In most of the United States, a few large firms dominate the health insurance marketplace. Moreover, these insurers tend to offer a limited product range to employers and their employees, as well as to individuals and the self-employed. While the products may meet the needs of some customers, they do not meet the needs of many others. In fact, given the size and diversity of the market, it is surprising how little diversity there is among the insurance products offered.

Large employers can negotiate health care plans with insurers on a bilateral basis, where the bargaining strengths of the insurer and the employer are more even. Small firms and individuals are more likely to be "price takers," with little ability to affect the price or composition of a health care plan. Their options are either to accept the package at the offered price or have no package at all (Koehler, 2002; Wilson, 2002). The only way individuals and small firms can increase their bargaining power, and hence their range of choices, is to join with others as members of a group or an association that can bargain with an insurer on the basis of more comparable strength.

The inequality of bargaining positions makes it difficult for individuals and small employers to obtain an attractive health plan at a favorable rate (Milam, 2002). Small employers report that insurers offer plans that have high rates, high deductibles, long waiting periods, and inflexible provisions (Manzullo, 2002). Lacking a range of insurance alternatives, the small employer must choose an unattractive plan, offer employees some other (less desirable) employee benefit, or pay higher (taxable) wages instead.

"It is difficult for individuals and small employers to obtain attractive health plans at favorable rates."

Measuring the Degree of Competition: Herfindahl-Hirshman Index.We introduce the concept of the Herfindahl-Hirshman Index (HHI) with a short anecdote about the Microsoft merger plans with Intuit, given as a student question in Baye's Managerial Economics & Business Strategy (Baye, 2000):

In April 1995 the nightly news and newspapers across the world reported that the U.S. Justice Department filed suit to block software giant Microsoft's planned acquisition of financial software maker Intuit. Estimated reports placed Microsoft's share of the personal finance software market at about 20 percent, compared with Intuit's 70 percent share.

After spending over $4 million on merger plans, Microsoft announced in May 1995 that it had decided to call off the merger. In light of the dynamic nature of the software industry, Microsoft did not want to be tied up in a lengthy legal battle. In addition to the lost $4 million, Microsoft paid Intuit over $40 million for calling off the deal.

...the Justice Department generally challenges mergers when the relevant Herfindahl-Hirshman index is greater than 1,800 and the resulting increase in the index as a result of the merger is more than 100. Based on the reported market shares of Microsoft and Intuit, the Herfindahl-Hirshman index for the personal finance software market was at least 5,300 before the proposed merger, and would have increased to at least 8,100 after the merger. Thus, it seems that Microsoft should have realized that the Justice Department would attempt to block the merger. Spending $4 million attempting to justify the merger on technological or efficiency grounds was a gamble that did not pay off for Microsoft.

"A few large firms dominate the health insurance market-place."

The Herfindahl-Hirshman index is simple to calculate and is often used as a yardstick to indicate the competitiveness of a market (O'Sullivan and Sheffrin, 2001; Boyes and Melvin, 2002; Baye, 2000). For example, it is used as a measure of industry/market concentration before and after a proposed merger (Coate and Langenfield, 1993), as in the Microsoft case above. The contrast of the market positions of the insurers versus individuals and small employers is stark. The insurer market is highly concentrated, with only a few small firms serving niche markets. The U.S. Department of Justice (DOJ) and the Federal Trade Commission (FTC) have jointly issued guidelines for horizontal mergers (Coate and Langenfield, 1993) that are used as regulatory measures of industry concentration. The guidelines state in part:3

… in some circumstances, where only a few firms account for most of the sales of a product, those firms can exercise market power, perhaps even approximating the performance of a monopolist, by either explicitly or implicitly coordinating their actions. Circumstances also may permit a single firm, not a monopolist, to exercise market power through unilateral or non-coordinated conduct - conduct the success of which does not rely on the concurrence of other firms in the market or on coordinated responses by those firms. In any case, the result of the exercise of market power is a transfer of wealth from buyers to sellers or a misallocation of resources.

Note that the existence of only a few firms in a market does not always mean resources are being misallocated, especially if potential entrants into the market stand ready to meet unmet consumer needs. However, such competition for the market is unlikely to produce the desired outcome if there are artificial barriers to entry. Put another way, the most important antidote for monopoly or near monopoly is ease of entry into the market by outside potential competitors.

As a tool for assessing the degree of market concentration, the Herfindahl-Hirshman Index (HHI) is a function of the number of firms in a market and their respective market shares (Gilligan, 2002; Hirschey and Pappas, 2000; Katz and Rosen, 1991). It is calculated by the following formula:

HHI = 10,000 [Σ(S₁)² ] = 10,000 [(S_i)² + (S₂) ² +(S₃)² + … + (S_n)² ],

Where the S_i represent market share of each of the firms. For example, a market consisting of four firms with market shares of 30 percent, 30 percent, 20 percent and 20 percent has an HHI of 10,000 x (.3)² + (.3)² + (.2)² + (.2)² = 2600. In general, the HHI ranges from 10,000 (in the case of pure monopoly) to a number approaching zero (in the case of an atomistic market). Exhibit I shows how the index is used to judge whether the firms are highly concentrated in a given industry. Current market share data for specific insurers is not easily obtainable because it is not in the public domain. However, the formula is a useful measure of market concentration where the data are available.

"The antidote for monopoly is free entry into the market by competitors."

Measuring the Degree of Competition: The Four-Firm Concentration Ratio and Other Ratios. Another measure of market concentration is the Four-Firm Concentration Ratio. It is simply the sum of the respective market shares of the top four firms in a given industry for the area of interest. The formula is:

CR₄ = S (S_i) = S₁ + S₂ + S₃ + S₄,
where S_i is the market share of the i^th firm. Thus, in the example given above, the Four-Firm Concentration Ratio would be 100 percent.

Table II presents similar measures for four firms, eight firms, 20 firms and 50 firms. The four-firm ratio is most widely used, since it indicates a greater degree of clustering of firms. As an aid to interpreting the results, Exhibit II presents concentration ratios and their relationship to market structure.

Concentration in the Health Insurance Marketplace. A number of reliable sources of market share data are available from governmental agencies and research institutes.4 Table II shows the Census Bureau calculation of the share of the largest firms in the market for small group insurance. As the table shows, the largest four firms account for 65 percent of HMO business or a 65 percent market share that, according to most analysts, would be a strong oligopoly market structure. The table also shows that the eight largest firms account for almost all of the remaining market share.

Table III and Table IIIa shows a state-by-state assessment of the small group market as of December 2002, by the General Accounting Office (GAO), based on reports from state insurance regulators. The GAO provided the following summary:

• The median number of insurers in the small group market per state was 28, with a range from 4 in Hawaii to 77 in Indiana.

• The median market share of the largest insurer was about 33 percent, with a range from about 14 percent in Texas to about 89 percent in North Dakota.

• The five largest insurers, when combined, represented three-quarters or more of the market in 19 of 34 states supplying information, and they represented more than 90 percent in 7 of these states.

• Twenty-five of 37 states supplying information identified a Blue Cross Blue Shield (BCBS) insurer as the largest organization offering health insurance in the small group market, and in all but one of the remaining 12 states a BCBS insurer was among the five largest.

• The median market share of all the BCBS insurers in the 34 states supplying information was about 34 percent, with a range from about 3 percent in Vermont to about 89 percent in North Dakota; in 9 of these states BCBS carriers combined for half or more of the market.

Table III and Table IIIa is instructive in many ways. Simply put, there is a very high degree of market concentration in most states. In Oklahoma, Connecticut, Idaho, Maine, Maryland, North Dakota and Vermont, the largest five carriers have more than 90 percent of the total market share. The numbers also imply that the markets are concentrated, no matter how concentration is measured.5

"The largest insurer is often the only insurer, and its products are often offered on a 'take it or leave it' basis."

What the numbers do not show is perhaps the most important feature of health insurance markets: the impact of the largest carriers in geographic regions within states. Indeed, in many cities and towns the largest insurer is the only insurer (De Posada, 2002; Turner, 2002; Dressler, 1999). In these markets products are often offered on a "take it or leave it" basis. They may be overpriced, with benefits that do not fit the needs of many firms and many employees. With few or no alternatives, buyers must purchase an imperfect substitute for the type of insurance they prefer or forgo insurance altogether. For individuals and very small firms, the latter alternative is increasingly the alternative of choice (Tucker, 2003).

Barriers to Entry. The small group market, like the individual market, is highly concentrated on the insurer side and atomistic on the purchaser side. The result is that many needs go unmet. So why don't other insurers enter the market to meet these needs? The reason is the existence of many barriers to entry. Gerard Conway, of the Medical Society of the State of New York (Conway, 2001), gives some concrete examples:

For example, in order to be financially viable, health insurers need to develop sufficient business to permit the spreading of risk. In its challenge to the Aetna/Prudential merger, the Department of Justice noted that 'effective new entry for an HMO or HMO/POS plan in Houston or Dallas typically takes two to three years and costs approximately $50,000,000.'

Many insurance companies spend millions of dollars a year in local television and print ads, typically during employer 'open enrollment' seasons. In markets where a limited number of insurers already cover a large percentage of a market's population, it could take several years for a new health insurer to develop name and product recognition with purchasers and convince them to disrupt their current relationships with existing health insurers.

Health insurers also depend on a network of physicians, hospitals and health care providers. As the Department of Justice noted in the Aetna/Prudential merger, building a network can take years. In addition, exclusive contracts between existing insurers and providers can thwart or deter efforts by a new entrant to build a network.

All of these factors can operate as formidable barriers to entry for a new health insurance company trying to establish a foothold in a concentrated market, and even more so in the highly concentrated markets identified in this study.

The insurance company and its product are only one part of the competitive picture. Multiple tie-ins are both formal and informal. The tie-in between the health care provider network and the insurer, for example, is a significant barrier to entry.

"Large insurers use market power to negotiate lower rates with doctors and hospitals."

Every large managed care organization (MCO) has a development staff that negotiates with medical providers. Those that are included in the managed care network are listed in a directory as providers of choice for the MCO, and patients are referred to those providers. In a preferred provider organization (PPO), patients must pay more out of pocket for the service if their doctor is not listed as a recommended provider. In an exclusive provider organization (EPO), they must pay the entire amount out of pocket. The very existence of such networks of approved providers is a barrier to a new entrant, who has no established network.

Large insurers also use their market power to negotiate lower rates with doctors and hospitals than a smaller insurer or a new entrant can negotiate. The extent of this power was revealed in an eye-opening study by the Division of Governmental Affairs of the Medical Society of the State of New York (Conway, 2001). The Executive Summary of that study concludes:

With only one or a few HMOs in a region controlling all of the patient lives compared against thousands of individual health care providers who are legally prohibited from coming together to negotiate contracts with these dominant regional entities, the tremendous imbalance in market power becomes obvious.

This imbalance of power relegates the contracts that physicians and other providers must sign with the HMOs to those of contracts of adhesion: "take-it-or-leave-it" contracts that do not afford physicians and others any realistic opportunity to negotiate the terms therein.

"Large insurers with networks have information that small insurers and small AHPs do not."

Another powerful (maybe the most powerful) barrier to entry concerns the role of information about claims loss events and histories. In the property and casualty market it is a common practice to have up-to-date information that is well documented and is freely dispersed throughout the industry (Shaker and Gembicki, 1999). By contrast, health insurers hold loss experience as proprietary data and generally refuse to share it with any entity except their large corporate clients. Small insurers must purchase the information a few fragments at a time.

In every business, information is power. In health insurance, large insurers with networks have information that small insurers and small AHPs do not (Shaker and Gembicki, 1999; Fialka, 1997). This constitutes an enormous barrier to entry. [See the Case Study sidebar.]