KEY TERMS AND CONCEPTS
Benefit/premium ratio Community rating Experience rating Risk-adjusted premiums Underwriting cycle Guaranteed issue Guaranteed renewal Portability
Pre-existing exclusion

182

CHAPTER

9
The Market for Health Insurance:
Its Performance and Structure
Learning Objectives
Upon completing this chapter, the reader should be able to:
•	Describe how the health insurance market evolved overtime.
•	Understand the reasons why the health insurance market is very price competitive.
•	Explain why medical loss ratios are not useful for inferring insurer efficiency or quality.
•	Describe the reasons for the underwriting cycle.
•	Evaluate the equity and efficiency consequences of mandating community rating.
•	Explain how risk selection adversely affects the health insurance market.

CHAPTER 9 The Market for Health Insurance: Its Performance and Structure • 183

INTRODUCTION: ECONOMIC EFFICIENCY
It is important to determine how efficiently each sec-tor of the medical care market performs. If these separate sub-markets do not perform efficiently, then there may be a legitimate role for public intervention to increase the efficiency of the marketplace. Government intervention to increase efficiency is different from, and should be kept separate from, government intervention to redistribute the output of the medical care market. A government policy that at-tempts to do both simultaneously, either through a government agency or comprehensive regulation, may do neither as well as separate policies directed toward either efficiency or equity.
Economic efficiency with regard to the supply of health insurance typically means that there are no en-try barriers; that the number of firms in the market is the "right" number—that is, each firm operates at a minimum point on the long-run average cost curve; that each firm attempts to minimize its cost of production—that is, achieve internal efficiency; and that the firms are price competitive. However, even if the health insurance industry is economically efficient in the supply of health insurance, imperfections may exist in the input market in which insurance companies are demanders (purchasers) of physician and hospital services. Physicians and hospitals are suppliers of these inputs. To the extent imperfections exist in these "input" markets, the price of health insurance will be higher, and there will be less variety in the types of health insurance products sold.
The performance of the health insurance market will be evaluated on how competitive it is and also on whether suppliers of medical services have placed restrictions on an insurer's ability to sell certain types of insurance products. Hypotheses will be offered to ex-plain possible divergence from economic efficiency, since any intervention to improve economic efficiency in this market should be consistent with the reasons for inadequate performance.
BACKGROUND
Blue Cross plans were started, capitalized, and con-trolled by hospitals as non-profit health insurers. The

first Blue Cross plan began in the 1930s, and the benefit package was designed to increase the demand for hospital care. Blue Cross had a service benefit policy, a patient was entitled to 30 days of hospital care (the only benefit Blue Cross provided), and did not have to pay any deductible or co-payment for their stay (1). Regardless of whether the participating hospital had high or low costs, Blue Cross paid their enrollees' hospital bills in full. Thus hospitals did not have to compete on price for patients. Blue Cross reimbursed hospitals according to their charges or their costs.
Blue Cross plans initially offered group insurance in order to avoid adverse selection. They priced their insurance policies using "c'ommunity rating," whereby all the insured in the same geographic area or "community" (which may be as large as a state) are charged the same basic premium even though a group's claims experience or an individual's risk level differs.
Each Blue Cross plan was required to sign up 75 percent of the hospitals and beds in its area. Blue Cross was thereby precluded from establishing a preferred provider network and forcing hospitals to compete to join Blue Cross' network.'
Each Blue Cross plan had a monopoly within its market over its type of service. Blue Cross plans were not permitted to compete with each other as did corn-. mercial insurers; each plan served a particular geographic market, and other Blue plans were not al-lowed to enter another Blue plan's market. If one Blue Cross firm was more efficient and wished to expand its market, it could not do so at the expense of another Blue Cross plan. (The national Blue Cross organization, which owns the Blue Cross trademark and licenses plans to use it, opposed such competitive behavior. However, given the applicability of the anti-trust laws to the health field, Blue Cross plans can no longer divide up markets among themselves.) Each plan benefited bybeing the designated representative
1. Olson claims that "this requirement ensured that no Blue Cross plan could select only the most efficient hospitals in its area. Its effect was to reduce competitive pressures on less efficient hospitals." Mancur Olson, "Introduction" in Mancur Olson, ed., A New Approach to the Economics of Health Care, (Washington, D.C.: American Enterprise Institute, 1981), p. 10.

184 • Health Care Economics

of Blue Cross' reputation and by being the only one to offer the Blue Cross insurance package to subscribers.
Blue Cross is a loose federation of independently operating plans joined together by an interplan system for handling claims incurred in other areas. The national Blue Cross organization provides certain important functions, such as representing all Blue Cross plans in their relations with the federal government and testifying on legislation affecting the health insurance industry.
Blue Shield plans, started by medical societies, provided insurance coverage for physician services and reimbursed participating physicians according to their usual fees (up to a percentile limit), thereby lessening their enrollees' incentive to shop around. Patients whose incomes were below a specified level were insured according to a service benefit; that is, they had their physician fees paid in full by Blue Shield. Patients whose incomes were above the specified limits could be "balanced billed" by physicians for the difference between Blue Shield's physician payment and the physician's customary fee. Over time, as more Blue Shield subscribers' income exceeded the specified income level and were balanced billed, employers threatened to switch insurers if Blue Shield did not eliminate balance billing. To survive, against their medical society's opposition, Blue Shield plans agreed to a service benefit plan for all their sub-scribers. Blue Shield plans also used community rating for determining its premiums.
Blue Cross and Blue Shield maintained the principle of "free choice" of provider; that is, their enrollees were not given a financial incentive to choose between providers on the basis of price.
The Blue plans were innovators in the health insurance market. These plans demonstrated that by insuring large groups, adverse selection would not bankrupt the health insurer. Given the success of the Blue plans and the growth of private insurance, commercial (for-profit) insurers entered the market in the 1940s. Throughout the 1930s, 1940s, and the early 1950s, the Blue plans were the dominant health insurers. Not until the mid 1950s did commercial insurers grow more rapidly than Blue Cross-Blue Shield (BCBS) and have a greater share of the private insurance market.

Commercial insurers sold indemnity insurance, typically paid the subscriber a certain dollar amount for hospital and physician services, as contrasted to the Blues' service benefits which paid the provider in full for the cost of the service. The commercial insurers also differed from the Blues in that they relied on "experience rating" rather than community rating for pricing their policies. Experience rating relied on the group's prior claims experience (or a new group's risk level) to determine its premium. Thus all groups were charged different premiums based on their own experience. By using experience rating, the commercials were able to attract the lower risk groups from BCBS since the commercials charged lower risk groups lower premiums than did BCBS, which charged those groups an average, or the community rated, premium.
Experience rating increased the market share of the commercial insurers and eventually forced the Blues to abandon community rating; as lower risk groups switched to the commercials, the average risk level of those with the Blues increased, as did the community rated premium.
During the 1980s, the private health insurance market underwent dramatic changes. New types of insurance products were developed, the most notable being Health Maintenance Organizations (HMOs). Commercial insurers and BCBS plans, which previously offered only indemnity and service benefit policies, also offered HMO options to their subscribers. Similarly, independent HMOs offered their group enrollees an indemnity option in addition to an HMO. Another option offered by HMOs was a Point of Service (POS) plan, which allowed an HMO's enrollee to seek care from a non-HMO provider but at a high co-payment, usually 40 percent.
The variety of health insurance products has grown rapidly since the early 1980s, as have the methods of provider reimbursement. In 1980, traditional insurance with unrestricted access to all providers comprised 95 percent of all private insurance. By 1993, only 46 percent of the privately insured were enrolled in traditional insurance, and by 2003 that percentage was down to only 5 percent. Managed care has become the dominant forms of health insurance. See Figure 9-1. Managed care

Figure 9-1. Health plan enrollment, selected years, 1981-2003

186 • Health Care Economics

broadly defined refers to both HMOs and health insurance (both indemnity and service benefit policies) that use utilization management. Appropriate use of medical services, such as prior authorization for a hospital admission or for outpatient surgery, review of the patient's length of hospital stay, case management of catastrophic care, and monitoring physicians' utilization patterns are examples of utilization management.
Health insurers also include a Preferred Provider Organization (PPO) as an option to their enrollees. PPOs are a closed panel of providers who are willing to discount their prices and/or who have lower use rates than other providers. (PPOs are a means of price competition between providers who are part of a PPO and those who are not.) Enrollees who use a PPO provider pay a lower co-payment and much higher co-pay if they use a non-PPO provider. PPO providers hope to receive a greater volume of a firm's employees in return for discounting their prices and/or being more appropriate users of services. PPOs have developed rapidly since the mid 1980s.
A large number of employers have decided to self-insure (whereby they, rather than the insurer, bear the financial risk of their employees' medical expenses). The employer may then contract with an insurer or a Third Party Administrator (TPA) to provide Administrative Services Only (ASO), including claims processing. Smaller companies also consider this option, together with a reinsurance component, to protect themselves against an employee's catastrophic medical expenses. In 1974 (as part of ERISA—The Employment Retirement Income Security Act), Congress exempted self-insured firms from state regulations mandating that insurance include such provisions as hair transplants and in vitro fertilization, as well as the inclusion of certain providers, such as chiropractors and faith healers. By becoming self-insured, these firms are able to reduce their health care costs by excluding state mandates from their coverage.
Thus the health insurance market consists of traditional indemnity-type plans based on fee-for-service payment, service benefit plans (BCBS), HMOs, PPOs, and self-insured companies. Fee-for-service plans are

predominately managed care since they include utilization review mechanisms. In addition to their own plans, commercial insurers and BCBS also market HMOs, PPOs, and Administrative Service Only (ASO) contracts to employers who are self insured. There are also independent Third Party Administrators (TPAs), HMOs, and PPOs who market their services directly to employers.
The "product," health insurance, differs both ac-cording to "real" characteristics such as type of coverage, patient cost-sharing arrangements, methods of claims payment, the provider panel, as well as ac-cording to perceived differences in product, such as reputation for payment of claims. Premium differences between insurance firms would be expected to differ in accordance with these product differences. If the price of insurance between firms differs by a greater amount than what is justified by product differences, groups would be expected to switch insurers.
Thus insurance companies compete on the basis of price as well as in terms of product differences. If insured groups are able to switch insurers according to differences in prices and products, the market will perform in an efficient manner. The "product" will be expected to change over time and also to conform more closely to the preferences of the insured group.2
Since 1980, in addition to changes in the types of insurance products being offered, there have also been important organizational changes among the Blue plans. As a result of mergers and acquisitions, the number of Blue plans decreased from 114 in 1980 to 77 in 1990 and to 42 by 2003. In 1987, Congress re-moved the Blue's federal tax exemption believing that they performed no differently than the commercial insurers. Further, in 1994, the Blue Cross Association permitted its member plans to become for-profit.
2. Since there are such large differences in the costs of handling a group and an individual, most individuals in a group would prefer to forego the benefits of individually tailored policies to take ad-vantage of the lower cost of a single group policy.

CHAPTER 9 The Market for Health Insurance: Its Performance and Structure • 187

THE STRUCTURE OF THE HEALTH INSURANCE MARKET

Important in determining the number of competing firms, firm behavior, and the performance of the industry is the industry's market structure. Economies of scale, entry barriers, and whether any firms have cost advantages over other firms determine the market structure of the health insurance market.3

Economies of Scale:

Economies of scale, given the size of the market for health insurance, determine how many firms can compete in the sale of insurance. The extent of economies of scale also indicates whether the insurance business is a "natural" monopoly; that is, can the functions performed by insurance companies be per-formed less expensively by just one firm? (Another aspect of efficiency in production concerns whether each firm is operating in the most efficient manner.)
It has been difficult to separately estimate the extent of economies of scale in supplying health insurance from differences in the firm's (internal) efficiency and the functions it performs. Many companies differ in their administrative functions and they do not perform them equally well. The range of administrative functions, includes marketing and selling policies, processing applications and policies, maintaining the policy file, processing claims, re-viewing claims, and paying claims. The variety of contracts offered, each entailing a different cost, and the extent to which the company has group or individual policies (it is more costly to handle individual policies) also differs among firms.
Several studies have attempted to empirically estimate the extent of economies of scale among different health insurers. Using data from the early 1970s, Vogel and Blair examined economies of scale for commercial health insurance companies only since their output mix (e.g., variety of contracts, percentage of
3. As will be discussed later, state regulations may affect competition in the individual insurance market.

non-group policies, etc.) was very different from that of Blue Cross. The authors determined that economies of scale do exist, and that the administrative cost ratio declines with increased size of operation. When economies of scale were investigated separately for Blue Cross and for Blue Shield (in their non-Medicare business), no economies of scale were found. The authors then included in their analysis BCBS plans that had merged. They observed lower administrative costs for these merged, larger firms. Based on these studies, the authors concluded that economies of scale do exist in the non-profit sector, al-though the gains from such economies are offset by internal inefficiency ("x-inefficiency") because they were nonprofit firms (2).
In a follow-up study, Blair and Vogel undertook a "survivor" analysis to test for economies of scale (3). In this type of analysis, firms are assigned to different categories according to their size. The growth of firms in each size category is studied over time. If substantial economies of scale exist, then firms in the largest size classes will grow rapidly at the expense of firms in the smaller size categories. Smaller firms will either have to expand their scale of operation (and/or merge), or they will be forced to leave the industry. The authors found that all but the smallest size categories expanded over the period 1958 to 1973. They concluded that economies of scale existed but that they were not as large as originally believed since other size categories also grew.
The authors also attempted to determine whether economies of scale exist in the administration of Medicare Part A (hospital claims payment). They found results opposite of what they expected. Administrative costs per claim increased with the size of the firm. The interpretation of this finding was that the cost-based method used by Medicare to pay intermediaries encouraged higher administrative costs (4). An experiment in which the government awarded Medicare Part B contracts on the basis of a competitive bid found that submitted bids were quite low relative to their historical cost and lower than carriers reimbursed on a cost basis (5). The authors concluded that sizable government savings were possible if Medicare intermediaries were selected and paid

188 • Health Care Economics

according to a competitive bid rather than the cost-based payment system.
Also suggestive of economies of scale are the mergers of Blue Cross-Blue Shield plans over the past decade. Smaller Blue plans have found that the size of their market area limits their growth, and they are reluctant to enter and compete in other Blue plan's markets. In addition to the usual reasons for expecting economies of scale, such as lower marketing, claims processing, and administrative costs, larger insurers with subscribers in many different geographic areas are able to undertake analyses of different practice patterns and determine, for given illnesses, which practice patterns result in both lower costs of treatment and improved outcomes. These findings can then be disseminated to participating providers in other geographic areas.
Even though economies of scale exist in the insurance industry and financial requirements exist for be-coming an insurer (such as minimum reserve requirements), a firm selling health insurance in one city can easily market its product in another city while centralizing all of its administrative functions. Entry by insurers into profitable markets is relatively low cost. Thus either a sufficient number of insurers exist within a market or can potentially enter that market for the health insurance industry to be competitive. There are more than 1,000 for-profit health insurers and 42 Blue Cross and Blue Shield plans.

Blue Cross-Blue Shield Cost Advantages

Differences in costs between firms, unrelated to their efficiency, have given some types of insurers a competitive advantage over other firms, thereby affecting the industry's structure. Blue Cross and Blue Shield plans received two important cost advantages over commercial insurers that enabled them to increase their market share at the expense of their competitors.
Favorable Tax Treatment: Until 1987, Blue Cross plans were exempt from both federal and state premium taxes because they were believed to behave differently than their for-profit competitors. Commercial insurers, on average, pay a 2 percent state tax on their

total premiums. However, since administrative expenses are typically 10 percent of premiums, 2 per-cent of total premiums is equal to 20 percent of administrative expenses. Thus the Blues' tax exemption was a significant portion of administrative expenses. Studies found that the competitive advantage of the Blues' exemption from state premium taxes enabled Blue Cross to increase its market share between 1 and 6.7 percent (6).
In return for such favorable tax treatment, how-ever, the Blues were subject to greater regulation by state insurance commissioners who approved their premium increases. Several states limited premium increases that the Blues wanted to charge their non-group (individual) enrollees, which the Blues claim caused them to lose money on this line of business. To escape such regulation, a number of Blue Cross plans converted to mutual insurance companies.
The Blues lost their federal (but not state) tax-exempt status under the 1986 tax reform legislation. A Government Accounting Office (GAO) report found that the pricing practices of the Blues were similar to those of the commercials, namely experience rating of large groups; there were few subsidies for high-risk individuals enrolling in the Blues; that the Blues had profit-making subsidiaries; and that "all these activities tend to reinforce the perception that the plans are similar to commercial companies" (7).
The Blue Cross Hospital Discount: The second, and perhaps more important, competitive advantage that Blue Cross had over commercial insurers is the price discount that Blue Cross received from hospitals that was unavailable to other insurers. The size of the hospital discount to Blue Cross was as high as 27 percent in some states. According to one study, the Blues' discount resulted in an average increase in their market share of 7 percent (8).
The competitive consequences of Blue Cross' cost advantages were as follows. A firm in a competitive market with a cost advantage could undercut the prices of other firms and drive them from the market. If this were to occur, the public would benefit from that cost reduction in terms of lower prices. However, researchers found that BCBS plans with a cost advan-

CHAPTER 9 The Market for Health Insurance: Its Performance and Structure . 189

tage were able to increase their market shares, but not to the extent thought possible. The researchers developed several hypotheses as to how Blue Cross plans used their competitive advantage.
Because the Blues were controlled by the hospitals, it was in the hospitals' interest to provide the Blues with a competitive cost advantage, namely, a discount. In this way, the price of Blue Cross coverage was lowered relative to commercial insurance. Hospitals benefited by assisting the expansion of a more expensive type of insurance (only hospital care). Hospitals were consequently able to increase their volume and charges faster than they would have otherwise.
Weller distinguishes between discounts that are pro-competitive (i.e., a firm is a tough bargainer and tries to reach the lowest price possible from its sup-pliers) and discounts that are anti-competitive (i.e., a supplier gives a favored purchaser a preferential price). Based on the findings that Blue Cross plans were started and controlled by hospitals and that those Blue Cross plans with relatively high market shares were also in areas where hospital costs were relatively high, Weller concluded that the hospital discount could be explained more adequately in terms of anti-competitive behavior on the part of hospitals (9).
Another study concluded that in addition to benefiting hospitals, the Blue plans were less efficient. Thus their cost advantage was also used to benefit their management and employees in terms of higher salaries and internal "slack" within the organization (10).
These cost advantages have provided the Blues with greater market shares than they might otherwise have had, their hospitals with more advantageous benefits, as well as benefiting Blue Cross management. Had it not been for their relatively greater administrative inefficiency and their more costly hospital-only benefit package, the commercial insurers would have suffered even greater lost market shares.
Blue Cross plans are no longer controlled by hospitals. As Blue Cross competes with other insurers,

hospitals and Blue Cross have developed an adversarial relationship. However, even though the cost ad-vantages (preferential tax exemptions and hospital discounts) that contributed to such a large market share were removed, the large market share of the Blues still provided those Blue plans with increased market power, hence a competitive advantage (11). A Blue Cross plan that is the dominant insurer in an area is able to extract a discount from hospitals because of its purchasing power than is an insurer with a small market share. The hospital must continue to give a discount to a dominant insurer if it is not to suffer large losses of patients to competitive hospitals.
One study found that the Blues used their large market share (monopsony power) to extract greater price concessions from hospitals and that in the price competitive health insurance market, these reduced input costs were passed on to employer groups as reduced premiums (12).
Current competitive pressures in the insurance market, the consolidation and mergers of BCBS plans, and the need for capital has resulted in a number of Blue plans converting to for-profit status, such as WellPoint and Trigon (13). Several very large for-profit Blue plans have become formidable competitors in the health insurance market and, seeking additional acquisitions, are attempting to become amongst the largest insurers in the industry. The profitability of these plans and their growth strategy suggest that there are large economies of scale in health insurance.

Changes in a Health Insurer's Market Shares

Although there appear to be large economies of scale in the production of health insurance, given the size of the insurance market, a sufficient number of insurers exist to make the health insurance market quite competitive.
Table 9-1 shows the population covered and relative market shares both over time and by type of carrier. While the overall market share of commercial insurers is greater than Blue Cross and Blue Shield, in any one market there are usually several commercial

190 • Health Care Economics

insurers, but generally only one Blue Cross-Blue Shield Plan. Thus, particularly in the northeast and midwest, the Blue Plans have a much larger market share than any one commercial insurer; in a number of states their market share exceeds those of all the commercial insurers. (It was not possible to separate out duplicate coverage between commercials, BCBS, and independent plans. An employer that self-insures, for example, may use an insurance company to administer their claims processing (ASO contract); this would show up as an increase in in-dependent plans as well as part of an insurer's market share.)
As shown in Table 9-1, there have been dramatic changes in market shares by type of insurance company, particularly starting in the mid 1980s. Independent plans, which include HMOs, company self-insurance plans, and administrative service con-tracts only, have increased their share of the market from 5 percent in 1970 to 30 percent in 1985 to 69 per-

cent in 1996; this increased growth came at the expense of traditional indemnity plans and Blue Cross, which have lost market share. The decline in market shares of BCBS plans has been dramatic.
INDUSTRY CONDUCT AND COMPETITIVE BEHAVIOR
The Components of the Health Insurance Premium
To understand how health insurers price their products, it is useful to examine the components of the health insurance premium, shown in Figure 9-2. The loading charge, which includes administrative and claims processing costs, marketing expense, reserves against losses, and profits, represents approximately 8 percent of the premium when insurance is sold to groups. The loading charge is much higher in the in‑

Table 9-1. Enrollment of Persons with Hospital Expense Protection, 1950-1996

CHAPTER 9 The Market for Health Insurance: lts Performance and Structure • 191

Figure 9-2. The determinants of health insurance premiums.
dividual market, reflecting higher marketing costs and higher reserves. The claims expense is affected by the group's risk factors, such as the employees' age and sex, the type of industry (e.g., construction workers or accountants), location (to reflect medical costs in that region), the benefit package desired by the employees, the medical inflation rate in the coming year, and which cost-containment policies (such as the size of the deductible) are included in the benefit package.
The size of the loading charge is related to the various cost-containment options, which increase administrative expense while reducing claims expense. Unless the additional cost of cost containment is less than the savings from reduced claims expense, they would not be undertaken. Thus managed care companies' higher administrative expenses are not an indication of inefficiency.

The price of insurance is the benefit/premium ratio, which is the percent of the total premium paid out in benefits to each insured group. If, for example, the premium for each member in a group was $1,000 per year and the utilization experience of that group resulted in an average payout of benefits equal to $900 per member per year, the benefit/premium ratio would be 0.9. The difference between benefits and total premiums (the "loading charge") goes for administration, claims processing, marketing, and insurer profit. In a price-competitive market, each of the components of the loading charge would be efficiently produced, and a competitive rate of profit would be included.
Another term for the benefit/premium ratio is the medical loss ratio. A high medical loss ratio means that the loading charge is a small percentage of the total premium.
When the benefit/premium ratio is close to 1.0, the group is "experience rated," that is, the premium reflects the expected experience of the group (and the loading charge is competitively produced). The benefit/premium ratio becomes closer to 1.0 the more competitive the industry and groups would be expected to change insurance companies when their benefit/premium ratio surpasses the amount they are willing to pay for real or perceived product differences between firms.
One indication of the competitiveness of the industry is the variation in benefit/premium ratios when size of group is held constant; the smaller the variation, the more efficient the market. (Because of economies of scale in marketing and administering different-sized groups, the larger the size of group, the closer the benefit/premium ratio would be to 1.0.)
Table 9-2 shows the ratios of expenditures (benefits) to premiums by different types of insurance plans for the period 1955 to 1996. Of interest in this table are the differences in the benefit/premium ratio between group and individual policies; group policies have lower marketing costs, and the insurer is less concerned about adverse selection. If an individual became part of a group, they would pay a much lower premium for the same coverage.
The use of the benefit/premium ratio as a measure of industry performance has diminished in more

192	Health Care Economics

recent years. Previously, when almost all health insurance consisted of indemnity plans and insurers performed only administrative tasks, the benefit premium ratio was an indication of how much was spent on administration and how much on the delivery of medical services. With the growth of managed care and multiple types of health plans, however, the benefit/premium ratio no longer simply measures the di-vision of medical and administrative expense.
Currently, a low benefit/premium ratio can indicate increased responsibility by the insurer for medical management functions, such as utilization re-view, quality assurance, and provider profiling, functions that have as their purpose lower medical costs. Further, health plans today offer a variety of products, from indemnity, to closed panels of providers, an HMO option, a Point of Service (POS) plan (where the HMO patient can use non-HMO providers and pay a high co-payment), as well as a variety of pharmacy benefits for the different health plans, life and disability insurance, dental plans, and mental benefits. This greater range of products and benefits has increased the administrative and market

ing cost to the insurer. (These are not wasteful expenditures since they are in response to purchaser demands.) Similarly, insurers differ in their percentage of individual, small group, and large employer enrollees, which affect their marketing and enrollment costs. (Appendix 1 discusses this subject in greater detail.)
The previous close approximation of the benefit/premium ratio to 1 shown in Table 9-2 suggests that health insurance has been a relatively price-competitive industry. As the industry has changed starting in the mid 1980s, however, measures other than the benefit/premium ratio discussed below are more indicative of the price competitiveness of this industry.

Insurer Price Competition

Until the mid 1980s, price competition among traditional insurers was based on the size of the loading charge. Actuaries estimated the expected claims expense given the above risk factors of the group, the group's location, benefits, and so on. Insurers there-fore had an incentive to minimize their loading

Table 9-2. Ratio of Benefit Expenditures to Premium Income, According to Type of Plan, 1955-1996

CHAPTER 9 The Market for Health Insurance: Its Performance and Structure • 193

charge. Cost containment measures such as utilization review and PPOs were viewed as an intrusion into the practice of medicine by the medical profession and were not used by insurers.
The introduction of utilization management and the use of provider panels dramatically changed the role of health insurers with regard to the practice of medicine. Insurers no longer passively accepted physicians' treatment decisions. Instead they established practice guidelines and reviewed physicians' medical decisions. Provider panels affected the patient's choice of provider. This change in the insurers' role did not (and was not able to) occur until the anti-trust laws became applicable to the medical services industry in 1982.
When HMOs began to enter the group health insurance market in the early to mid 1980s, they set their premiums just below the premiums charged by traditional insurers. This practice was referred to as 'shadow pricing." At that time, most (if not all) of the premium was paid by the employer on behalf of the employee. When the employee did pay part of the premium, it was not related to cost differences between different health plans. The employees' choice of health plan was therefore unaffected by differences in prices between health plans. To compete against the traditional plan which offered unlimited choice of provider, HMOs, with their restricted provider panels, offered more benefits. Although the HMO had a lower cost of providing care, it still charged premiums that were only slightly below those of the non-HMO health plans. The difference between their premiums and costs of care were used to provide the employee with greater benefits and increase the HMO's profits.
Employers initially believed that offering an HMO option to their employees would reduce insurance premiums because the HMO's lower cost would be passed on to the employer. However, this did not occur because of the HMOs use of shadow pricing. The rapid growth in HMOs did not occur until employers received some of the savings in the form of lower premiums and/or employees became responsible for paying the difference between the lowest cost plan and the plan they chose.
Another form of competitive behavior engaged in by insurers and HMOs was preferred risk selection.

When an HMO was offered along with a traditional health plan to an employer group, at similar premiums, the traditional plan received an adverse risk group. HMOs were able to attract a lower risk group of employees through design of their benefit package, for example, emphasizing well baby care. Also, those who were at higher risk or who were ill wanted to continue with their own physicians rather than switch to the HMO's restricted provider panel. It was for this reason that traditional health plans, when offered along with HMOs, wanted to be assured that they would receive a Minimum percentage of the employees in a group (e.g., 50 percent of the employees). Alternatively, the insurer would offer the employer a choice of different plans, managed fee-for-service and an HMO, at the same premium for each age-sex risk group, and the insurer then made the monetary transfers between its own plans. Similarly, to internalize the cost of adverse selection to the non-HMO plan, when a single HMO is offered to an employee group, the HMO also offered a non-HMO product along with their HMO for the same premium in order to provide an employee group with more choice.
There are subtle methods by which a health insurer can achieve a preferred (low) risk group when the premiums of the different risk groups are not risk-adjusted. The plan can contract with new specialists compared to specialists who have been in practice longer (and whose chronically ill patients would re-main with them). The health plan can advertise in newspapers rather than keeping brochures in physicians' offices where the population reading them are, on average, sicker than those who read the newspaper. And waiting rooms for pediatric patients can be attractive and waiting times short, compared to waiting times and access to referrals for chronically ill patients.
To date, risk-adjusted premiums have not been widely used by employers (nor have medical groups accepting sub-capitation payments from HMOs used them). Medicare pays HMOs a risk-adjusted premium for those aged who join an HMO. However, the risk factors used by Medicare have been insufficient to fully account for the preferred risk group received by HMOs. Risk adjustment is an area that is receiving a great deal of attention and research funding.

194 • Health Care Economics

Risk-adjusted premiums would limit insurers' ability to compete 'on how well they can select preferred risks. Insurers would then have to compete on their administrative expense (loading charge) and on how well they manage risk. Risk-adjusted premiums provide efficient insurers with an incentive to accept high-risk patients. A risk-adjusted premium that fairly reflects the expected expense of high-risk patients provides insurers with an incentive to innovate and to manage the care of such patients. (Appendix 2 discusses how to construct risk adjusted premiums.)

Insurer Price Elasticities of Demand: Consumer Price Sensitivity Among Health Plans

Consumer willingness to switch health plans in response to changes in their out-of-pocket premiums is an indication that insurer demand curves are price elastic, which is characteristic of a very competitive industry. An insurer's demand curve is much more price elastic than the overall market demand for health insurance since there are better substitutes to each insurer than there is to health insurance in general.
Several studies have estimated the price elasticity of demand for a health plan; these results are shown in Table 9-3. The elasticity estimates indicate that in

surers face very price elastic demand curves, one estimate is as high as -7.9. However, firm price elasticities shown in Table 9-3 are average price elasticities that may obscure important variations within the population. Price elasticities are likely to differ according to population characteristics, such as age, health status, income, and how long a person has been in a health plan. To determine the likely effect on a firm's demand as a result of the firm changing its price, it is more useful to estimate price elasticities according to the above population characteristics.
The following discussion provides a more complete explanation of how price elasticity differs by the switching costs of different population groups and how these estimates compare to using average price elasticities presented in Table 9-3.
In a typical large-employer setting, employees have a choice of several health plans and are able to change health plans during open enrollment periods. Once enrolled in a health plan, however, there are switching "costs" of changing plans. The employee has to spend time learning about the other health plans, their provider networks, and possibly establish a relationship with a new physician. A new plan offers greater uncertainty since employees have experience with the quality and access of their current plan. Switching costs are likely to be higher for those who have had a longer relationship with their health plan

Table 9-3. Price Elasticities for Health Insurance Plans

CHAPTER 9 The Market for Health Insurance: Its Performance and Structure • 195

and participating physician, those who are older, and those who are in poorer health.
If switching costs are sufficiently high, employees may remain in a plan even if their monthly out-of-pocket premium (co-premium) increases relative to the co-premiums of alternative plans; they become less price sensitive to price differences among competing health plans. High switching costs make health plan demand curves less price elastic and therefore limit price competition among health plans.
Switching costs are a concern in health insurance markets if they are correlated with health risk. If switching costs are greater for enrollees who have a greater need for medical care, then they will be less likely than low-risk enrollees to switch plans in response to a change in relative prices. If this occurs, then price changes will lead not only to shifts in market share, but also to changes in the cost of providing health care across plans. A plan that loses share due to an increase in relative price will tend to see its aver-age cost increase as younger and healthier enrollees switch to lower-priced plans. If this occurs and premiums are not risk-adjusted, adverse selection will result.
The effect of a change in relative co-premiums on employee switching behavior was recently analyzed (14). The study was based on 5 years (1993 to 1997) of open enrollment data from a large employer (the University of California) comprising more than 100,000 employees at 11 locations throughout California having a standard benefit design. Administrative data on each employee provided in-formation on the employee's age, sex, salary, job tenure, job classification (academic, management, or support staff), and home ZIP code to indicate whether the employee lives in a rural area. Unique to this study was the ability to match employees (and their spouses) with data from other sources to develop measures of health status. Data from the California Cancer Registry (CCR) and from the Office of Statewide Health Planning and Development (OSHPD) were matched to employees (and spouses) for the period 1988 to 1997 (diagnosed cancers) and 1991 to 1997 (hospitalizations by DRG) for identifying those individuals considered to be of "high risk" and who are likely to face higher switching costs due to an

established provider relationship. Given the ability to match employee identifiers with data from the CCR and OSHPD, it was possible to construct the above health status indicators for new enrollees prior to their UC employment, which was not possible for other such studies. Data on cancer diagnosis or hospitalizations should be relevant to employee and spouse health plan choice decisions.
At each location for each year, employees had a choice of an indemnity plan, a PPO/POS plan, and several HMOs.
In 1994, the University of California changed the method by which it contributed to its employees' health plan premiums. At each of the University's nine campuses, there were two fee-for-service plans (a "high option" indemnity plan and a PPO) and several HMOs. Prior to 1994, the University had paid the full premium for most plans and subsidized the cost of the most expensive plans. In 1994, the University limited its contribution to the cost of the least expensive plan; employees had to pay the additional cost (co-premium) of more expensive plans. Given the five years of study data, substantial variation in premiums exist within as well as across health plans.
The following study findings, presented in Table 9-4, are:

•	Employees are very price sensitive when choosing a health plan. A 10 percent increase in the relative price of a health plan will cause a decrease in enrollment of between 20 and 80 percent depending upon the employee's age, how long they have been employed, and their health status.
•	In each of the health status/age categories, the longer the person has been employed with the company (tenure), the lower their price sensitivity.
•	For each health status/tenure category, the higher the person's age, the lower their price sensitivity.
•	Within each age/tenure category, the higher the risk level, the lower the price sensitivity.
To illustrate the effect of a change in relative health plan prices when enrollees who differ in age, job tenure, and health risk have different price sensitivi‑

196 • Health Care Economics

ties, the study authors conducted a simulation analysis of a $5 and a $25 monthly premium increase. Four competing health plans are hypothesized, each having the same distribution of enrollee characteristics (age, job tenure, and risk level) and market share. The hypothetical health plan before any premium changes is shown in the top section of Table 9-5. The second section of the table illustrates the effects on the plan that increases its premium by $5 or by $25; its market share declines, the average age of its enrollees as well as the percent of its enrollees in the high-risk category increases, and the expected monthly claims cost per household increases. Those plans not in-creasing their premium, shown in the bottom section of the table, experience an increase in market share, a decline in their enrollees monthly claims cost, a de-crease in the average age of its enrollees, and end up with a lower risk group.

Table 9-4. Insurer Perspective Price Elasticities

Table 9-5. Simulation Analysis:The Effect of a Premium Increase on Plan Market Share and Expected Claims Costs

CHAPTER 9 The Market for Health Insurance: Its Performance and Structure • 197

The study findings have important implications for health plan price competition. Requiring employees to bear the additional cost of choosing a more ex-pensive health plan makes those employees more price sensitive. If a health plan were to increase its relative premiums, it would suffer a large reduction in market share among newly hired young employees in the low-risk category. Conversely, the plan would lose a much smaller percentage of older employees in the high-risk category.
The correlation of price sensitivity and health risk implies that changes in relative prices will lead to:

•	Changes in the market shares of competing plans.
•	Changes in the expected costs of plans due to changes in the average risk profiles of their enrollees.

Health plans that increase their relative premiums will tend to see their risk pools deteriorate as younger, more price sensitive, lower-risk enrollees leave for lower-priced plans.
Because older enrollees who have a higher health risk and who are more costly to insure are less likely to switch health plans in response to premium in-creases, insurers who increase their premiums (relative to their competitors) will not only lose market share but also experience higher claims cost as the younger, healthier, enrollees switch to lower-cost plans.
In the absence of risk-adjusted premiums, price competition among insurers will increase as insurers compete on price both to gain market share and to at-tract lower-risk enrollees.
Risk-adjusted premiums would eliminate distortions in health plan choices that arise when premiums differ because of differences in the risk of enrollees across plans.
These findings indicate that the demand curve facing the individual health plan is very price elastic; small relative price increases (co-premiums) will cause much greater percentage decreases in a health plan's enrollment, making such price increases unprofitable.

The Underwriting Cycle
The recurrent underwriting cycle in the group market is another indication of the price competitiveness of the health insurance industry. This cycle is characterized by three years of underwriting losses followed by three years of underwriting profits (15). The underwriting cycle goes back to at least the 1960s; more recent data on the cycle are shown in Figure 9-3.
The underwriting cycle, which results in profits and losses to health insurers, is not caused by large swings in subscribers' claims expenses but is instead a pricing cycle. The reasons for the recurrent cycle are as follows: When health insurers are very profitable in their group business (underwriting profits at their peak), they seek to increase their market share (in the group market) by lowering their prices. As the insurer begins to reduce their premiums, their medical loss ratio increases (claims expense as a portion of the de-creased premium increases). Given the price competitiveness of the insurance market, groups are able to compare premiums at different insurers, thus all insurers respond to an insurer's reduction in premiums (relative to the claims expense of a group) by reducing their premiums as well. As each insurer lowers its premium to gain market share, and the other insurers follow those price reductions, profitability of the insured groups fall.
During the profitable stage of the underwriting cycle, the insurer's sales force, which is rewarded with bonuses for signing more groups (and not penalized for signing unprofitable groups), is typically given greater authority (relative to the insurer's actuaries) to reduce premiums and sign up higher risk groups.
There is a time lag between when an insurer negotiates a premium with an insured group and when the insurer begins to receive the claims expense originating from that group and is able to calculate its medical loss ratio. The time lag may be between six to nine months. Often before the insurer has a full understanding of its underwriting profit (or loss) on each insured group, it will have to negotiate the following year's premium with that group. Insurers are

Figure 9-3. Blue Cross-Blue Shield Underwriting Gains and Losses, 1980–2002 (in percentages of revenue).

CHAPTER 9 The Market for Health Insurance: Its Performance and Structure • 199

initially unaware that they are incurring losses, and when they do they cannot immediately change their premiums; they must wait until the next renewal period.
Once the insurer experiences underwriting losses, the actuaries have greater input into each insured group's pricing decision. Premiums are rapidly in-creased for all groups, particularly those groups with the largest losses. At this point, the insurer is no longer interested in increasing market share; the insurer's goal is to return to profitability.
As the insurer reduces the number of unprofitable groups and increases premiums on other groups, its underwriting profit increases. After a few years, the insurer believes that it could increase profitability further by increasing its market share, and the cycle be-gins once again.
It is surprising that this pricing cycle continually repeats itself. If, however, at the profitable stage of the cycle several large insurers decide to lower their premiums to increase market share, insurers who do not respond with similar price reductions will lose most of their group business. Thus the insurance under-writing cycle provides evidence of the price competitiveness of the group insurance market.
The underwriting cycle affects the annual rate of increase in premiums, thus it is important for under-standing the reasons for short-term changes in premiums. The effects of public policy as well as private cost containment efforts may be minimized or exaggerated because of when those changes occur during the underwriting cycle (16).

The Efficiency and Equity Aspects of Community Rating

A further example of the insurance industry's price competitiveness was the use of community rating as a method for pricing health insurance and how market forces caused a change in that approach. Community rating, as contrasted to experience rating, charges sub-scribers the same premium regardless of the experience or risk factors, i.e., age and sex, of the group.
An early example of the use (and consequences) of community rating was by Blue Cross. Aged persons

(who had much higher hospital use rates than younger persons) were charged the same premium 4 The benefit/premium ratio for aged persons was, therefore, greater than 1.0; the benefits paid on their behalf exceeded the premiums they paid for insurance. Since the average benefit/premium ratio for all groups in a community rating system had to be close to 1.0, this meant that low users of hospital services had benefit/premium ratios much less than 1.0.
When the expected costs of groups differ, the effect of community rating is that a subsidy is provided to high-use groups financed by a (regressive) "tax" on lower-use groups. A large intergenerational transfer would be expected to occur wherein younger age groups subsidize older age groups who have higher use rates (17). Any such "subsidy-tax" system can be evaluated on the basis of two economic criteria: first, its effect on efficiency—namely, does it affect the quantity of health insurance purchased?—and second, its equity—does such a redistribution scheme cause higher-income subscribers to subsidize lower-income subscribers?
With regard to the efficiency aspects of community rating, low-user groups are typically low-risk groups. An individual is willing to pay a certain amount above the pure premium for health insurance. Charging low-risk groups a much greater amount above their pure premium than if they were experience rated results in fewer low-user groups purchasing insurance. Low-user groups might decide that they would be better off if they self-insured (no insurance) rather than pay the community rate. Depending upon the price elasticity of demand for insurance, low-user groups would be expected to demand less insurance under community rating.
Similar to an excise tax that is placed on some goods and services but not others (hence distorting their relative prices), a community rate is a tax on the insurance premium of a low-risk person. The result of such a "tax" is a decreased demand for health insurance coverage. Community rating does not permit
4. Even under community rating, however, premiums differed ac-cording to whether the individual was married or single and whether or not he or she belonged to a group.

200 • Health Care Economics

low-risk groups to purchase insurance at its costs of production, which is its actuarial value plus administrative cost.
Community rating is considered economically in-efficient. Low-risk groups buy too little insurance; they cannot buy insurance at the cost of producing it (for their risk group). (A similar inefficiency occurs when a monopolist charges a price for a service that exceeds its cost of production.) High-risk groups buy "too much" insurance; since the price of insurance is subsidized, their price is below the cost of producing their insurance, thus the marginal benefits of their additional insurance is less than the marginal costs of producing the additional coverage.
As shown in Figure 9-4, CR is the community rated premium which is the average of the experience rated premiums of high- and low-risk groups, whose experience rated premiums are, respectively, PHR and PLR. Assuming the demand curve for health insurance by both groups is the same and indicated by D, then when both groups are experience rated, they will demand QHR and QLR quantity of health insurance, respectively. Their marginal costs, reflected in their experience rated premiums, equals the marginal benefits they receive, namely the quantity demanded of health insurance.
If community rating is mandated, the marginal cost of insurance is increased for low-risk groups and decreased for high-risk groups; low-risk groups move up their demand curve and demand less health insurance, Qo, while high-risk groups move down their demand curve and demand a greater quantity of health insurance, Qo. Under community rating, the marginal benefits of insurance to both groups are no longer equal to their respective marginal cost of producing those benefits. The marginal costs are less than the marginal benefits for low-risk groups, while the marginal costs exceed the marginal benefits for high-risk groups. The quantity demanded for each group is no longer optimal.
Community rating is also inefficient because it subsidizes and therefore increases unhealthy lifestyle behavior. As long as there is some price elasticity to unhealthy lifestyles, community rating removes the financial incentive to reduce such activities, such as smoking, being overweight, having high blood pres‑

Figure 9-4. The economic inefficiency of community rating.
sure, etc. Further, community rating decreases an employer's incentive to undertake risk-reducing behavior among its employees for the purpose of reducing both the employer's and employees' medical expenses, hence premiums.
Perhaps the main reason for mandating community rating, according to its advocates, is that it would increase the number of insured persons, primarily those who are at higher risk, by being able to afford the lower premiums. Without relying on government subsidies, community rating subsidizes high-risk (presumably low income) persons by taxing low-risk (presumably higher-income persons).5 However,
5. An additional reason suggested for community rating is that it is insurance with a longer time horizon. Since everyone grows old, the young (low risk) who subsidize the aged eventually receive such a subsidy themselves. However, when the premium (based on average risk) exceeds what a low-risk premium would cost, low-risk individuals would buy less insurance. Subsidized high-risk individuals would buy more insurance. This is inefficient (one cannot purchase insurance at the cost of producing it), as well as being an unstable situation; it therefore could not exist in a price-competitive insurance market. Instead, it would be more equitable to vary the insurance premium over time according to age, since age (a proxy for risk) is also correlated with income and assets. Thus an age-adjusted premium would be more equitable over time than community rating.

CHAPTER 9 The Market for Health Insurance: Its Performance and Structure • 201

community rating not only is an inefficient mechanism for redistributing medical care, but it has in-equitable redistributive effects.
Using risk factors such as age and sex as the criteria for providing insurance subsidies assumes that all high-risk people have lower incomes than low-risk people. However, many older people have higher in-comes than those who are younger. The direction of the subsidy, however, goes from the younger (low risk) to the older (high risk) person, regardless of their relative incomes. Further, the actual subsidy goes to the group that uses more medical services, not necessarily to the group that has the highest risk of hospitalization.
Empirical studies document the unintended redistributive effects of community rating (18). A study of Michigan Blue Cross revealed that under community rating the most heavily subsidized group were auto workers. The next most heavily subsidized group was comprised of healthcare professionals—physicians, nurses, and other hospital employees. These subsidized groups had higher-than-average incomes. What occurred under community rating was that the subsidy-tax concept operated in reverse: those with lower incomes subsidized those with higher incomes. Similarly, if community rating was to be geographically based, then there would be unintended wealth transfers from poorer, rural communities to wealthier, urban communities that have higher health care expenditures.
If society agreed with the value judgment that subsidies should be provided to lower-income families to increase their purchase of health insurance, this goal could be achieved more efficiently through a system of direct subsidies to those families instead of at-tempting such redistribution indirectly through community rating.6
6. Blue Cross' goals did not include being the most efficient welfare agent. Instead, Blue Cross may have attempted to increase its enrollment and in so doing, allocated its taxes and subsidies ac-cording to a policy that facilitated the greatest increase in its growth. This policy would result in charging lower premiums to groups whose demands are more elastic (such as large unions) and higher premiums to groups with less elastic demands, instead of matching the subsidy to income level.

Community rating is inefficient because it distorts the price of health insurance to different user groups. It raises the price of health insurance to low-user groups, thereby decreasing their demand for health insurance. Their demand for health insurance was less than if they had been experience rated. Community rating is also an inefficient method of distributing subsidies for the purchase of health insurance.
Community rating cannot survive in a price competitive market (19). Competitive forces cause insurance premiums to become experience rated. This is in fact what occurred. In the mid 1950s, commercial insurers charged low-user groups experience rated premiums. As low-user groups left Blue Cross, the community rated premium to the remaining Blue Cross subscribers increased; this in turn caused additional groups, who were subsidizing others, to switch to commercial insurers. Blue Cross had to abandon community rating in its group market. Even Blue Cross plans, such as Michigan Blue Cross, that had a great deal of market power (because of strong union preferences for a non-profit insurer) had to change its rating practices.
Advocates of community rating have sought legislation to legally mandate it since it could not survive in a competitive market. An example of one such case is provided by the experience of New York State, where community rating was enacted for the individual and small group markets and took effect in April 1993.
New York health insurers were required to offer a community rate regardless of age, sex, or other risk factors, such as medical condition. Initial reports of the effect of community rating were predictable. Large numbers of young healthy people dropped their coverage as their rates sharply increased (20). The insurance pool began to consist of a greater number of older, sicker persons. The average age of policyholders increased, as did the average claim expense, which for some insurers, doubled. (Average claims cost in-creased 46 percent for the individual market.) The total number of insured persons decreased, increasing the number of uninsured by 400,000.
A recent study of New York's community rating legislation arrives at a somewhat different conclusion (21). The authors compared three states, New York

202 • Health Care Economics

(which implemented community rating), Pennsylvania (which did not), and Connecticut (which placed very few restrictions on how insurers could set their premiums). They found that "While coverage rates in the New York small group market did fall, and the age distribution of the covered population did shift towards older persons in a manner consistent with a market-wide death spiral, . . . we find almost identical changes in Pennsylvania and Connecticut. . . . " They further ". . . find evidence that New York's reforms led to an increase in the market share of HMOs in the small group and individual market." The authors conclude that the primary goal of community rating proponents, an increase in the per-cent of the population with insurance, did not occur.
The major effect of community rating in New York, according to the above study, was a shift away from indemnity insurance to HMOs. If these more restrictive forms of insurance that are better able to control costs were unavailable, it is likely that premiums would have sufficiently risen to result in the predicted adverse death spiral, dramatically reducing the number of insured.
Proposals have been made at both the federal and state level to require "community rating" as a basis for establishing health insurance premiums. Legally mandating community rating eventually results in insurers engaging in preferred risk selection. If the benefit coverage is not mandated along with community rating, then insurers would compete for low-risk groups by structuring their benefits accordingly, e.g., including higher deductibles, emphasizing wellness programs, and de-emphasizing chronic care specialists. It is more likely that along with community rating a standard benefit package would also be man-dated. However, insurers could still attempt to enroll low-risk groups according to where they locate their providers, the services they emphasize, and access to referrals for specialists. An additional problem with mandating a standard benefits package is that sub-scribers have different preferences regarding the benefits they are willing to purchase and the size of the deductible and co-payment desired (both of which determine their premium).
Maintaining a community rate with a single set of benefits when subscribers differ in their utilization

experience and in their preference for benefits, cost sharing, and cost containment techniques is highly in-efficient. Diversity in consumer preferences can be dealt with most efficiently by a health insurance system that offers a variety of benefits, cost-sharing arrangements, and rate structures. If society desires everyone should have at least a minimum level of health insurance, subsidies can be provided directly to those with low incomes instead of mandating a community rated insurance scheme for all.

The McCarran-Ferguson Act

Enacted in 1945, the McCarran-Ferguson Act provides the insurance industry with a limited exemption from the anti-trust laws (22). The Act states that the anti-trust laws apply to the business of insurance unless the insurance companies are regulated by the states. Even though the state may regulate the insurers, insurers are still prohibited from engaging in boycotts, coercion, or acts of intimidation.
Various medical organizations have claimed that the McCarran-Ferguson Act has permitted health insurers to act in an anti-competitive manner; colluding to fix both the prices they charge and to limit how much they pay physicians. Further, that the collusive activities of health insurers contribute to the rising cost of health insurance premiums.
No evidence exists that health insurers collude in setting premiums above the competitive level. The most serious impediment to competitive pricing has been in the state regulated individual market when the state mandates community rating. Further, the structure of the health insurance market is very competitive; there are a large number of insurers, and the costs of entry are relatively low. Even though large economies of scale in the production of insurance exist, low entry costs make insurance markets highly contestable. The ability of groups to become self-insured also limits insurers' ability to engage in anti-competitive pricing. The underwriting cycle is additional evidence of a lack of collusive pricing by insurers, otherwise insurers would not suffer continual periods of large underwriting losses.
The structure of the industry and the number of actual and potential competitors, together with their

CHAPTER 9 The Market for Health Insurance: Its Performance and Structure • 203

pricing behavior, indicate that the health insurance market is very price competitive. Shifting the cause of rapidly rising premiums to insurers deflects attention from the actual reasons for rapidly rising premiums, such as greater use of expensive technology, rising in-put prices, and inappropriate use of services.
THE PERFORMANCE OF THE HEALTH INSURANCE MARKET

Two important aspects of market performance are the extent of price and product competition among insurers. Price competition among insurers reduces the loading charge and eliminates any excess profits; when firms earn normal rates of return, premiums reflect the cost of producing health insurance. Product competition forces insurers to respond to the insured population's preferences for different types of insurance. The health insurance industry has changed over time; from predominately non-profit insurers to mostly for-profits, to new types of health plans, and a change in the role of insurers from merely administering employer health benefits to a more interventionist role with the rise of managed care. The performance of the industry depends upon how competitive it is and how well it responds to consumer demands.
Insurer Profitability
The most relevant time for evaluating the performance of the industry is from the mid 1990s to the present. During this period, managed care became a national phenomenon (previously it was dominant only in certain sections of the country). In more recent years, managed care's restrictive cost controls were loosened and providers, through mergers and market consolidations, were able to exercise market power in their health plan negotiations.
The yardstick for measuring market performance is how close the industry approximates the model of a perfectly competitive market. Several characteristics of the competitive model are price competition, free entry and exit, and in the long run, prices reflect costs of production, and no excess profits exist.

It is difficult to determine whether premiums reflect costs since the divergence between the benefit/premium ratio and 1.0 may be the result of increasing administrative functions related to cost containment pro-grams, the multiplicity of insurance products offered, and so on. Instead, the price competitiveness and profitability of the industry over time are used to indicate the competitiveness of the industry.
Three examples were used to indicate the price competitiveness of the industry: insurer-firm demand curves, the underwriting cycle, and community rating. Firm demand curves were determined to be very price elastic based on studies of the likelihood of employees switching health plans as a result of small changes in their co-premiums. The underwriting cycle occurred because insurers reduced their prices to increase their market share, followed by price in-creases to recover from severe losses. Community rating disappeared (except in state-regulated individual markets) because of lower prices offered by insurers to groups whose experience rated premium was be-low the community rate (large groups were also able to self-insure if their claims experience was below the community rate). The market for health insurance was considered to be highly price competitive.
The second indication of competitive markets is whether above normal profits are able to persist over time. Even though some insurers may be able to have higher profits for a longer period than other firms (perhaps due to superior management), the insurance industry, on average, does not exhibit persistent high profits. Again, data on the underwriting cycle support the hypothesis that insurers do not earn continual high rates of return. The net profit margin on insurers' premiums have varied over time from slightly greater than 4 percent to losses almost reaching negative 4 percent. In recent years, the net margin has been profitable. Although insurers also earn interest on their premiums in addition to their underwriting margin, the size of the margins and their variability are indicative of a relatively competitive industry (23).

Product Competition in the Health Insurance Market

The health insurance industry is a supplier of insurance and a demander of medical services; it thus

204	Health Care Economics

operates in two different markets. As a supplier of health insurance, insurers can be a price competitive industry even though the markets in which they purchase medical services may be monopolistic. To the extent that the medical services market is not price competitive, then insurance premiums will be higher since claims expense will be greater than if the input (provider) market were competitive. In addition to in-creasing input prices, a non-competitive medical services (input) market may also be able to restrict the types of products that health insurers can market, such as cost containment programs and participation in HMOs. Thus the ability of insurers to respond to consumer demands will affect the performance of the health insurance market.
An important development over the past decade has been the introduction of cost containment pro-grams by the health insurance industry. Cost containment methods include utilization review (such as pre-authorization prior to being admitted to a hospital), concurrent review (review of length of stay while in the hospital), second opinions for surgery, drug formularies, as well as Health Maintenance Organizations (HMOs) and Preferred Provider Organizations (PPOs). These cost containment approaches differ from the use of deductibles and cost sharing, which have long existed, in that these newer approaches place the insurer between the traditional patient-physician relationship. The physician's decision-making authority is subject to review.
The Previous Unavailability of Cost Containment Methods: The rapid increases in medical expenditures and health insurance premiums are not a recent phenomenon. Therefore why weren't insurance companies more aggressive in adopting such measures previously in their attempts to control rising costs? One study examining the potential savings to an employer from adopting utilization review found that it was very effective in reducing hospital use and medical expenditures; the savings-to-cost ratio was found to be 8 to 1 (24).
One possible reason for the unavailability of such restrictive cost control insurance products was insufficient demand by the purchasers of health insurance, employers and employees. Employer-purchased health insurance is exempt from federal, state, and

Social Security taxes; thus the employee does not bear the full cost of rising medical expenditures. The after-tax value of the savings to employees from more restrictive cost containment methods was too low given the high marginal income tax rates during the 1960s and 1970s. Many employees also believed that health benefits were a hard-won benefit and that restrictions on those benefits would be a "give back." Further, firms engaged in overseas competition were provided with import protection, e.g., the auto companies benefited from "voluntary" quotas being placed on Japanese imports, which made it possible to pass on higher employee costs (in the form of medical care) to consumers in the form of higher auto prices. (With a less price elastic demand curve as a result of de-creased availability of foreign substitutes, increased employee health costs (compensation) resulted in higher auto prices; in the 1980s, with more import competition and a more elastic demand curve, in-creased employee medical costs caused greater de-creases in production and employment, thereby in-creasing employer and employee concern with rising medical costs.)
While it is possible that there might not have been much demand for restrictive cost containment methods among firms, it is unlikely that all firms and purchasers would have been opposed to such measures. It is therefore necessary to examine supply side reasons why cost control measures were not offered.
A second possible explanation for the previous lack of cost control programs is that other insurers would copy an insurer who innovated in developing such programs. The innovator would not gain any competitive advantage and would incur costs if the innovation did not work. Similarly, if an insurance company were successful in changing the practice style of physicians, then the physicians would treat other insurer's patients in a similar manner; the innovating insurer would incur the costs of inducing physicians to change and not receive any competitive advantage (25).
The third, and most likely, explanation for the lack of cost control methods is based on anti-competitive behavior by providers.
Health insurance consists of three components: the pooling of risks, the administration of claims, and the

CHAPTER 9 The Market for Health Insurance: Its Performance and Structure • 205

expense of physician and hospital services. In a competitive market, an insurance company will be able to lower its costs (hence increase its profits or lower its premiums) if, in performing the risk function, it selects preferred risks (individuals who are less costly) and if it is efficient in the administration of claims. Insurance companies would be able to reduce their costs for medical services if they are able to purchase hospital and physician services at lower prices or have their subscribers use fewer such services. Health providers have always been more concerned with the prices they received and whether controls were placed on the use of their services than on how insurance companies pool their risks and administer their claims.
Competition among insurance companies on the basis of how well they are able to reduce provider prices or utilization is contrary to the economic interests of physicians and hospitals. Blue Cross and Blue Shield plans, which were developed and controlled by hospitals and physicians, therefore did not engage in such cost control activities. When other insurers did initiate such activities, physicians (and other health providers) engaged in anti-competitive behavior to prevent the insurer from continuing such actions.
Faced with competition during the early 1930s, insurers lowered their costs; insurers in Oregon placed restraints on physician utilization. Preauthorization of services and monitoring of claims were used. Physicians accepted such constraints on their behavior since it was during the depression, physicians did not have as many patients, and they were unsure of their ability to collect from those they did have. Consumers benefited from these cost containment measures through lower insurance premiums.
The response by the Oregon medical society was twofold: first, to threaten physicians who participated in such insurance plans with expulsion from the medical society and, second, the medical society started its own insurance plan, which did not use aggressive utilization review procedures. With the growth of their own insurance plan, physicians were encouraged to boycott other insurance plans. The medical society's sponsored health plan grew, and enrollment in other insurance plans declined. To secure physician partic

ipation, other insurers had to become less aggressive in their cost containment efforts (26). The medical societies were thereby able to ensure that the type of insurance programs offered to the public were also those that were in the physicians' economic interests.
Additional examples of such anti-competitive behavior were organized medicine's actions against capitated (prepaid) health plans, such as Kaiser and HMOs (27).
Through their anti-competitive behavior, medical organizations precluded certain types of insurance coverage that would have reduced medical expenses from being offered in the insurance market. Co-payments and deductibles have always been accept-able to physician organizations since they did not interfere with physician pricing or decision-making.
The Supreme Court's ruling in 1982 that upheld the applicability of the anti-trust laws to the health professions made such anti-competitive behavior illegal.
Throughout the 1980s, in return for lower premium increases, employer and employee demand for cost containment programs increased. The reduction of federal tax rates in 1981 also served to stimulate demand for such cost containment products by decreasing the tax subsidy for more comprehensive insurance. Free of anti-competitive restraints on the types of insurance products they were able to offer, insurance companies were better able to match their insurance products to the preferences of each employer group.
Recent Developments in Health Insurance Products: Managed care techniques, such as limited provider networks, prior authorization for inpatient care and for specialist referrals, primary care gatekeepers, and negotiated discounts with providers, as well as provider risk sharing through capitation, proved successful. By the mid-1990s, health insurance premiums were barely rising; in California, a state where man-aged care started early, premiums, in absolute dollars, actually declined during that period.
Rapidly increasing insurance premiums and relatively stable incomes during the late 1980s and early 1990s stimulated the demand for managed care. How-ever, as real incomes began to increase during the late 1990s and employers competed for labor driving

206 • Health Care Economics

wages still higher, employees wanted health benefits with fewer restrictions and greater access to specialists. The demand for tightly managed care plans declined. Managed care firms responded to these changes in consumer demand and broadened their provider net-works and eliminated other cost containment techniques, thereby increasing access to care. As health plans relaxed their restrictions, they began to lose their ability to control costs.
At the same time consumer demand was changing, a backlash against managed care occurred. Led by anecdotes of denial of care and physician anger against the interference of managed care in their practices, legislators at both the state and federal level began to place limits on managed care.
With the loosening of managed care's cost control and the continuing growth of technology and new drugs, health insurance premiums once again began to increase rapidly.
To control rising health care costs, employers are increasing deductibles and co-payments and limiting their health plan contribution. Current cost containment approaches impose greater financial incentives on employees to use fewer services and to select less expensive health plans. Insurers and employers are searching for new ways to contain rising health costs.
A relatively new approach being considered by several large employers as a means of reducing rap-idly increasing insurance premiums is a defined contribution plan (DCP) (31). Although this approach has received a great deal of publicity, its popularity is uncertain.
The idea of a defined contribution is not new; providing employees with a fixed dollar amount to use in choosing a health plan has been proposed by many as a means of making employees price sensitive to the cost of different health plans and stimulating competition.
The new use of the DCP insurance product reduces the employer's involvement in managing their employees' health benefits, shifting more of the decision-making to the employee. The DCP plan works as follows: The employer allocates a specific (tax exempt) dollar amount for the employee's health benefits. Part of this amount is deposited in an employee account from which the employee can purchase medical serv

ices. The remainder of the employer's contribution is used to purchase a large deductible catastrophic health insurance policy. The employee is responsible for the difference in medical expenses between the amount deposited in their account and the catastrophic policy deductible level. (Unused funds in the account roll over into the following year and may be taken by the employee if they change jobs). Lastly, the companies marketing such DCPs offer the use of the Internet to assist employees with their decision-making, such as establishing preferred provider networks.
The growth of defined contribution plans, if it were to become widespread, would represent a dramatic shift in the private health insurance system. Instead of employers contracting with large insurers to manage their employees' health benefits, the employee becomes responsible for their medical expenses until their catastrophic insurance limit is reached. Employees would need the appropriate information to make informed decisions on their medical needs and choice of provider.

Federal and State Health Insurance Regulation

Federal Legislation: In 1996, health insurance regulatory reforms were enacted at the federal level. The Health Insurance Portability and Accountability Act (HIPAA) removed certain health insurance market imperfections. Included in the legislation was Guaranteed Issue, whereby health insurers have to offer group health insurance to groups willing to purchase it. Thus insurers would not be able to deny coverage to groups they believe would be high risk. Guaranteed Renewal requires health insurers to renew all health insurance policies, precluding them from dropping individuals or groups who incur high medical costs. Consistent with the concept of insurance, a person who purchases insurance should not lose it once they incur a serious illness. Portability is important because employees are often reluctant to leave their jobs because they cannot take their health insurance with them. Under the new legislation, employees are able to continue their insurance coverage if they move to another employee group or if they become self-employed. Limitations on Pre-Existing

CHAPTER 9 The Market for Health Insurance: Its Performance and Structure • 207

Exclusions means that once an individual has met the (usual 12 month) pre-existing exclusion limit for any illness, an insurer cannot re-impose another 12-month waiting period if the employee changes jobs. Employees are thus more likely to be able to change jobs without fear of being without health insurance if they or a family member have an illness.
In addition to the above, the new law expanded the tax deductibility of health insurance premiums (up to SO percent from the current 30 percent) for the self-employed by the year 2006. This will begin to eliminate an inequity that exists between the self-employed and those employed by groups, who currently receive 100 percent tax deductibility of their premiums.
State Health Insurance Regulation: States have also enacted health insurance legislation; state high-risk pools have enabled those who are uninsurable to purchase insurance at subsidized rates. However, other state legislation has impeded the efficient functioning of the insurance market, such as mandated community rating, reduced limits on pre-existing exclusion waiting periods, mandated benefits and providers, rate regulation of insurance premiums, and Any Willing Provider (AWP) laws. These laws have adversely impacted the market's efficiency.
Any Willing Provider laws require insurers to accept all out-of-network providers that agree to abide by the plan's contract terms. About 25 states have en-acted AWP laws. Traditionally, HMOs have been able to negotiate lower payments by assuring providers that their direct competitors would be excluded from the network, thereby guaranteeing them a larger volume of patients. But because AWP laws prevent HMOs from making these promises, providers have little incentive to offer discounted prices. These government restrictions reduce the options available for those consumers who are unwilling to pay for such open provider networks; their premiums are in-creased. A recent study, for example, found that AWP laws reduce the cost savings effect of HMOs, particularly with regard to physician expenditures; providing an economic rationale for physician support for such laws (29).
State requirements regarding rating methods and maximum premiums, particularly with regard to the Individual market, have resulted in a decline in compe

tition as the number of insurers participating in the individual insurance market decreased. For example, in 1995 the insurance commissioner in Washington State decreed that for a given period of time the 12-month waiting period for pre-existing conditions would be eliminated, and after that the pre-existing waiting period should only be three months and that insurers serving the individual market could not in-crease their premiums (30). Adverse selection began. Those who were sick purchased insurance—some from their hospital beds. Those with chronic conditions left the state's high-risk pool to purchase less ex-pensive private coverage. The demand for insurance declined because low-risk individuals believed that they could buy insurance once they became ill, given the short waiting period.
Insurance companies filed lawsuits seeking large rate increases as their claims increased. Individuals who had insurance began to drop their coverage as the courts permitted insurers to increase their rates. Given the losses incurred by the insurers and the uncertainty over future rate increases, the number of insurers participating in the individual market decreased.
Washington State provides an example of the equity and efficiency consequences when the individual health insurance market is regulated. Insurers will exit markets and others will not enter when government regulation creates uncertainty whether profits can be earned. Consequently, few insurers will compete, and choice of insurers and products will be limited.

SUMMARY

The market structure of the health insurance industry was examined with respect to the extent of economies of scale, whether barriers to entry existed, and whether any insurers had any cost advantages over other insurers. Although there appear to be large economies of scale in the production and sale of health insurance, there are a large number of insurers and few barriers to entry. The market structure for insurance is considered to be competitive.
Blue Cross was established by hospitals and grew at a rapid rate because it was able to see the vast potential demand for coverage of health care costs. The

208 • Health Care Economics

commercial insurance companies entering the market after Blue Cross also grew because of their product and pricing innovations. They offered a benefit coverage (major medical insurance) that differed from that offered by Blue Cross, they offered indemnity payments rather than a service benefit policy to sub-scribers and providers, and they priced their premiums according to the experience of the group, which led to the demise of community rating. The newest entrants, HMOs and PPOs, were a response to market demand for lower premiums that was not being met by traditional insurers. Unless competition were possible, it is unlikely that consumers would have been offered a greater choice in benefits, cost-sharing arrangements, premiums to match their own experience, and types of insurance products.
The applicability of the anti-trust laws to the health field removed restrictions on the types of products insurers are permitted to sell. Previously, medical societies had been able to act anti-competitively to restrict an insurer's sale of cost control programs that interfered with physicians' decision-making authority. The previous role of providers in limiting the sale of cost control products by insurers illustrates the importance of competition in provider markets on the price and quantity of medical care. The demand for medical services and the supply of those services are linked together by the health insurance market. Thus, even if the health insurance market were competitive, restrictions in provider markets (either anti-competitive or legal) can have adverse effects on consumers.
The health insurance market is very price competitive, as indicated by the estimated high-price elastic firm demand curves, the recurring underwriting cycle, and inability of the Blues to maintain community rating.
The use of benefit/premium (medical loss) ratios as a measure of efficiency has lost its relevance given the wide variety of policies and functions performed by different insurers.
The performance of the health insurance industry has improved as employees (or employers acting on their behalf) have become more price sensitive in their choice of health plans and a large variety of types of health plans are now available. Indicative of the competitiveness of the industry is its lack of ex

cess profits and cyclical periods of underwriting losses.
Competitive markets force insurers to minimize their administrative costs and to respond to insured groups demands for different types of insurance coverage. The incentives inherent in such competition are more effective for achieving economic efficiency in the demand and supply of health insurance than having one large firm administer a standard insurance policy for everyone. Innovations in benefit packages and in cost minimization are more likely to occur when there are strong competitive pressures than when firms, whether they are for-profit or non-profit, are protected from such competition.
A growing concern with regard to efficiency and equity, however, are regulations enacted by some states and those being considered by other states. These regulations, such as shorter waiting periods for pre-existing conditions, community rating, and state mandates, decrease the demand for insurance by al-lowing people to wait until they are ill before they buy insurance (shorter waiting periods), impose a regressive "tax" on low-income groups to subsidize the care of those who are older and at higher risk (community rating), and increase the cost of health insurance (state mandates), thereby decreasing the demand for insurance (31).
APPENDIX 1: THE USE OF MEDICAL LOSS RATIOS AS A MEASURE OF HEALTH PLAN PERFORMANCE
Critics of private health insurers have pointed to their high administrative costs and the correspondingly lower portion of claims payout (low medical loss ratio) as an indication of poor performance. These critics claim that it would be in the public interest if a greater portion of the premium dollar were paid out for medical services than retained for administration and profits. "Single Payer" advocates have used Canada's higher medical loss ratios to justify a Canadian-type system. Medical societies have (selfinterestly) proposed limits on insurers' administrative expenses to increase physician payments.

CHAPTER 9 The Market for Health Insurance: Its Performance and Structure • 209

Superficially it would appear that the lower the administrative costs (as a percentage of premiums) the more efficient the insurer, and that the insurer is less likely to skimp on quality of care. Further, the greater the proportion of the premium being returned in the form of medical services, the more apparent value the enrollee receives from buying health insurance.
A for-profit insurance company would only undertake those administrative functions that have a favorable cost-benefit ratio, otherwise they would be foregoing profit. If administrative expenses were wasteful, a competitive insurer could enter the market, have lower administrative costs, consequently charge lower premiums, and increase their market share. That this does not occur suggests that administrative costs are not a sign of inefficiency.
Can any validity be attached to either a high or low medical loss ratio?

The Absolute Size of the Premium

Concentrating on the administrative expense portion of the premium ignores the absolute size of the premium. Any health care system, whether it is Canada's or this country's Medicare system whose administrative costs are a small percentage, such as 3 percent for Medicare, may have higher premiums than a managed care firm offering the same benefits but whose administrative cost are a higher percentage of premiums. Medicare, which may simply pay for all claims submitted by health care providers, will have low administrative costs but also spend more in medical claims because it does not adequately check for fraud and abuse. Medicare may pay for services not per-formed, services may be up-coded, unnecessary services may be provided, and services are provided in more expensive settings when the patient could be cared for in an outpatient facility or in their own home.
The U.S. Government Accounting Office has claimed that Medicare's administrative costs are too low; that Medicare could save money (reduce their medical expenses) if they used some of the private sector's managed care techniques.
There are also a number of other reasons why medical loss ratios should not be used to indicate an in-

surer's efficiency, quality of care provided, or the value received by its enrollees.

Insurance Products Offered

The greater the variety of health insurance products offered by an insurer, the greater their administrative cost. An insurer that offers an indemnity product as well as a PPO, an HMO, pharmacy benefit plans, vision benefits, dental plans, life and disability insurance, and different combinations of deductibles and co-payments with each of the above plans is going to have a higher administrative cost than an insurer than offers fewer products and co-payment options.
Insurers that offer a wide variety of health plans have joint marketing, enrollment, and administrative costs that can be allocated in various ways to the different health plans. Depending upon how these joint costs are allocated, some health plans may show higher administrative costs than others.
Similarly, insurers that operate in different states may report different medical loss ratios based on how the insurer allocates joint costs across its state plans. For example, the insurer may centralize the marketing and enrollment costs of a large corporate account that has enrollees in multiple states.

Differences in the Types of Insurance Purchasers

Insurers that enroll a higher proportion of small groups and individuals will have higher marketing (hence administrative) costs than insurers that concentrate on large employer groups. It is much less costly to market to a single corporate headquarters for thousands of employees than to advertise and sign up a few employees at a time. Large employers will also perform some of the enrollment functions themselves. Insurer concern with adverse selection (hence monitoring costs) is greatly reduced when a large employer group is enrolled than when the same number of self-employed individuals seek to buy insurance.
Large employer groups typically have more comprehensive benefits than those enrolled in the individual market. Thus the medical loss ratio will also be higher among large groups for no other reason that

210 • Health Care Economics

the number of medical claims and cost of those claims will be higher among those with more comprehensive benefits.

The Functions Performed By the Insurer

Insurers differ in the functions they perform, which affects their administrative cost ratio. An insurer that undertakes utilization management rather than simply paying all claims submitted will have higher administrative costs (as a percentage of premiums) but lower premiums. These insurers will be more efficient as well as offer enrollees greater value for their premiums.
Similarly, an insurer that emphasizes preventive services to its enrollees, tracking enrollees by their age and the last time they had certain preventive services, will have higher administrative costs. Further, an in-surer that collects data from both its enrollees and its providers on quality of care, patient waiting times for services, and patient satisfaction will have higher administrative expense than other types of insurers.

Relationships Between the Insurer and Its Providers

Administrative costs will be higher in those insurers that perform all the administrative functions them-selves than when those same functions are the responsibility of their contracted providers. For example, an insurer that capitates a medical group in effect delegates various administrative functions, such as medical management and physician quality reviews, to the medical groups. The administrative costs for these functions are included in the medical group's negotiated capitation payment and are not visible; the insurer will appear to have a very high medical loss ratio compared to an insurer who does not delegate these functions.
Insurers who have a large provider network will have higher administrative costs than insurers that contract with fewer hospitals and physicians. In this case the size of the network, consequently the insurer's administrative cost, are determined by enrollee preferences as to how much provider choice and travel distance to a provider they are willing to accept.

Variability of Medical Loss Ratios

The use of medical loss ratios as an indication of in-surer efficiency, quality, or to justify restricting for-profit insurers is inappropriate. Medical loss ratios among insurers can vary for many reasons. Some non-profit insurers have higher medical loss ratios than for-profit insurers, while some for-profits have higher medical loss ratios than non-profits. There is no consistent pattern. Even for the same insurer (whether it is for-profit or non-profit), its medical loss ratio varies greatly across different states.?
Rather than relying on such a flawed measure as an insurer's medical loss ratio, it would be more appropriate for those interested in health care reform to directly compare insurer performance according to quality of care provided, patient satisfaction, benefit structure, and overall premiums. While more difficult to do, such comparisons are more meaningful than re-lying on a simple medical loss ratio.
APPENDIX 2: DEVELOPING RISK-ADJUSTED PREMIUMS

Risk-adjusted premiums are based on various proxies for employee risk factors, such as age and sex. In the following example, for simplicity, age is used as the measure of risk for incurring medical expenditures (32).
Assume an employer group has ten employees that differ in age. As shown in Table 9-6, column 1 de-scribes the four age levels of the employees. Column 2 indicates the risk factor associated with each age group. The "average" employee is assumed to be age 40 and to have a risk factor of 1.0. Each of the other age group's risk factors is calculated relative to the average employee whose risk factor is 1.0. For example, if a 30-year-old person, on average, incurs $800 med‑
7. Robinson's article on which this discussion is based includes a table showing the medical loss ratios for a number of for-profit and non-profit insurers in the different states in which they operate. James C. Robinson, "Use and Abuse of the Medical Loss Ratio to Measure Health Plan Performance," Health Affairs, 16(4) July/ August 1997,176–187.

CHAPTER 9 The Market for Health Insurance: Its Performance and Structure . 211

Table 9-6. A Hypothetical Example of Risk-Adjusted Premiums

ical expenses in a year and the average employee who is a 40-year-old incurs $1,000 medical expenses, then the risk factor for the 30-year-old person is 0.8. Similarly, if 60-year-old employees incur, on average, $1,600 of medical expenses each year, then their risk factor, relative to those who are 40, is 1.6. The risk factors for each employee group can be calculated using past medical claims data.
(Another risk factor such as sex can be incorporated by simply expanding the rows (to eight) in the table above so that for each age group there is a risk factor for males and one for females.)
The third column in Table 9-6 lists the number of employees in each age group with their corresponding risk factor. Column 4 is a calculation of the total level of risk by age group. In the 30-year age group there are 3 employees, each with a 0.8 risk factor, for a risk total of 2.4. Summing up the total risk by each age group equals 11.5. Dividing the total risk level (11.5)

by the 10 employees results in an average risk factor per employee equal to 1.15.
Assume first that the employer does not use risk-adjusted premiums and pays $100 per member per month (PMPM) to each of two competing health plans. As shown in Table 9-7, each health plan enrolls five employees, who differ in their risk factors. Plan
A enrolls two 30 year olds (total risk factor is 2 x 0.8 = 1.6), two 40 year olds (2 x 1.0 = 2), and one 50 year old (1.3), for a total risk level of 4.9. Plan B enrolls one 30 year old (0.8), two 50 year olds (2 x 1.3 =2.6), and two 60 year olds (2 x 1.6 = 3.2) for a total risk level of 6.6.
Both health plans receive a total of $500 for five employees, but Plan A's risk level for those employees is 4.9 compared to 6.6 for Plan B. Plan A will make a profit based on preferred risk selection, while Plan
B will lose money because it received a higher risk group. Plan B will eventually have to exit the industry, not because it is less efficient than Plan A but be-cause it received a higher risk group.
If the employer used a risk-adjusted premium, then the average monthly premium per employee ($100 PMPM) is divided by the average risk level of the employees (1.15), which equals $87 PMPM.
Assuming the same employees went to the same health plan as in the previous example, then Plan A would receive

2 x 0.8 x 587. = $139.2 plus 2 X 1.0 x $87. = $174. plus 1 x 1.3 x $87. = $113.1 for a total amount of $426.30

Table 9-7. Risk Levels in Two Hypothetical Health Plans

212 • Health Care Economics

Plan B would receive $574 for its five employees who are at higher risk.
The above example assumed the employer paid the entire premium for each employee. The next ex-ample assumes an employer uses risk-adjusted premiums but that an employee choosing a more expensive health plan pays the additional cost of the more costly plan.
Each health plan competes for employees based on a demographically neutral premium (DNP); the premium is based on an average employee with a risk factor of 1.0. For example, an HMO offers a DNP of $100 PMPM. A competing PPO offers a DNP of $110 PMPM. As shown in Table 9-8, a 40 year old choosing the HMO pays no premium, and the employer pays the HMO $100. A40 year old choosing the PPO would pay $10 per month and the employer would pay $100, with the PPO receiving its DNP of $110 PMPM. The PPO enrolling a 30 year old receives $88, which is the DNP multiplied by the employee's risk factor ($100 x 0.8 = $88.); that premium is split between the employee who pays $10, which is the additional amount of the more costly health plan, DNPPPO — DNPHmo ($110 — $100), and the employer who pays S78 ($88 — $10). A 50 year old choosing the PPO would pay $10 (DNPPPO — DNPHMO , $110 — $100), and the employer would pay $133 (1.3 X $100 — $10).
When a health plan is paid a risk-adjusted premium, the plan is paid more for enrolling higher-risk employees and therefore has an incentive to compete for such enrollees. Further, high- and low-risk employees enrolling in the same plan pay the same amount.

REVIEW QUESTIONS
1.	Describe the types of competitors in the health insurance market.
What components determine the size of a premium?
3.	Does a benefit-to-premium (or medical loss) ratio close to 1.0 necessarily mean that the in-surer is being efficient and is minimizing the cost of providing medical services?
What determines the price elasticity of demand for an individual insurer? Why does the price elasticity of demand facing the individual in-surer differ from the overall market demand for health insurance?
What is the difference between "experience" rating and "community" rating? Under which pricing system do insurers have an incentive to engage in preferred risk selection?
6.	Discuss whether or not community rating is economically efficient and equitable.
7.	Explain why an insurer's pricing strategy of reducing its relative co-premium charged to an employee group would also reduce the average risk level of its subscribers.
What would be the effect of "risk-adjusted" premiums on insurers' engaging in preferred risk selection strategies?
Do All-Payer systems whereby the state regulates hospital charges so that every purchaser pays the same price for hospital care enhance competition among insurers? Who do you believe would be for and against All-Payer systems?

pWrapPolygonVertices8;7;(20736,0);(20736,376);(0,376);(0,21601);(21600,21601);(21600,0);(20736,0);fBehindDocument0Table 9-8. Risk-Adjusted Premiums with Employees Paying the Additional Cost of a More Expensive Health Plan

CHAPTER 9 The Market for Health Insurance: Its Performance and Structure • 213
10.	Explain how managed care plans (such as HMOs) and defined contribution plans are alternative approaches for controlling moral hazard.
11.	Why are Any Willing Provider laws anti-competitive?
12.	How have previous anti-competitive restrictions by medical societies affected the types of health insurance products offered?
REFERENCES
1.	Louis Reed, Blue Cross and Medical Service Plans, (Washington, D.C.: U.S. Public Health Service), 1947. Also see Robert Eilers, Regulation of Blue Cross and Blue Shield Plans, (Homewood, Ill.: Richard D. Irwin), 1963.
Ronald J. Vogel and Roger D. Blair, Health Insurance Administrative Costs, Social Security Administration, Office of Research and Statistics Paper 21, October 1975.