W(h)ither health insurers?

The talk around the country among health insurance companies is that their insurance business is dying.

What is happening? First, the consolidations in other industries, resulting in large, multistate corporations, already mean that many companies self insure their employees. Even many local firms have large enough work forces that they can be self-contained risk pools. (One source I found says that in 2008, 89 percent of workers employed in firms with 5000 or more employees were in self-insured plans.) There is no sense compensating insurance companies for actuarial risk when your employee base is that large. Instead, the insurance companies or other firms are hired solely to administer the benefit plans.

For those insurance markets that still exist, the provisions for transparency under the national health care reform law, and the insurance exchanges that will be set up, will result in the commoditization of insurance products. That commoditization will drive down the profit margins that would otherwise exist in this market segment.

The result is that health insurance companies will become financial services organizations more than insurance entities. Think of them as another form of banking, where minimizing transaction costs becomes imperative, and where the use of derivatives and other hedges makes the difference in who makes money and who doesn't.

This, in turn, also implies that scale matters. Like banks and credit card companies, the larger ones incur a lower cost for each transaction. Several years ago, I was told that the minimum size needed to be a successful insurance company was two million subscribers. That was before the national health reform bill passed.

What does all of this mean for the relatively small insurance companies that serve Massachusetts? The same trends apply, but they have been aggravated by recent state action that limits premium increases for small business and individual policies. That action has explicitly made that business line unprofitable.

What can Massachusetts firms do to maintain their profit margins? (Yes, I know they are non-profits, but even non-profits need a positive bottom line.) There are two basic approaches: One is to grow in size to reduce transaction costs. On that front, is it reasonable to expect some consolidation of companies in this state? (See chart with membership, courtesy of figures reported by Rob Weisman at the Boston Globe.)

The other approach is to find new lines of business. The large national companies are already exploring that. What valued-added services could Massachusetts insurers bring to the marketplace?