McKinsey has studied the hospital networks that are being used by plans on the new public health exchanges. They divide networks into three groups that they call broad, narrow, and ultra-narrow. Broad networks contain more than 70 percent of the 20 largest hospitals in the relevant area, whereas ultra-narrow networks contain less than 30 percent. McKinsey found that over two-thirds of the networks are either narrow or ultra narrow. (Download the study here.)

McKinsey takes a benign view of the situation. They feel that these narrow networks are expanding consumer choice. Offering a narrow network is one of the few really effective means that health insurers have left to restrain costs. If insurers expected the exchanges to attract price-sensitive consumers, insurers would naturally offer networks that were narrower than their typical offerings. In the McKinsey study, policies with broad networks were 26 percent more expensive than equivalent policies with narrow networks. This is a pretty substantial price differential. McKinsey found that hospitals included in the narrow networks were comparable in quality to those being excluded.

Although narrow networks shouldn’t be surprising to health policy wonks, they have shocked many patients. Recently Megan McArdle described the growing pushback against the the ultra-narrow networks. She thinks that they may not be “long for this world.”

Regulatory overreach is a real possibility. The downside of narrow networks is instantly recognizable; however, the benefits are a little harder to explain. Many people assume that narrow networks save money primarily by excluding the expensive hospitals. However, insurers do more than shop for a good deal, they are actively bargaining on behalf of their customers. It’s not just that “you get what you pay for,” but “you get what you pay for” after insurers get the best deal possible. Essentially, an insurance company engages in collective bargaining based on the fact that they can steer a large number of patients to providers in their network. Insurers can steer more patients to a given provider by limiting the number of providers in the network.

Essential to the insurers’ bargaining power is the option to exclude providers. Imagine a situation where there were two hospitals in town and the insurer was philosophically opposed to excluding either hospital. The insurer approaches the first hospital and says, “We are bargaining on behalf of our customers who represent 10 percent of the population in your area. We think this merits a substantial discount off your usual charges.”

The hospital negotiator says: “Interesting. That many customers would really come in handy. But what could you do to make sure that your customers come to our hospital instead of the hospital across town?”

The insurer replies: “Nothing. Our customers need access to all the hospitals in the area. Steering patients to your hospital would be a great disservice to them.”

The hospital replies: “If I’m going to get half your business regardless of my rates, why would I offer you any discount at all. Hmmm … by law, your policies now have no lifetime limits. And with the caps on out-of-pocket costs, it might make sense for us to raise our rates. I wonder if we are charging heart patients enough for the aspirin that we give them.”

The insurer reconsiders: “Okay, what if we exclude the other hospital in the neighborhood from the network. If we do this, you can be pretty certain that you’ll get 90 percent of our business.”

The hospital negotiator smiles, “For that we can offer a steep discount.”

Networks can be maddening. Inadvertently using out-of-network providers can be financially draining. However, the more we insulate patients from the cost of medical care, the more important it is that insurers can effectively bargain with providers.