6 Health Insurance Competition
Competition in health insurance is not straightforward. Unlike most markets, the product is complex, consumer choice is intermediated, and risk selection looms large. Evaluating whether competition is desirable means comparing it not only to imperfect competition in private markets but also to the strengths and weaknesses of public provision. Much of this discussion follows Einav and Levin (2015).
A natural starting question is whether we want to rely on competition at all, or whether a more public system is preferable. Public programs such as Medicare and Medicaid are relatively simple, with lower administrative costs and insulation from selection problems. Yet they are also vulnerable to waste, political influence, and bureaucratic inertia.
Private insurance, in contrast, promises efficiency gains from rivalry—better prices, innovation, and customer service. But these gains depend critically on whether market design and regulation can mitigate adverse selection and concentration. In what follows, we examine how competition is structured in practice, the role of risk adjustment in sustaining it, and the performance of “managed competition” models like Medicare Advantage.
6.1 What is competition in health insurance?
Health insurance is purchased and priced very differently than most products, which makes competition harder to evaluate. In many settings, the “buyer” is not the individual enrollee but an employer or government agency, and the product itself bundles together risk pooling, networks, and administrative services.
In employer-sponsored insurance, the structure differs by firm size. Small employers typically choose among insurers and then offer their workers a limited menu of plans. Here the employer acts as the effective purchaser, and insurers set terms based on the expected risk profile of the workforce. Large employers, by contrast, often self-insure: they bear the financial risk themselves and contract with insurers mainly for claims processing and network management. In this case, the insurer is less exposed to selection risk, and competition plays out more in the quality and cost of administrative services.
Other settings—such as the ACA exchanges, Medicaid managed care, or Medicare Advantage—rely on managed competition. Private insurers operate within a regulated framework, sometimes alongside public plans. Regulators define standardized products, enforce consumer protections, and structure payments to limit adverse selection. These markets illustrate how competition in health insurance almost always requires a significant role for public rules to shape the terms of rivalry.
6.2 Risk adjustment
As we saw in the last Chapter, adverse selection plays a central role in private health insurance markets. Left unchecked, insurers would have strong incentives to design benefits and pricing to attract healthier individuals, leaving those with higher needs underinsured or facing higher costs.
If we want to rely on a market-based system, we need tools to blunt these incentives. The most important is risk adjustment, which drives a wedge between what enrollees pay and what insurers receive. For example, in Medicare Advantage (MA), enrollees face uniform premiums, while CMS pays insurers risk-adjusted amounts based on enrollee characteristics. Other mechanisms—such as plan lock-in and open enrollment periods—also help limit selection.
The introduction of a new risk adjustment system in MA between 2003 and 2006 had a dramatic effect. Before, MA enrollees used only about 60% as much care as fee-for-service (FFS) beneficiaries, and those switching back to FFS used 160% more than average. After implementation, health differences between MA and FFS enrollees shrank to less than 5%.
Despite these gains, risk adjustment has limits. In MA, risk scores explain less than 15% of individual variation in utilization, even if mean predictions are close. More importantly, risk adjustment is subject to manipulation: insurers have strong incentives to code diagnoses more aggressively (“upcoding”) to raise payments. Policymakers thus face a tradeoff: making formulas rich enough to reduce selection without creating loopholes that plans can exploit. The goal is to reduce incentives to cherry-pick healthy patients without rewarding coding intensity rather than genuine health risk.
6.3 Managed competition
Even with risk adjustment, health insurance markets rarely approach what we would call a clearly competitive market? Demand for coverage is relatively price-inelastic, entry costs are high, and most local markets are dominated by just a few insurers. For example, in Medicare Advantage (MA), three insurers often account for more than 95% of enrollment in a given county. This concentration reflects fixed costs of entry, CMS network requirements, and the need to build provider networks.
Because competition is limited, policymakers often rely on managed competition: markets are opened to private plans, but rules and payment formulas are designed to mimic the discipline of competition. The MA payment system is a good illustration. Plans submit bids relative to a benchmark \(B\) based on FFS costs. If a plan’s bid \(b\) falls below the benchmark, the plan receives \(b\) plus part of the gap between \(B\) and \(b\) as a rebate; if \(b\) exceeds \(B\), the difference is passed on as a higher premium to the enrollee.
To see how plans set prices, consider their problem in risk-adjusted units: \[\max_{p_{j}} \left(p_{j} + B - c_{j} \right) Q_{j}(p_{j}, p_{-j}),\]
where \(p_{j}\) is the plan’s price, \(c_{j}\) is their cost per enrollee, and \(Q_{j}\) is plan j’s quantity (in risk units). This yields an optimal pricing condition of:
\[\begin{align} \frac{d \pi}{d p_{j}} = Q_{j}(p_{j}, p_{-j}) + \frac{d Q_{j}}{d p_{j}} ( p_{j} + B - c_{j}) &= 0 \\ p_{j} + B - c_{j} = \frac{ - Q_{j} }{ \frac{d Q_{j}}{d p_{j}}} &= \left(\frac{d \ln Q_{j}}{d p_{j}}\right)^{-1} \\ p_{j} &= c_{j} - B + \left(\frac{d \ln Q_{j}}{d p_{j}}\right)^{-1} \\ b_{j} &= c_{j} + \left(\frac{d \ln Q_{j}}{d p_{j}}\right)^{-1} \\ \end{align}\]
Thus, the bid equals marginal cost plus a markup inversely related to demand elasticity. When enrollment is sensitive to benefits, markups shrink; when demand is inelastic, markups grow. Empirical evidence suggests markups of 10–25%.
What does this mean for policy? Studies such as Curto et al. (2021) show that MA plans deliver care at lower resource cost than FFS Medicare, but bids are higher than FFS spending would have been. On net, taxpayers spend roughly 15% more, with about 40% of those excess payments returned to enrollees as extra benefits and the rest retained by insurers. The central lesson is that market design matters: small changes in benchmarks and rebate rules can shift billions of dollars between taxpayers, insurers, and beneficiaries.
6.4 Takeaways
In sum, competition in health insurance typically does not emerge naturally. Instead, it is often encouraged and sustained through careful regulation. Risk adjustment and managed competition illustrate how carefully designed rules can make private markets viable, but also how fragile the balance is between efficiency, equity, and fiscal cost. Whether we want to rely on competition therefore depends less on an abstract comparison with public provision and more on how well policy can channel insurer incentives toward outcomes that serve beneficiaries and taxpayers alike.