U.S. Industry Outlook: Hard Truths on Health Reform

View the Moody's Economy.com U.S. Industry Forecast.

• Large health insurance firms are better able to spread risk and cut administrative costs.
• Structural economies of scale also push the industry toward consolidation.
• An insurance exchange would create a new pool and significantly reduce premiums for individual consumers.
• Lower prices in one insurance pool will not necessarily push prices down in other pools.

The insurance industry has been battered by the financial crisis, with many firms forced to take hefty write-downs. While a huge government bailout kept AIG from failing, other firms have been unable to withstand heavy losses. Mergers and acquisitions since 2007 have further reduced competitiveness within both the industry's property and casualty and life and health insurance segments. As a result, the concentration in market share among the largest firms has increased.

So far this year, 142 insurance merger deals have taken place in the U.S., with a total value of $5.3 billion, putting insurance tenth among all industries, according to Mergerstat. The average deal value is approximately $37 million, indicating that, for the most part, larger firms are acquiring smaller ones. Insurance has considerable economies of scale. Especially in health insurance, large corporations have lower administrative costs per policy and larger pools over which to spread risk; they also are better able to build large provider networks and employ sophisticated data systems.

In addition to extending health insurance coverage to all Americans, holding down cost is a central goal of the healthcare reform proposals being debated in Congress. Adopting best practices and new information systems are seen as means to increase efficiency and lower costs for providers that will ultimately be passed along to patients. A new exchange that includes insurance co-ops and perhaps publicly operated plans are supposed to enhance bargaining power by spreading risk over larger pools of consumers. Reformers also hope these larger pools will attract more insurers, thereby increasing competition within the industry and forcing prices down. The structure of the insurance industry suggests this will be only partly successful.

Limited competition

Consolidation in life and health insurance has increased revenue concentration among larger firms. The Hirschman-Herfindahl index, a measure of industry concentration, indicates that from 1999 through 2006, industry concentration was largely stable, albeit at levels reflecting limited competition. In 2007 and 2008, consolidation raised the index considerably. According to the American Medical Association, some firms enjoy near-monopolies in some regions because of state regulations and other barriers to entry, with market share exceeding 50%. In a sixth of U.S. metropolitan areas, a single health insurer holds market share of 70% or better. Moody's Economy.com estimates that life and health insurance was the second most concentrated of all U.S. industries in 2008, behind only general merchandise retail.

To force more competition, various healthcare proposals would require that any insurer licensed by a state participate in that state's exchange to market coverage to small groups and individuals. However, larger firms are better able to control costs and would likely be among the most competitive in the exchange. New firms are unlikely to pull significant market share from larger, established insurers without significant government intervention.

Another barrier to entry is the volume of business required to spread risk and cover costs. Insurance is the most capital-intensive of all U.S. industries, according to our estimates, and building up market share requires substantial investment. The amount of capital required to compete also pushes the industry toward fewer and larger firms.

Being in a highly concentrated industry with substantial capital requirements also gives insurers a high degree of pricing power. Moody's Economy.com ranks life and health insurance fourth among all U.S. industries in terms of pricing power. The producer price index for insurance typically rises faster than overall prices, and insurers have been relatively successful in passing those costs to consumers. Premiums for group medical insurance generally rise more slowly than rates for individual coverage, showing that groups have negotiating power. Nevertheless, the CPI for medical care typically outpaces average consumer price growth.

Premium control

Current healthcare reform proposals would create an insurance exchange from which those currently unable to afford insurance or otherwise uninsured could obtain affordable coverage. With the added requirement that all citizens purchase health insurance, this would create a large, new pool of more than 30 million customers. The new pool would attract insurers and encourage competition.

In recent years, the cost of insurance has risen nearly three times faster for individual plan holders than for group plan holders. The insurance exchange would give states and nonprofit cooperatives increased power to negotiate lower rates by creating larger pools over which insurers could spread risk. As the number of competitors grew, premiums would likely be lower for individuals seeking coverage, including those who previously could not afford insurance at all.

Several factors would limit, but not prevent, an increase in competition and therefore restrict the ability to hold down premiums. First, the reform legislation does not remove states' ability to regulate insurers operating within their borders. This could maintain barriers to entry, at least within states, if not across the whole industry. Though the exchanges could offer national and cross-state plans, prices would be adjusted to reflect local costs.

Second, insurance is not a commodity, and one plan does not fit all. A minimum-coverage plan, no matter how inexpensive, will not compete effectively with more comprehensive, employer-provided coverage. As such, the enlarged market would remain fragmented, and certain segments would be insulated from price changes elsewhere.

Costly subsidies

Third, many exchange customers would still be unable to pay the full cost of insurance. More than half of all uninsured Americans earn less than $50,000 per year, making it difficult for some of them to afford coverage. Tax credits will be available for those whose adjusted gross incomes are less than three times the federal poverty level, with larger credits for those closest to the poverty line. But with the income gap widening and more people falling into poverty every year, these subsidies would grow more expensive over time.

In addition, maximum out-of-pocket expenses would be reduced for those earning up to four times the poverty level income, making this coverage less lucrative for private insurers. To a certain extent, tax credits provided by the government would support prices for minimum coverage, removing some pressure to lower prices. Households not qualifying for tax credits but still able to afford minimum coverage could face higher costs than without government assistance in the equation.

Finally, new regulations that bar insurance companies from imposing annual and lifetime payout limits and denying coverage for pre-existing conditions would carry a price, and would initially boost the cost of coverage.

Nevertheless, the new insurance pool would have the potential to lower prices measurably for those consumers who currently buy insurance directly and have seen the highest premium increases, since they would now be represented as a group through the exchange. In addition, states could merge pooling and rating requirements for the individual and small-group markets, effectively creating a larger combined pool over which risk could be distributed. This method has proved effective in holding premium increases down in Massachusetts, which has had comprehensive healthcare in place for several years.

More in the pool

Of the estimated 46.3 million uninsured Americans, most are of working age and have no access to government health insurance. If they are unemployed or their employers do not offer insurance plans, the current reform proposals would require them to buy coverage through the exchange. This pool of 30 million or more is likely to swell as some small businesses drop coverage and instead opt for assisting employees to lower their insurance costs through the exchange. Similarly, many individuals who now purchase insurance directly because they have no other option will also turn to the exchange in hopes of cutting their cost for coverage.

Regulating prices charged by healthcare providers would help contain the rate of premium inflation. Proposals include linking payments to providers to the adoption of best practices geared to quality outcomes. One method of controlling healthcare and insurance costs actually comes from the stimulus package adopted earlier this year, which included $19 billion to promote the adoption of electronic medical records systems. Such systems are not yet widespread but have increased efficiency and reduced administrative costs where they have been adopted.

The healthcare plans now before Congress may not result in universal health insurance, despite the intentions of reform advocates. Since compliance would be tracked through federal income tax returns, people who do not file tax returns may not be tracked. The poorest citizens most in need of assistance could still fall through the cracks.