A Report on the Actuarial, Marketing, and Legal Analyses of the CLASS Program. III. Industry Analysis

10/14/2011

Industry analysis proceeds by considering a series of economic factors that may affect the intensity of competition and thereby affect profitability. When assessing profitability, no single factor is definitive. Nor is there a formula that translates the totality of the analysis into a particular level of profits. The analysis instead provides a qualitative assessment of profitability. Industry analysis also examines trends in these factors, to facilitate a forecast of future profit trends. If several key factors trend in the same direction, then forecasts about trends in profitability are more reliable.

Industry analysis is often associated with the work of Harvard economist Michael Porter, who identified five major forces that affect profitability--Internal Rivalry, Entry, Substitutes, Buyer Power and Supplier Power. In order to organize our analysis, we follow the Template for Doing a Five Forces Analysis that appears in Besanko, Dranove, et al., Economics of Strategy, which slightly modifies and updates the Porter framework. This template consists of a series of factors to be considered in conjunction with each force.

a. Internal Rivalry

Degree of Seller Concentration.As reported above, the LTCI market is relatively unconcentrated. This tends to increase price competition. There has been no pronounced trend in seller concentration. Some smaller players, such as State Farm, may be seeking to gain share.

Despite the relatively large number of competitors, there is substantial heterogeneity in pricing. Broker World conducted an experiment in which it solicited pricing quotes on behalf of a fictitious employer. Plan design was held constant and prices were quoted by age of enrollee and for plans with and without inflation adjustment. Five of the six survey targets responded. For plans without inflation adjustment, the ratio of maximum to minimum price quotes ranged from 116-151% ,withno discernable correlation between price dispersion and enrollee age. For plans with inflation adjustment, the ratio of maximum to minimum price quotes ranged from 121-191%, and dispersion was negatively correlated with enrollee age.20

Rate of Industry Growth. The LTCI market is currently stagnant, perhaps because of the economic downturn. This can intensify pressure on firms to lower prices in order to boost business. As the economy improves, sales of LTCI should improve as well, easing pricing pressure.

Other factors may affect industry growth. The baby boom bubble is entering the prime years for purchasing LTCI, thereby boosting demand. Strains on Medicaid budgets might limit federal and state funding for long term care, thereby increasing the demand for LTCI. Likewise, cutbacks to the Medicare Part C program (i.e., Medicare Advantage) might increase demand for LTCI. On the other hand, the movement of business to health insurance exchanges might reduce employer involvement in providing health benefits, thereby reducing demand for LTCI.

Cost Differences Among Firms. All major players have similar administrative and marketing cost structures. However, plans may have markedly different underwriting policies and selection strategies leading to different cost structures. This is reflected by the evidence on price dispersion reported in Broker World.

Excess Capacity. Capacity, as normally construed, is a nonissue in LTCI. However, firms may be constrained from growth if they lack financial capital. Economic recovery may provide life insurance firms with the cash required to support growth.

Product Differentiation. In one sense, the products are highly homogeneous--the value of a $150 daily benefit is essentially the same regardless of the source of those funds. Homogeneity in certain benefit features is driven by HIPPA regulations, which specify requirements that plans must satisfy in order for premiums to be (partly) tax-deductible and benefits tax-exempt.

LTCI requires a fairly substantial outlay and consumers likely spend considerable time evaluating the product. Thus, one might expect to see strong price sensitivity. Due to the role of the sales agent, however, consumers may be loyal to one product or another. About half of all sales occur through company agents who may already have a relationship with the client through the sale of life insurance. There has recently been a shift of sales to independent agents who may represent several LTCI sellers. If this shift continues, consumers may display less loyalty and pricing pressures may intensify.

Switching costs. Consumers who have already purchased LTCI have enormous switching costs, as the premium is based on the age of initial purchase. Thus, virtually all price competition is largely restricted to new customers.

Observability of prices. Sellers can more easily tacitly collude if they can observe and quickly react to competitor price changes. (The reason is that any effort by one firm to gain market share through a price reduction is easily and quickly mimicked by its rivals.) Pricing in the individual market is customer specific, making “copycat” price matching difficult. Pricing in the group market is also not easily observed. Observabilitymay increase substantially if the LTCI market switches to a Geico/Progressive sales model, as we discuss below.

Use of Facilitating Practices. NAIC regulations may serve to put a floor on insurance rates, anchoring premiums and acting as a “facilitating practice” (In this context, facilitating practices are practices that, by increasing price transparency or creating focal pricing points, may make tacit coordination on pricing more likely or sustainable). NAIC regulations that act as a floor on pricing would limit each LTC insurer’s ability to gain market share by setting an aggressive premium.

Size of sales orders. Sellers price more aggressively when each sale represents a large portion of their business. With the exception of very large employer groups, most sales are a miniscule portion of total business. CLASS may shift more attention to employer-based sales, which could intensify price competition.

Exit Barriers. Price competition is reduced when firms can easily exit markets, as they are more prone to exit than endure bitter price wars. LTCI carriers could face considerable harm to their reputations in the much larger life insurance market if they exited LTCI. They would be more likely to sell their existing policies to another carrier.21 Overall, we would expect LTCI carriers to defend their positions if their survival is threatened.

Industry Elasticity of Demand. The industry elasticity of demand is estimated to be around 0.75 which is not particularly high. Price increases, if they can be sustained, will not drive away so many customers as to drastically affect industry profits.

Overall Assessment of Internal Rivalry. Despite the relatively unconcentrated market, we believe that internal rivalry has been relatively muted, due to the importance of personalized sales contact. If the product were simplified to the point where consumers feel comfortable purchasing LTCI without a sales agent, then the remaining factors tend to weigh towards intense competition.

b. Entry and Exit

All of the major LTCI carriers have considerable experience. This section identifies barriers to entry and growth by newcomers and pays particular attention to potential lowering of entry barriers should LTCI become commoditized.

Economies of Scale and Scope. Traditional production economies associated with the spreading of facilities costs are absent. There are economies of scale and scope in marketing and selling of LTCI, as life insurance companies can efficiently identify potential LTCI customers. If LTCI is commoditized, these selling economies will become much weaker.

Importance of Reputation. As noted in Tables 1a and 1b, all of the major LTCI sellers are established life insurance companies. Ostensibly, consumers purchase from sellers with proven track records, as sellers who exit the market may be unable to fulfill their LTCI contracts. Even if the product is commoditized, consumers will still place a high value on the seller’s financial stability.

Access to Distribution Channels. LTCI is currently sold through life insurance company agents and independent brokers. Distribution through the Internet will be possible if the product is commoditized.

Access to Key Inputs (Technology/Raw Materials/Know-how/Favorable Locations). These are not important entry barriers.

Experience Curve. Incumbents have the benefit of client lists that allow them to more efficiently deploy their sales forces. The actuarial models required for pricing LTCI are available from independent consultants. Still, LTCI companies have varied in the extent to which they are able to successfully model key profit drivers, such as cost growth and drop-out rates, so new entrants may be placed at a disadvantage while they accumulate LTC underwriting expertise.

Strategic Behavior of Incumbents in Response to Entry. Because there has been no major entrant in recent years, there is no evidence one way or the other as to how incumbents would respond to entry. Moreover, a government plan may be viewed as a more committed entrant (e.g., unlikely to be driven out of the market via aggressive pricing) and so would likely generate a different strategic response than a private entrant.

Exit Barriers There are substantial exit barriers. Regulators will protect covered lives, and major carriers will be reluctant to harm their reputations in the much larger life insurance market by withdrawing from the LTCI market in a way that undermines commitments made to their installed base of enrollees.

Overall Assessment of Entry and Exit. Incumbents are protected by their longstanding reputations and access to selling channels. The latter may break down if LTCI is commoditized, but the former may remain important. Consumers may be willing to purchase annual auto insurance from GEICO or Progressive, but will they be willing to purchase LTCI from upstart firms, given payout periods that may be years or decades in the future?

c. Substitutes and Complements

Availability of Close Substitutes. LTCI protects future wealth. Consumers who are worried about the cost of lengthy nursing home stays are likely to have estates worth several hundred thousand dollars and are apt to purchase life insurance, which in this context can be viewed as a substitute for LTCI. This explains why the same channel is used for both insurance products. Consumers who are worried about the costs of short term nursing home stays and home care due to an acute condition are likely to have somewhat smaller estates. There are currently no good substitutes for LTCI for these individuals--we return to this point below.

Medicaid has been an important substitute for individuals of lesser means.

Price-Value Characteristics of Substitutes. Whole life insurance can replenish an estate drained by costly nursing home bills; term life may no longer be active by the time a nursing home is needed. But whole life is an imperfect substitute because the funds are not available until the patient is deceased.22 Medicaid is an imperfect substitute because many long term care providers will not accept it and individuals must meet income thresholds to qualify. Additionally, many individuals may fear that Medicaid will be underfunded in the future, further hampering access to care for beneficiaries.

State Medicaid Partnerships. These programs, which are active in most states, are intended to encourage the middle class to purchase LTCI.23 “In the Partnership model, states offer the guarantee that if benefits under a Partnership policy do not sufficiently cover the cost of care, the consumer will qualify for Medicaid under special eligibility rules that allow a pre-specified amount of assets to be disregarded . . . [t]his is generally referred to as ‘asset protection’.”24 CLASS should obtain similar asset protection for its products.

Availability of Complements. The continued growth in the demand for home health care and assisted living arrangements will place greater financial strains on the elderly and increase the value of LTCI.

Overall Assessment of Substitutes and Complements. As fears about Medicaid’s viability intensify and alternative long term care arrangements multiply, demand for LTCI is likely to grow substantially. This trend is unlikely to be meaningfully offset by growth of the limited set of substitutes or to be hampered by a lack of complements.

d. Buyer and Supplier Power

Supplier power is not an issue for LTCI, as there are no essential raw materials or technology required for sales. Buyer power stems largely from the power of insurance brokers. Brokers in the individual LTCI market have power if LTCI customers have a relationship with their broker and not with the LTCI company. In this case, the broker can command a large commission or threaten to sell competitors’ products. However, about half of sales in the individual market are currently done by company agents, rather than independent brokers.

LTCI group sales rely on a different brokerage channel, but the same considerations apply. Other considerations, such as the size of brokers or their ability to integrate into LTCI sales, are nonissues.

Overall Assessment of Buyer and Supplier Power. Broker power is limited by several factors. First, they are not concentrated, so LTCI firms can switch brokers at will. Second, partial integration allows LTCI companies to credibly threaten to move to a fully integrated sales model should independent brokers seek too much power. In the future, commoditization of LTCI could break the power of brokers even as it fundamentally changes competition among LTCI firms.

e. Summary of Five Forces Assessment

The profitability of the LTCI market depends on the extent to which several factors apply:

  • Consumers find it difficult to evaluate the product and rely on the advice of brokers and the reputations of established sellers (+)
  • Perceived product complexity limits commoditization and entry by aggressive price cutting firms (+)
  • Competition and partial integration by LTCI firms limit broker power (+)
  • The viability of Medicaid as a LTCI insurer for those of limited means (–)

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