Code Red: Two Economists Examine the U.S. Healthcare System

May 20, 2010

We’ve All Got the Blues

Filed under: Competition,Health insurance,Health spending — David Dranove and Craig Garthwaite (from Oct 11, 2013) @ 10:29 am

My late colleague, Walt McNerney, was president of the Blue Cross and Blue Shield Association in the 1970s. I miss him, but I am sort of glad that he doesn’t have to hear all the commotion being made over the profits reaped by today’s Blue plans. I wonder if he would say it was their own damn fault.

Founded during the depression, the Blues represented a win/win for patients who could prepay for their medical care and providers who received a steady source of revenue. The Blues were owned by the providers and Blue coverage was always the most comprehensive (the better to boost demand for medical care.) State laws granted the Blues tax exempt status and in exchange the plans community rated. This allowed for-profit insurers to cherry pick healthy enrollees but the Blues always kept dominant market shares in their territories.

When Walt McNerney took over the leadership of the association, Americans were upset about rising costs. The Blues were still respected insurers and Walt used his position to education Blue plan leaders about managed care. Blue HMOs became some of the most successful in the nation, paving the way for other insurers to offer managed care plans of their own. The Blues also experimented with payment rules and utilization review.

And then the HMO backlash hit. About the only feature of managed care that survived intact is selective contracting. Hospitals and insurers understood the importance of clout and hospitals in many markets merged to suffocate competition. But the largest insurers – the Blues – did not have to merge. Most Blues had market shares in their territories of 40 percent; many had shares above 60 percent. These shares have held steady over the years. With this leverage, the Blues can pay providers among the lowest rates while offering customers the widest networks. That alone guarantees market success, and huge profits.

Blue plan executives see the dollar signs. But nonprofit executives are banned from “inurement” (essentially, compensation based on profitability.) And so Blue executives convinced their boards to convert to for-profit status. They preached the mantra of economies of scale, but the evidence for such economies is minimal. They preached the mantra of capital but they mostly used their capital to enter new markets, and acquire existing plans, and gain even more clout. There was little in it for consumers.

Gone are the days when the Blues did well by doing good. Walt McNerney would hardly recognize many of today’s Blues, with names like Wellpoint, Excellus, and the utterly unimaginative Healthcare Services Corporation. (The latter is a “mutual” –it gets to call itself a nonprofit while paying its CEO about $10 million annually.) These Blues earn returns on assets that dwarf returns in most industries. (In fairness, some Blue plans remain nonprofit, realize minimal returns on assets, and honor the ban on inurement.) And while their total profits are a drop in the ocean of overall healthcare spending, the profit-seeking Blues have settled into a comfortable status quo where market power has become the overarching business strategy. Innovation in healthcare delivery? Forget about it. Payment reform? Forget about it. Let others take the risks. The Blues rake in the profits.

If market clout is their raison d’etre, why tolerate them?


  1. I challenge the assertion that Blues plans did not have to merge. The de-mutualization of non-profit health insurers in the 1990s was a reaction to the roll-up, LBO, merger sprees of the 1970s & 1980s. Everybody is looking for a villain, but none is to be found in the health care industry. To understand the problem, we have to start by looking at Wall Street.

    The popularity of syndicated bank loans created a financing vehicle that wreaked havoc on American industries. The message to Main Street was clear: modernize or risk obsolescence, innovate or be acquired, specialize or die. As expected, a merger spree began that re-shaped the industrial landscape. Weaker firms got acquired by their stronger, more efficient counterparts. Gaps in the strategic composition of industries were filled by financially-driven transactions by respectable private equity firms including KKR, Blackstone and the less respectable Gordon Gekko wannabes.

    As the merger activity occurred, opportunities changed for Blue Cross. From a healthcare perspective, Blues plans were no longer offering coverage to single-entity factories in the heartland of America. When those factories were taken over by major industrial complexes, Blues plans found themselves competing against for-profit insurance giants like Aetna, CIGNA & United Healthcare. The consolidations at Wellpoint, HCSC and Anthem were not offensive moves, they were defensive. Many Blues plans opted to go it alone. In many cases, they operated under the radar, serving the fragmented small business markets. But as small businesses started to join insurance-purchasing cooperatives, they became attractive to the big league insurers.

    We cannot turn back the hands of time. What is done is done. But what we are left with is a broken system and nobody to blame. There are no culprits, only opportunities as to what to do next.

    Comment by Hermann Mazard — May 21, 2010 @ 10:56 am

    • I strongly disagree. The only thing the commercial insurers seemed to have that the Blues lacked was national networks. But the Blues offered these as well through mutual agreement. Besides, none of the Blues are broad enough, even to this day, to offer national networks on their own. That has not prevented them from maintaining or even increasing their market shares.

      You might argue that the commercials had better access to capital markets and so the nonprofit Blues needed to convert to for-profit status in order to raise equity capital. There is no evidence that the Blues were capital constrained. But suppose that they were. They have used their equity capital merely to buy up other plans, not to invest in actual productive assets. There has been essentially no value creation.

      Managers may have an imperative to grow their firms in order to enlarge their empires, and your comment suggests that Wall Street has done much to serve managers’ interests. But this does not equate to value creation. And if the only justification for the metasthesation of for-profit Blues is growth, then what is in it for the rest of us?

      A good colleague of mine was a very senior executive of a Blue plan that merged and gave up its nonprofit status. He has subsequently served as CEO of a couple of health plans. He too remains convinced that the growth of the for-profit Blues had nothing to do with value creation and everything to do with self-aggrandizement.

      Comment by dranove — May 21, 2010 @ 11:08 am

  2. David,

    Is that $10 million salary for the CEO of HCSC accurate? Do you have substantiation?

    Comment by Brian H — May 21, 2010 @ 4:54 pm

    • Read the link in my post. 8.7m last year for the new CEO. 36m over three years for the previous CEO.

      Comment by dranove — May 21, 2010 @ 5:02 pm

  3. Different people have different needs and requirements of relevant health problems.
    Also, people come from different walks of life and financial aid. It is not mandatory that each plan is good for everyone. All these plans have been designed taking into account the needs and budgets of people of diverse origins. Because there are many health insurance plans available on the market in the United Kingdom today. Therefore, it is always useful to know what you expected and your family the best.

    Comment by — June 7, 2010 @ 12:19 am

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