The pecuniary distortion of limited networks

NBER Working Paper 23742: Equilibrium Provider Networks: Bargaining and Exclusion in Health Care Markets

By Kate Ho and Robin S. Lee
National Bureau of Economic Research, August 2017


Why do insurers choose to exclude medical providers, and when would this be socially desirable? We examine network design from the perspective of a profit-maximizing insurer and a social planner to evaluate the welfare effects of narrow networks and restrictions on their use. An insurer may engage in exclusion to steer patients to less expensive providers, cream-skim enrollees, and negotiate lower reimbursement rates. Private incentives for exclusion may diverge from social incentives: in addition to the standard quality distortion arising from market power, there is a "pecuniary" distortion introduced when insurers commit to restricted networks in order to negotiate lower rates. We introduce a new bargaining solution concept for bilateral oligopoly, Nash-in-Nash with Threat of Replacement, that captures such bargaining incentives and rationalizes observed levels of exclusion. Pairing our framework with hospital and insurance demand estimates from Ho and Lee (2017), we compare social, consumer, and insurer-optimal hospital networks for the largest non-integrated HMO carrier in California across several geographic markets. We find that both an insurer and consumers prefer narrower networks than the social planner in most markets. The insurer benefits from lower negotiated reimbursement rates (up to 30% in some markets), and consumers benefit when savings are passed along in the form of lower premiums. A social planner may prefer a broader network if it encourages the utilization of more efficient insurers or providers. We predict that, on average, network regulation prohibiting exclusion has no significant effect on social surplus but increases hospital prices and premiums and lowers consumer surplus. However, there are distributional effects, and regulation may prevent harm to consumers living close to excluded hospitals.

From the Introduction

Since the passage of the Affordable Care Act (2010) there has been growing concern among policymakers about “narrow network” health insurance plans that exclude particular medical providers. Selective contracting by insurers — in which only particular providers are accessible — is not a new phenomenon. Dating back to the 1980s, managed care insurers have used exclusion to steer patients towards more cost effective or higher quality hospitals and physicians, and to negotiate lower reimbursement rates. While networks broadened somewhat with the “managed care backlash” of the 1990s (Glied, 2000), recent high profile exclusions from state exchange plans have reinvigorated the debate over the desirability of such practices. Amid concerns that restrictive insurer networks may adversely affect consumers by preventing access to high-quality hospitals (Ho, 2006), or may be used to “cream skim” healthier patients, regulators at the state and federal levels are considering formal network adequacy standards for both commercial plans and plans offered on state insurance exchanges.

In this paper, we examine the private and social incentives for exclusion of hospitals from insurer networks, and consider the potential effects of network adequacy regulations in the U.S. commercial (employer-sponsored) health insurance market. We begin with a simple framework that isolates the fundamental economic trade-offs when deciding whether or not to exclude a hospital, and identifies the empirical objects required to measure the costs and benefits from exclusion. We then extend the model of the U.S. commercial health care market developed and estimated in Ho and Lee (2017) — which incorporates insurer-employer bargaining over premiums and consumer demand for hospitals and health insurers — to capture exclusionary incentives on the part of insurers. Extensions include incorporating a stage of strategic network formation by an insurer and allowing for endogenous outside options in bargaining. Finally, we use our model to predict equilibrium market outcomes under hospital networks that would be chosen by an agent maximizing social or consumer welfare, or by a profit-maximizing insurer. By comparing outcomes across networks either maximizing different objectives or required to cover all hospitals in a market, we uncover circumstances when private incentives diverge from social or consumer preferences, and evaluate the effects of certain forms of network regulation.


Narrow provider networks have grown more prevalent in both exchange and employer-sponsored health care markets in recent years. Their presence raises important questions. Are these plans effective at reducing spending, and if so, through what means? And is regulation warranted — are the networks that are introduced too narrow from either a social or consumer welfare perspective?

Our paper addresses these and related questions. We extend the model of the commercial U.S. health care market developed in Ho and Lee (2017) by endogenizing an insurer’s hospital network and incorporating a new bargaining concept that explicitly captures an insurer’s incentives to exclude. In the employer-sponsored setting that we examine, we find that selective contracting and informed network design can have substantial effects on overall health care spending. Narrow hospital networks are preferred by a profit-maximizing insurer primarily due to their ability to substantially reduce negotiated rates — and not necessarily due to cream-skimming healthier enrollees or steering patients towards lower-cost hospitals. A private insurer tends to engage in exclusion more than is socially optimal, but typically does so to a lesser extent than the average consumer would prefer because consumers often benefit from substantial premium reductions.

These results support the argument that allowing insurers to exclude providers can substantially reduce hospital payments and premiums without significantly affecting social surplus. This tends to benefit consumers (and hence employers) on average, implying that employers and insurers may wish to work together to control spending through exclusion. Our framework may be useful for these and other interested parties to inform network design. It also can be used to address potential distributional consequences of exclusion by identifying affected populations and quantifying the transfers needed to offset harm from reduced access.



By Don McCanne, M.D.

This paper looks at the motivation of insurers in establishing narrower hospital networks (profit-maximization, of course) and the perspective of the consumer (i.e., patient) and the social planner.

For the insurer, it’s simple. Contract with the hospital(s) that will agree to the lowest negotiated rates. Quality, cream-skimming or steering patients to lower-cost hospitals has little to do with it as long as the insurers save on negotiated rates.

These economists join others in concluding that consumers prefer narrower-network insurance plans. But it needs to be emphasized, once again, that patients are not choosing narrower-network plans simply because they prefer not to be burdened by having to make decisions regarding having a broader choice in their health care options. They choose narrower-network plans solely for one reason - lower insurance premiums. It would be incorrect to conclude that patients do not mind giving up provider choice as long as they can save some money. Rather it is that insurance premiums have become so expensive that they find paying them often creates a financial hardship. They do not want to give up their choice of health care providers, but many often feel that they have no other option since they have little or no disposable income.

From the standpoint of the social planner, health care resources should be made available based on need. Arbitrarily removing options for care based on pecuniary benefit to the insurer conflicts with optimal social planning. These and other economists tend to be somewhat, but not completely, dismissive of the social planner. They do concede that it could be beneficial to address “potential distributional consequences of exclusion by identifying affected populations and quantifying the transfers needed to offset harm from reduced access.” Or, “there are distributional effects, and regulation may prevent harm to consumers living close to excluded hospitals.”

It shouldn’t be just about money - about insurers’ profits and about patients’ spending as consumers. Social planning is crucial in providing optimal access to health care services. It doesn’t take much thought to conclude which model emphasizes social planning - the for-profit, private insurance model, or the patient service model of a well designed, single payer national health program - an improved Medicare for all. If you need a reminder, the traditional Medicare program does not use provider networks. Costs are contained in much more patient-friendly ways.

Stay informed! Visit to sign up for daily email updates.