Health Care Consolidation: Efficiency or Monopoly?

Who (or what) should be blamed for the dramatic increase in the cost of private health insurance in the United States?

To a certain extent, of course, the aging of the population and the development of technologically complex treatment options have contributed to the burgeoning costs of insurance. Consolidation activities within certain sectors of the health care industry have impacted costs as well, with hospital mergers eliminating competition among providers and insurer mergers doing likewise among payers.

Last week, however, the city of Pittsburgh, Pennysylvania witnessed a health care consolidation transaction of a different kind. Instead of a large hospital or insurer swallowing up a rival, the insurance company Highmark decided to cross industry sectors and directly acquire West Penn Allegheny Health System and its Allegheny General Hospital subsidiary.

Why would Highmark want to do such a thing? And is the emergence of insurer / provider conglomerates a beneficial public policy development … or yet another nail in the coffin of a competitive health care system?

A Case of Vertical Integration

A producer purchase of a provider system isn’t a terribly unusual event from a macro-economic perspective. Energy production companies have owned or franchised retail consumer outlets for decades; Exxon Mobil and Chevron, for instance, simultaneously drill for oil, refine it into gasoline, and then develop franchise contracts with gasoline stations to provide it to consumers. Energy firms have even coined specialized terms to describe the dual sides of their business operations: the phrase upstream activities refers to the production process, whereas downstream activities refers to the refining, sales, and marketing processes.

Economists refer to this type of merger as vertical integration, a process by which a single firm acquires (or otherwise controls) an entire value chain of the production, sales, and distribution of a category of products or services. It is distinctly different than horizontal integration, a process by which firms merge with their competitors (or potential competitors) in order to develop larger market shares in their narrowly defined segments of their value chains.

In the private sector health insurance industry, employers generally purchase access to health care from insurance companies, which then contract with hospitals and other providers to deliver services to employees. Although patient advocates and provider lobbyists may argue that hospitals and patients occupy the very center of the health care system, from a value chain perspective, insurers can be characterized as upstream organizations and hospital networks as downstream organizations.

A Mixed Record

Clearly, vertical integration strategies have succeeded in the energy industry. But can they do so in the health care industry?

Based on recent history, the track record for such business strategies among insurers and providers is most decidedly mixed. On the one hand, Kaiser Permanente of California has remained one of the most highly respected and successful health care conglomerates in the nation by managing provider and insurer functions simultaneously. On the other hand, though, Humana — one of the largest health insurers in the United States — pulled out of the provider market in 1993 after concluding that there are too many natural conflicts of interest between the two industry segments to justify a conglomerate approach.

New York State, a geographic pillar of the national health care industry, has also experienced mixed results. On the one hand, the rise of the Catholic Church’s statewide health plan Fidelis Care did nothing to save St. Vincent’s Hospital of Manhattan, or its seven fellow Catholic hospitals in New York City, from closure. On the other hand, the New York City Health and Hospitals Corporation continues to find success with its wholly owned MetroPlus health plan subsidiary.

Efficiency vs. Competition

Interestingly, California and New York represent relatively competitive health care markets, with several hospital networks and insurance companies competing for business in each state’s major population centers. It is possible that the natural forces of free market capitalism have helped blunt the deadening anti-competitive effects of vertical integration in these regions, thereby preventing conglomerates from evolving into monopolies.

Pittsburgh, though, represents a very different type of health care market. Its hospital sector is currently dominated by the University of Pittsburgh Medical Center; thus, Highmark’s acquisition of the badly trailing second tier hospital may actually result in an increase of provider competition. Usually, merger partners argue that the beneficial cost efficiencies to be derived through consolidation justify the possible harmful effects of a loss of competitive players; in Highmark’s case, though, public policy advocates in the Steel City may enjoy the twin benefits of cost efficiencies and greater (as opposed to lesser) competition.

It is understandable why Highmark was attracted to the acquisition opportunity; after all, by strengthening the closest rival to a dominant hospital system, it may be able to improve its own contracting position with both medical providers. Although conventional wisdom stipulates that competitive markets often suffer whenever major organizations merge or acquire each other, from a public policy perspective, this particular merger might well produce a different outcome.