronym LEHID, for Larg Employr Halth Insuranc Datast. B. Study Sampl Th study sampl is limitd to fully-insurd plans, for which prmiums ar dtrmind prior to th start of th calndar yar. 15 Th shift toward slf-insurd plans, highlightd in th KFF- HRET survy, is also apparnt in LEHID: th proportion of mploys nrolld in slf-insurd plans incrasd from 58 to 76 prcnt btwn 1998 and Howvr, th total numbr of mploys in fully-insurd plans is still sizabl, avraging 1.6 million pr yar Som carrirs with a national prsnc will ngotiat a singl rat for all mploys nationwid. S footnot 18 for a discussion of th implications of national pricing for th mpirical analysis. 15 Slf-insurd plans rport prmium quivalnts, thir prdictions of costs pr nroll. Ths figurs combin claim rimbursmnt, fs paid to carrirs, and prmiums for any stop-loss insuranc. 16 Thr is a good dal of ovrlap in th carrirs srving slf-insurd and fully-insurd groups. Among carrirs srving mor than 5 clints in LEHID, 57 prcnt hav both fully-insurd and slf-insurd plans, 41 prcnt hav 9

10 I rstrict th study sampl to obsrvations in gographic markts containing 20 or mor distinct mployrs; that is, 20+ mployrs must offr a fully-insurd (FI) choic in that marktyar. This rstriction is imposd to nsur accurat stimats of markt structur, namly th total numbr of carrirs srving a givn gographic markt. 17 Only 3 prcnt of th fullyinsurd mploys in my sampl ar droppd as a rsult of this rstriction. Not this LEHID- FI sampl is not th sampl usd for th rgrssion analysis; that sampl is furthr limitd to plans for which profits of th associatd mployr can b obtaind, and is dscribd blow. Figur 2 shows that prmium growth in th LEHID-FI sampl tracks th lvls and trnds publishd by KFF/HRET for FI plans fairly closly. This bods wll for th gnralizability of th data and rsults. Figur 5 graphs th distribution of markts in th LEHID-FI sampl by th numbr of carrirs in th markt. Data ar prsntd sparatly for 1998, 2001, and Th fraction of markts with fwr than 6 carrirs incrasd from 10 to 35 prcnt ovr this priod, whil th fraction with mor than 10 carrirs dcrasd from 35 to 7 prcnt. Th incras in concntration is also manifstd in othr masurs such as th HHI and th 4-firm concntration ratio. Howvr, ths masurs ar mor pron to masurmnt rror du to th siz and nonrandom natur of th sampl. FIGURE 5 AROUND HERE only fully-insurd plans, and 2 prcnt hav only slf-insurd plans. Th smallr carrirs (<=5 clints) ar mor likly to b pur plays, with 11, 54, and 35 prcnt in ths catgoris, rspctivly. Figurs ar tabulatd using th carrir-yar as th unit of obsrvation. 17 Attmpts to stimat th numbr of carrirs from altrnativ sourcs wr unsuccssful. Thr ar thr potntial sourcs of nationwid data for th study priod: th Ara Rsourc Fil, Intrstudy (a privat firm that compils data on HMOs from stat rgulatory filings and various othr sourcs), and wb sarchs. Th Ara Rsourc Fil rports th numbr of HMOs hadquartrd in ach county, clarly a vry poor stimat of th dsird variabl. Intrstudy provids information on th numbr and nrollmnt of HMOs by MSA. Howvr, th Intrstudy data is prohibitivly xpnsiv, xcluds PPOs (which clarly compt with HMOs) in most yars covrd by this study, and has bn roundly criticizd for th mthods it uss to attribut nrollmnt to diffrnt gographic aras (Scanlon t al 2006). Wb sarchs also provd fruitlss for svral rasons. It is difficult to find tim-sris data for all markts, and to accuratly captur th srvic ara for ach halthplan from th limitd dscriptions availabl onlin. Som insurrs idntifid in ths sarchs only srv particular markt sgmnts (.g. th individual markt or th Mdicaid markt), and this analysis is concrnd with th larg, fully-insurd group markt. Using th LEHID data itslf (aftr applying th stringnt 20+ critrion) should yild th most accurat stimat of th numbr of carrirs srving th customr sgmnt and gographic markt of intrst. 10

11 Th ky indpndnt variabl for th analysis is th oprating profit of mployrs. To obtain profit data, I cratd a crosswalk fil to match LEHID-FI mployrs to companis apparing in Compustat, a databas of financial statistics. Th matchs wr idntifid by hand using company nams, industry, locations, and numbr of mploys. Extnsiv wb rsarch was rquird to vrify matchs for som obsrvations, spcially in cass of subsidiaris, non- U.S. firms, and firms involvd in mrgrs and acquisitions. Profit is masurd by th aftr-tax rturn on assts, dfind as (arnings bfor xtraordinary itms + intrst xpns) / (gross assts (including dprciation/amortization)). 18 Bcaus Compustat is limitd to larg, publiclytradd firms, th LEHID FI-Compustat sampl omits public-sctor, nonprofit, and privatly-hld mployrs, as wll as mployrs that do not appar in Compustat or lack data for th variabls usd to calculat oprating profits. Of th 1678 mployr-yars in th LEHID FI sampl, I am abl to calculat laggd profit for 1151, or 69 prcnt of obsrvations. To control for local conomic conditions and halthcar utilization trnds, I add data on th unmploymnt rat (rportd by th Burau of Labor Statistics) and th Avrag Adjustd Pr Capita Cost for Mdicar nrolls (abbrviatd AAPCC and rportd by th Cntr for Mdicar and Mdicaid Srvics). Both masurs ar availabl at th county-yar lvl, whras LEHID markts ar dfind by my sourc using 3-digit zipcods. Th corrspondnc is gnrally on-to-on in major mtropolitan aras, whr most LEHID mploys ar locatd. For thos countis blonging to mor than on markt cod, I assign wights in proportion to th shar of th population in ach markt cod accountd for by th zipcods within that county. Tabl 1 prsnts dscriptiv statistics for th LEHID FI-Compustat sampl in ach yar. Th ky variabls includ annual prmium, nrollmnt, dmographic factor, plan dsign, plan typ, and laggd profit. 19 Annual prmium combins mployr and mploy contributions, and is a pr-mploy avrag. It rflcts both th faturs of th plan slctd (.g., insuranc 18 Compustat provids fiv altrnativ dfinitions of th aftr-tax rturn on gross assts. This dfinition corrsponds most closly to th masur of firm profitability usd in Disapparing dividnds: changing firm charactristics or lowring propnsity to pay? (Fama and Frnch 2001). Rsults using th four othr masurs ar xtrmly similar (s Onlin Appndix for dtails). 19 Prmiums ar rportd in nominal dollars. All spcifications us ln(prmium) as th dpndnt variabl and includ yar fixd ffcts, so nationwid dflators will not affct th cofficints of intrst. 11

12 carrir, bnfit dsign, tc.) as wll as th charactristics of th insurd population (.g., dmographics and risk profil). TABLE 1 ABOUT HERE Dmographic factor is a summary masur that rflcts family siz, gndr, and ag. Plan dsign capturs th gnrosity of bnfits, including th lvl of copaymnts rquird of nrolls. Th xact formula usd to calculat ths factors wr not disclosd to m. It is worth noting, howvr, that my sourc uss ths factors to normaliz and thn compar prmiums across plans and firms, and thy ar an industry ladr in halthplan slction and dsign. Th dclin in plan dsign during th study priod is also notworthy, as it is consistnt with rports that mployrs hav rducd bnfits in an ffort to contain cost growth (so-calld bnfit buybacks ). Four plan typs ar rprsntd in th data. Ordrd by th rstrictivnss of th providr ntwork for ach plan, ths ar: Indmnity (all providrs covrd), PPO (prfrrd providrs fully covrd, non-prfrrd providrs covrd in part), POS ( point of srvic plan: car is managd as in an HMO, and if approval for a srvic is obtaind prfrrd providrs ar covrd in full and non-prfrrd providrs in part), and HMO (car is managd and prfrrd providrs ar fully covrd). Approximatly 90 prcnt of th plans in th LEHID FI-Compustat sampl ar HMOs. As discussd abov, profit is laggd two yars to rflct th timlin for plan slction. Thus th 2001 rcssion is apparnt in th summary statistics for Th rcssion had varying impacts across firms and sctors, as vidncd by th larg incras in th standard dviation in This is prcisly th typ of variation that idntifis th ffct of intrst. Th LEHID FI-Compustat sampl includs an avrag of 144 mployrs and 102 markts pr yar. Th dclin in obsrvations during th last two yars rflcts both th trnd away from 12

13 FI plans, and a gnral dclin in th numbr of mployrs in th LEHID sampl. 20 Ths trnds ar apparnt in Appndix Tabl 1, which givs th numbr of mployrs includd in LEHID in vry yar, togthr with th shar with at last 1 FI plan and at last 1 SI plan. II. Do Profitabl Firms Pay Mor For Halth Insuranc? A. Main Analysis My mpirical stratgy rlis on th assumption that mployrs ar willing to pay mor for halth insuranc whn profits ar high (why is th subjct of Sctions 5 and 6). If tru, insuranc carrirs may xploit this circumstanc by adjusting prmiums accordingly. Th ky rgrssion rlats plan prmiums to laggd mployr profits. Rcall a plan is an mployr-gographic markt- insuranc carrir-plan typ combination, dnotd by th subscript mcj. Th first spcification can b xprssd as follows: (1) ln(prmium) mcjt = α + γ1 profit margin, t 2 + ξ [ +ρ + ν mcj m + ψ ] [ + X c mt + η j + δ β] [ +φ mt t + γ + ω ] + ε 2 jt dmographics mcjt + ς m mcjt Equation (1) includs fixd ffcts for ach mployr, markt m, carrir c, plan typ j, and yar t. Employr fixd ffcts hlp to captur unobsrvd, tim-invariant diffrncs in th composition of th population covrd, bnfit dsign, and usag pattrns for a givn mployr, all of which affct plan prmiums. Markt fixd ffcts captur diffrncs in mdical costs (.g., du to local wags) and practic. Thr is a litratur that documnts substantial diffrncs in mdical practic and utilization (though, intrstingly, not in outcoms) across gographic markts (.g., John E. Wnnbrg, Elliot S. Fishr, and Jonathan S. Skinnr (2002)). Plan typ fixd ffcts captur avrag pric diffrncs for ths broad product groups, and carrir fixd ffcts captur avrag pric diffrncs across carrirs du to tim-invariant 20 Th dclin is hightnd by th sampl rstriction that drops all obsrvations in markt-yars with fwr than 20 mployrs offring at last 1 fully-insurd plan. In sction 6, I confirm th rsults ar similar whn this rstriction is liftd. 13

14 charactristics such as rputation. Finally, yar fixd ffcts absorb annual growth in prmiums nationwid. Thr ar nin scond-ordr intractions that could thortically b includd in this spcification, howvr it is nithr computationally fasibl nor conomically snsibl to includ thm all in th baslin modl. 21 I rly on institutional knowldg to slct two to includ in all spcifications: plan typ-yar ffcts ( ω jt ) and mployr-markt ffcts ( ς m ). (Th rmaining 7 will vntually b includd in modls discussd blow.) Th plan typ-yar ffcts absorb diffrnt prmium growth pattrns across plan typs, such as th wll-known incras in HMO prmiums associatd with a loosning of HMO rstrictions during this ra of managd car backlash. Th mployr-markt intractions captur prmium diffrntials associatd with diffrncs in th composition of mploy populations and/or unobsrvd plan gnrosity across markts,.g. hadquartrs vs. rtail locations. Ths intractions will also captur prmium diffrntials associatd with mployrs who ar xpanding vrsus contracting th numbr of markts in which thy oprat. To th xtnt xpanding mployrs ar both mor profitabl and mor gnrous with insuranc bnfits (in dimnsions not capturd by th covariats alrady in th modl), th cofficint on profits could b upward-biasd in th absnc of ths intractions. Adding additional intraction trms to th modl (whthr scond-ordr or gratr) rducs th possibility of omittd variabls bias but also liminats potntially xognous variation that can b usd to idntify γ 1. In rcognition of this tradoff, I prsnt rsults for spcifications with and without th bracktd trms in quation 1. I bgin by introducing fixd ffcts for ach mployr-markt-plan typ-carrir combination ( ρ mcj ). Onc ths plan fixd ffcts ar includd, γ 1 is idntifid by within-plan changs in prmiums and changs in th profits of affiliatd mployrs (du to th inclusion of mployr fixd ffcts). Th ky advantag of including plan fixd ffcts is th limination of cross-sctional variation as a sourc of idntification for γ 1. For xampl, if firms xprincing positiv profit shocks tnd to choos gnrous bnfit packags (within a givn plan typ and carrir), in th 21 Not mployr-yar fixd ffcts cannot b includd, as this is th lvl of variation of th xplanatory variabl of intrst. 14

15 absnc of plan fixd ffcts γ 1 will rflct ths omittd factors. Howvr, som of this crosssctional variation may b dsirabl bcaus compting plans act as a constraint on th pricing of incumbnt providrs. Facd with an xcssiv pric incras, som mployrs may switch plans to obtain bttr pricing. Plan fixd ffcts liminat any variation in pric du to such switching. Thus, th baslin modl rvals whthr mployrs facing profit shocks nd up paying highr prmiums on avrag (rgardlss of switching bhavior), whil th modls with plan fixd ffcts rval whthr ths mployrs pay mor for th sam plans. Not th plan fixd ffcts also subsum 5 of th rmaining 7 scond-ordr intraction trms. 22 Th final two, markt-yar fixd ffcts and carrir-yar fixd ffcts, ar addrssd blow. Nxt, I add markt-yar masurs of conomic conditions (th unmploymnt rat) and costs (th pr-nroll avrag Mdicar xpnditur, known as th AAPCC) to captur changs in conomic conditions and halthcar trnds that may b corrlatd with both mployr profits and prmiums. Ths ar dnotd by X mt inclusion of ths covariats, markt-yar fixd ffcts (dnotd. If th cofficints of intrst ar snsitiv to th φ mt ) ar advisabl. Onc includd, γ 1 is idntifid by diffrncs in within-plan prmium growth for plans oprating in th sam markt. To clarify this sourc of idntification, considr as a hypothtical xampl th Chicago-basd halthplans offrd by Boing and Unitd Airlins in In th wak of th trrorist attacks in Sptmbr 2001, Unitd fild for bankruptcy whil Boing s fortuns soard. Controlling for th avrag prmium growth in Chicago, as wll as th avrag prmium growth for spcific plan typs nationwid, I xpct prmium incrass to b highr for Boing if γ 1 is positiv. 23 Of cours, a cost of including markt-yar intractions is that variations in avrag firm profits in a givn markt cannot hlp to idntify th cofficint of intrst. For xampl, many California-basd firms bnfitd from th tchnology boom in Th xtnt to which insurrs wr abl to captur ths rnts will not b rflctd in th stimats obtaind from modls with markt-yar fixd ffcts. (On th othr hand, nithr would th ffct of (hypothtically) fastr-than-normal cost growth in California b mislabld as rnt xtraction. Of cours, th impact of th conomic controls on th profit cofficint will rval th liklihood 22 Th fiv intractions ar: mployr-carrir, mployr-plantyp, markt-carrir, markt-plantyp, and carrirplantyp. Plan fixd ffcts also subsum th mployr-markt fixd ffcts includd in all spcifications, so tchnically thy captur 6 of th 9 possibl scond-ordr intraction trms. 23 Not this final modl ffctivly includs all nin scond-ordr intraction trms. 15

16 of such a bias.) For th sak of compltnss, I also confirm th snsitivity of th rsults to th inclusion of carrir-yar intraction trms, although ths ar unlikly to gnrat bias in th cofficint of intrst. 24 Bcaus prmium rats for th sam plan (i.. mcj combination) ar likly to b srially corrlatd ovr tim, I prform a formal tst as dscribd by Jffry M. Wooldridg (2001). 25 I rjct th null hypothsis of no srial corrlation with a p-valu smallr than.001. Givn th unbalancd natur of th panl, I cannot implmnt a fully robust stimator (i.. FGLS that allows for any htroskdasticity and srial corrlation in th rror trms), howvr I can and do corrct for AR(1) corrlation in th rrors using an FGLS stimator dsignd for this circumstanc by Badi H. Baltagi and Ping X. Wu (1999). 26 Tabl 2 prsnts rsults for th 4 spcifications rprsntd by quation (1). Th stimats of γ 1 ar all positiv, similar in magnitud, and statistically significant. Th point stimat incrass upon inclusion of plan fixd ffcts, and is unaffctd by th markt-yar covariats. This suggsts local conomic conditions and/or changs in halthcar utilization ar unlikly to b driving th rsults. Controlling for diffrncs in prmium growth across markts (column 7) rducs th magnitud of ˆγ 1 a bit, but this diffrnc is not statistically significant. Though not rportd in th tabl, adding carrir-yar intractions has virtually no impact on th cofficint stimats. Th rsults imply an mployr with a 10-prcntag point incras in profits can xpct to pay approximatly 0.3 prcnt mor in halth insuranc prmiums, ctris paribus. TABLE 2 ABOUT HERE 24 Carrir-yar intractions will b significant prdictors of prmiums if carrir-spcific financial conditions impact prmium incrass. Howvr, xcluding ths intractions will only bias th cofficint of intrst if mployrs with high or low profit shocks ar disproportionatly rprsntd in th customr bas of insurrs xprincing systmatically good or bad yars. Particularly aftr markt-yar intraction trms ar includd in th spcification, such a scnario is difficult to nvision. 25 This tst consists of running th first-diffrncd vrsion of quations (1) or (2) and rgrssing th rsulting rsiduals on thir on-priod lag. A cofficint significantly diffrnt from -0.5 implis srial corrlation. 26 Th Baltagi-Wu stimator is implmntd by th stata command xtrgar. For modls without plan fixd ffcts, th analogous command is xtpcs. An altrnativ (though infficint) approach is to us OLS and clustr th standard rrors by plan. Th point stimats ar similar, but th standard rrors tnd to b largr (as xpctd). 16

17 Nxt, I considr th possibility of bias du to changs in unobsrvd plan charactristics, such as providr ntworks, prscription drug formularis, and copaymnts. An altrnativ xplanation for th positiv stimat of γ 1 is that firms with positiv profit shocks rspond by incrasing bnfits for workrs, and mor bnfits com with a highr pric tag. As a first tst of this hypothsis, I add plan dsign to ach spcification. Th rsults ar rportd in columns 2, 4, 6, and 8 of Tabl 2, alongsid th corrsponding baslin spcifications. Th cofficint on plan dsign is always positiv and highly significant, suggsting it dos captur th gnrosity of bnfits. Howvr, th stimats of γ 1 rmain significant, and actually incras a bit (countr to th hypothsizd dirction of any omittd variabls bias). To th xtnt that othr omittd, timvarying plan charactristics ar corrlatd with this composit masur, this tst provids som rassuranc that ths omittd factors ar not gnrating th positiv stimats of γ 1. As a scond tst of this altrnativ xplanation, I considr how th stimat of γ 1 varis by th markt structur of th local insuranc industry. If γ 1 rflcts rnt xtraction by insuranc carrirs, it should b largr whr comptition is lss firc. If instad it rflcts th prdilction of profitabl mployrs to provid mor gnrous bnfits, it should b insnsitiv to th markt structur of th insuranc industry: thr is no obvious rason why multisit firms with high profits would incras bnfits most in th sits srvd by a concntratd insuranc sctor. 27 I stimat modls basd on th following quation: (2) ln(prmium) mcjt = α + + γ 2 + ω jt 5 γ NC= 1 m 1, NC 1( NC) dmographics + ς [ +ρ mcj m mcjt * profit margin + γ ] [ + X 3 mt plan dsign β] [ +φ mt, t 2 mcjt ] + ε + mcjt 4 NC NC= 1 + ξ λ + ν 1( NC) m + ψ mt c + η j + δ t whr NC stands for numbr of carrirs. I us 5 rangs for numbr of carrirs: 1-4, 5-6, 7-8, 9-10, and 11+. (As indicatd in Figur 5, ths catgoris captur th distribution of numbr of carrirs fairly wll; unfortunatly thr is insufficint data to subdivid th 1-4 catgory furthr.) 1(NC) mt is an indicator variabl that taks a valu of 1 if th obsrvation is from a markt-yar with NC carrirs. Thus, γ 1,3 is stimatd from obsrvations in markt-yars with 7-8 carrirs. 27 Similarly, profitabl firms could rspond to profit shocks by hiring mor xprincd mploys who ar oldr and costlir to insur. 17

18 Although an imprfct proxy for markt comptitivnss, th numbr of carrirs is th most accurat masur of markt structur availabl to m givn th non-random natur of th sampl. (In th Onlin Appndix, I confirm th rsults ar robust to rplacing ths catgoris with quintils for HHI.) Equation (2) also includs th numbr of carrir indicators to control for any markt-wid rlationship btwn ntry and xit and prmiums. Tabl 3 illustrats that th magnitud of ˆγ 1, NC dclins as th numbr of carrirs incrass. T-tsts rjct th null hypothsis γ ˆ ˆ 1,1 = γ1, 5 in favor of γˆ ˆ 1,1 > γ1, 5 in all spcifications with p-valus of.07 or lss. Th rlationship btwn profits and prmiums in th most comptitiv markts is not significant in any of th spcifications. Th point stimats ar affctd littl by th addition of markt-yar covariats, indicating that diffrncs in local conomic and halthcar utilization trnds ar unlikly to b gnrating th obsrvd snsitivity of prmiums to profits in markts with fw carrirs. Th cofficint on markts with 5-6 carrirs dclins in th spcification with markt-yar fixd ffcts, but othrwis th rsults rmain similar vn in this stringnt spcification, as wll as in th unrportd spcification that adds carrir-yar fixd ffcts. 28 TABLE 3 ABOUT HERE Th stimats indicat that profitabl firms pay mor for thir halth insuranc, ctris paribus. This ffct is only significant in markts with 10 or fwr major carrirs, and is most pronouncd in markts with 6 or fwr carrirs. In such markts, a profit incras of 10 prcntag points (roughly th standard dviation of profits during th 2001 rcssion) is associatd with an incras in halth insuranc prmiums of 1.2 prcnt. 29 Th vidnc that supplirs njoy significant markt powr vn whn up to 10 comptitors ar prsnt is consistnt with rlatd rsarch in industrial organization. Although a 28 Th cofficint stimats for th numbr of carrir indicators ar availabl upon rqust. Ths ar idntifid by changs in th numbr of carrirs within a givn markt ovr tim du to ntry, xit, and masurmnt rror. Th rsults ar robust to th xclusion of th numbr of carrirs indicators. 29 I obtain this stimat using th avrag of th rlvant cofficints in th spcification with plan fixd ffcts and markt-yar covariats (column 3, Tabl 3): xp((( )/2)*.1) =

19 much smallr numbr of firms is ndd to achiv prfct comptition in a homognous product markt (Timothy F. Brsnahan and Ptr C. Riss 1991), th numbr in a diffrntiatd product markt can b a good dal largr. David Dranov, Ann Gron and Michal J. Mazzo (2001) rport vidnc that th sixth HMO in an MSA arns supracomptitiv profits, on avrag. (Estimats for ntrants byond th sixth ar not rportd.) Onc thy catgoriz th HMOs by whthr thy hav national ntworks, thy find stpr dclins in profits with additional ntrants of th sam typ, although thy do not rport th maximal numbr of ach typ associatd with positiv profits. Givn th many dimnsions along which insuranc carrirs ar diffrntiatd, th rsult that 10 or mor ar ndd, on avrag, to inhibit customr-spcific rnt xtraction is in lin with thortical and mpirical prdictions. a. Altrnativ Explanations In this sction, I considr altrnativ xplanations for th ky findings. Th first altrnativ xplanation is that profitabl firms incras th gnrosity of thir plans mor in mor concntratd insuranc markts, and this phnomnon xplains th diffrntial prmium incras. To xamin this possibility, I r-stimat th modls abov using plan dsign as th dpndnt variabl. Although changs in plan dsign itslf will not impact th stimats I rport bcaus it is includd as a control in th ky spcifications, to th xtnt plan dsign is corrlatd with unobsrvabl gnrosity this analysis will xpos th fasibility of this altrnativ xplanation. Th rsults, rportd in th Onlin Appndix as Tabls OA1 and OA2, show that mployrs xprincing positiv profit shocks do not tnd to incras plan quality nationwid (rathr, thy dcras it), nor do thy incras quality rlativly mor in mor concntratd insuranc markts. A scond, rlatd concrn is that insurr markups for plan quality may b highr in mor concntratd markts. A highr markup for quality in concntratd markts could yild a similar pattrn of rsults vn if th incras in quality is th sam across all markts. Morovr, to th xtnt that concntratd insuranc markts coincid with concntratd halthcar providr markts, such a pattrn of markups could rflct th xrcis of markt powr by th lattr (or prhaps som combination of th two). To considr this altrnativ xplanation dirctly I r- 19

20 stimat th spcifications rprsntd by quation (2) with th addition of intractions btwn numbr of carrir catgoris and plan dsign. Th stimats ar prsntd in Tabl 4. Th cofficints and standard rrors on th intractions btwn markt structur and laggd profits ar virtually unchangd. In addition, thr is littl vidnc that th markup for plan quality is highr in mor concntratd markts. Th point stimats ar only largr for mor concntratd markts in on of th four spcifications (th modl without plan fixd ffcts), and vn in this spcification th diffrnc btwn th cofficint on plan dsign for th most and last concntratd markts is not statistically distinguishabl from zro. TABLE 4 ABOUT HERE Th prcding analysis raiss th qustion: ar thr othr factors corrlatd with insurr concntration that could b producing th obsrvd pattrn of findings? Tabl OA3 in th Onlin Appndix prsnts dscriptiv statistics for th markt-yars in ach catgory. Th tabl shows that th most concntratd markts hav smallr populations, lowr incom pr capita, and ar lss urban than th last concntratd markts. Howvr, it is important to rcogniz that th analysis of rnt xtraction dos not xamin th rlationship btwn markt structur and prmium lvls, which could crtainly b affctd by ths othr charactristics. Rathr, th study invstigats how individual insuranc contracts ar rvisd to rflct changs in individual customr charactristics. It is difficult to conciv of a mchanism whrby diffrncs in th undrlying attractivnss of a markt or in any othr markt-spcific charactristics - could gnrat th obsrvd bhavior. 30 For xampl, on unobsrvd markt charactristic is providr concntration. Evn if providr concntration is corrlatd with insurr concntration, th formr cannot pric-discriminat across spcific mployrs whn insurrs srv as intrmdiaris. Finally, th impact (on pric lvls) of any diffrncs across markt-yars in dmographics or providr concntration is controlld for in spcifications with markt-yar fixd ffcts. 30 On rfr offrd th following possibility: suppos firms with positiv profit shocks bcom mor costly to insur bcaus thir mploys utiliz mor mdical car. (This may occur, for xampl, if mploys of profitabl firms bcom lss concrnd about missing work to tnd to mdical issus.) Furthrmor, suppos th marginal cost of car is highr in markts srvd by a small numbr of insurrs. Although th data cannot rul out this altrnativ xplanation, it sms unlikly as it would rquir insurrs to corrctly prdict incrasd utilization by profitabl firms (as wll as gographic diffrncs in marginal costs, which insurrs may wll know). Not also that avrag Mdicar costs pr capita tnd to b lowr in concntratd markts. 20

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