The Effects of Market Structure and Payment Rate on the Entry of Private Health Plans into the Medicare Market

Frakt, Austin B., Pizer, Steven D., Feldman, Roger, Inquiry

Private insurance firms participating in Medicare can offer up to three principal plan types." coordinated care plans (CCPs), prescription drug plans (PDPs), and private fee-for-service (PFFS) plans. Firms can make entry and marketing decisions separately across plan types and geographic regions. In this study, we estimate firm-level models of Medicare private plan entry using data from the years 2007 to 2009. Our models" include a measure of market structure and separately identify CCP, PDP, and PFFS entry. We find evidence that entry barriers associated with CCP market concentration affect all three product types. We also find evidence of cross-product competition and common cost or demand factors that make entry with certain product combinations more likely. We predict that the market presence of CCPs and PFFS plans will decrease and that of PDPs will increase in response to payment reductions included in the new health reform law.

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Key questions in applied industrial organization pertain to the role of market structure in firms' entry decisions. A different set of inferences may be drawn about a market if concentration encourages entry rather than hinders it. On one hand, high market concentration suggests the existence of markups and a profit opportunity for potential entrants. On the other hand, incumbent firms may possess high market concentration due to barriers that preclude profitable entry of additional firms CAmel and Liang 1997). Thus, estimating the effect of market structure on entry provides a useful test of the presence of entry barriers. To our knowledge, no empirical analysis has been conducted that relates market structure to entry into the current, multiproduct Medicare private plan market.

In this study, we estimate reduced-form, firm-level entry models for the three main Medicare private plan types: coordinated care plans (CCPs) (largely health maintenance organizations [HMOs] and preferred provider organizations [PPOs]), private fee-for-service (PFFS) plans, and stand-alone prescription drug plans (PDPs). In doing so, we investigate the relation between market structure and entry for the multiproduct Medicare private plan market, controlling for the endogeneity of market structure with an instrumental variables (IV) approach. We focus on a select subset of plans that have exhibited the interest and ability to offer all three plan types. We find that higher CCP market concentration decreases the entry probability of that plan type, consistent with the presence of barriers to entry for the CCP submarket. We also find that CCP market concentration decreases the entry probability of the other two plan types, PFFS plans and PDPs, which is consistent with joint decision making across products within firms, possibly due to economies of scope.

We use our models to simulate changes in entry that would be induced by Medicare Advantage plan payment provisions in the new health reform law--the Patient Protection and Affordable Care Act (Pub. Law 111-148), as modified by the Health Care and Education Reconciliation Act of 2010 (Pub. Law 111-152) (hereafter jointly referred to as the ACA). Our simulations predict substantial market exit for the two main Medicare Advantage plan types that offer comprehensive benefits--CCPs and PFFS plans--and modest plan entry for PDPs.

These conclusions cannot be drawn from other Medicare plan entry models in the literature. To our knowledge, no recent paper has studied Medicare plan entry from the firm's perspective and none has estimated entry models across multiple product types. Our approach addresses these shortcomings. Because PDP entry decisions involve a different response to market characteristics in general and Medicare Advantage payment rates in particular, distinguishing PDPs from other plan types is a significant innovation in modeling entry of private plans into Medicare. (1) The same can be said for distinguishing PFFS plans and CCPs, although these plan types have more in common. Our models capture the differential effects of market characteristics on firms' entry decisions for these products by modeling them as distinct.

PDPs are a relatively new Medicare plan type, created within Medicare Part D (2) by the passage of the Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (MMA; Pub. Law 108-173). In 2006, PDPs joined CCPs and PFFS plans, which had been available under Medicare Part C. (3) These older Medicare Advantage plan types offer comprehensive coverage of all Medicare services for a predetermined monthly payment from Medicare that is adjusted for the enrollee's expected spending. The main difference is that CCPs use a network of contracted providers whereas PFFS plans do not. (4)

The MMA also increased payments to Medicare Advantage plans, contributing to an increase in the number of plans offered and the number of beneficiaries covered (Pizer, Frakt, and Feldman 2009). PFFS plans experienced the most rapid increase in popularity following passage of the MMA (Frakt, Pizer, and Feldman 2009). Commensurate increases in the Medicare budget have not gone unnoticed by policymakers, and the ACA will dramatically reduce government payments to plans. These reductions in plan payments might be expected to lead some firms to withdraw from Medicare, and possibly affect firms' decisions to offer PDP plans. Unlike Medicare Advantage plans, PDPs operate under a payment system with a national payment rate determined by the average of PDP plans' bids. However, if Medicare Advantage and PDP plans are demand substitutes, withdrawal of Medicare Advantage plans could induce an increase in the number of PDP plans offered.

After reviewing the relevant literature, covering the necessary background, and providing a conceptual orientation in the next section, we describe our methods, data, and results. The conclusion discusses the implications for market strategy and Medicare payment policy, as well as limitations and extensions of our work.

Background and Conceptual Approach

Entry and Market Structure

The industrial organization (IO) literature characterizes the various roles that market structure plays in market entry decisions. High market concentration is consistent with entry barriers, which can take many forms and arise in multiple ways. In health insurance markets, foreclosure--the reduction in competition due to vertical behavior--can arise from vertical integration (e.g., a hospital-insurer merger), exclusive contracting (e.g., contracts between insurers and providers or advertisers), or most-favored nation requirements (e.g., where an insurer pays unit prices that are no higher than those paid by any other insurer doing business with a hospital) (Gaynor and Vogt 2000).

Vertical behavior has been found to reduce the foreclosing firm's costs and raise those of rivals (Krattenmaker and Salop 1986). Raising rivals' costs has advantages over predatory price reductions, since it does not require "deep pockets" or entail lower (or negative) short-term profits (Salop and Scheffman 1983). Hence, one might expect insurers to enter into exclusive or long-term contracts with lower-cost providers, preventing existing market participants and potential market entrants from doing so. Gal-Or (1996) showed that a provider will accept an exclusive deal with an insurer, even at a lower rate of payment, in return for a larger volume of patients. Encinosa (1996) considered exclusive contracts between physician practices and HMOs. A risk-averse, incumbent HMO may foreclose rivals by entering into an exclusive deal with the only available provider. Gaynor and Vogt (2000) noted, however, that exclusive contracts "appear to be relatively rare between insurers and health care providers [though] long term services contracts are common, and may confer a degree of exclusivity on an insurer who is a large buyer" due to capacity constraints. For years, the American Medical Association has suggested in its annual report on competition in health insurance markets that incumbent insurers' exclusive provider networks reduce competition by making it more costly for potential rivals to enter (AMA 2010). Of the three plan types we consider, only CCPs establish provider networks. Thus, network-based entry barriers are directly possible only for that product type. However, as we will show, there may be spillovers to the PFFS and PDP markets.

Contestability theory suggests that high sunk costs--roosts that already have been incurred and cannot be recovered--can also deter market entry if firms anticipate they will serve as an exit barrier (Baumol, Panzer, and Willig 1982). Hilliard, Ghosh, and Santerre (2010) included the costs of marketing and establishing provider networks among insurers' sunk costs. Another barrier to entry is the high switching costs of consumers (Samuelson and Zeckhauser 1988). Age is negatively correlated with health plan switching (Atherly, Florence, and Thorpe 2005), so Medicare beneficiaries are likely "sticky," reluctant to change health insurance plans even if better options exist (Abaluck and Gruber 2009).

Approaches to Modeling Market Structure

The economics literature includes two fundamental approaches to capture effects of competition in models of entry and other market outcomes. Recent work on health care and insurance markets have included both structural (Maruyama 2011; Starc 2010; Lustig 2010) and reduced-form (Dafny and Duggan 2009; Dafny 2010; Bates and Santerre 2008; Schneider et al. 2008; Shen, Wu, and Melnick 2010; Moriya, Vogt, and Gaynor 2010) models. Structural models of entry have been applied in health care (most recently by Maruyama 2011) and, for decades, to problems in nonhealth industries as well (e.g., Berry 1992; Seim 2006). Many of the reduced-form models employ the Herfindahl-Hirschman index (HHI) as an independent variable (Dafny and Duggan 2009; Bates and Santerre 2008; Schneider et al. 2008; Shen, Wu, and Melnick 2010; Moriya, Vogt, and Gaynor 2010), as we do in our application. Though admittedly ad hoc, Gaynor and Town (2011) wrote that "one can think of [such models] as attempting to capture the impacts of relative bargaining power on price, using buyer and seller HHIs as proxies for bargaining power."

Reduced-form models that include HHIs distinguish themselves from structural models in other ways. A reduced-form approach permits the researcher to be agnostic about the underlying competitive game and, thereby, to avoid any game-theoretic assumptions (Gaynor and Town 2011). The trade-off is that reduced-form models do not estimate fundamental parameters associated with a game, as structural models do. A consequence of this distinction is that less precise insight might be gained from a reduced-form model than from a more detailed structural one, but with the advantages of requiring weaker assumptions and leading to easier interpretability and relying on simpler econometric methodology. In addition, despite its shortcomings, the HHI remains an important market measure for policy. The antitrust agencies still use it to inform their analysis of markets for anticompetitive mergers (U.S. DoJ and FTC 2010).

Though we acknowledge that there is an ongoing debate within IO and across empirical economics about the strengths and limitations of structural and reduced-form models (Angrist and Pischke 2010; Nevo and Whinston 2010), we argue that a reduced-form approach is suitable for our application. Outside of health care, structural models have been used to examine a problem similar to one we address: entry decisions by firms that can offer more than one product type. In a modification of the work of Bresnahan and Reiss (1991), Mazzeo (2002) did the path-breaking work, examining entry into motel markets by firms endogenously choosing high, medium, or low quality. Dranove, Gron, and Mazzeo (2003) applied the framework to commercial HMO entry, distinguishing between local and national products. Unfortunately, this approach requires firms to choose only one product type in each market and the approach becomes intractable with more than three types. Although we have only three types (CCP, PDP, and PFFS), firms may enter with one of seven configurations (CCP only, PDP only, PFFS only, CCP-PDP, CCP-PFFS, PFFS-PDP, or CCP-PDP-PFFS). Furthermore, one of our central research interests is to investigate how entry with one product type affects a firm's decision to enter with another product type, and the structural approach studies only the number of entrants of each type. Firm effects within markets cannot be measured.

The Medicare Private Plan Market

Since the emergence of PFFS plans in 2001 and PDPs in 2006, entry and marketing decisions related to those products, as well as enrollment options for beneficiaries, have become more complex. With this additional complexity comes opportunity. Firms may target their entry and marketing efforts geographically, as they did with provider network-based products under Medicare Advantage and its predecessor programs. In addition, they now may differentially allocate their marketing and advertising resources across product types and geography, emphasizing particular plan types where it is more profitable to do so. Moreover, firms are permitted to enroll beneficiaries simultaneously in a PDP and a PFFS product (but in no other combination of products), which motivates the joint marketing of at least those two types of plans.

In one of the few papers that qualitatively describes firm decision making in post-MMA Medicare, Gold (2007) reports on interviews conducted in spring 2006 with representatives of firms offering Medicare products. Firm representatives acknowledged several elements of strategy relevant to our work: 1) firms entered and marketed PFFS plans …

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Publication information: Article title: The Effects of Market Structure and Payment Rate on the Entry of Private Health Plans into the Medicare Market. Contributors: Frakt, Austin B. - Author, Pizer, Steven D. - Author, Feldman, Roger - Author. Journal title: Inquiry. Volume: 49. Issue: 1 Publication date: Spring 2012. Page number: 15+. © Not available. COPYRIGHT 2012 Gale Group.

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