Unbiased Analysis of Today's Healthcare Issues

Search Frictions in Employer-Based Insurance Markets

Written By: Jason Shafrin - Sep• 13•07

Despite much public rhetoric, why is preventative and chronic care so poor in the U.S.? The easy answer is that patients switch plans so frequently that insurance companies who invest in preventative care will incur the cost, but not reap the benefits. The harder question is why patients are switching health plans.

According to a working paper by Cebul, Herschman, Rebitzer, Taylor and Votruba featured on Slate, the answer may be “search frictions.” In the paper, turnover is generated from two sources: 1) from employees leaving the company for new jobs and 2) by having the employer switch to a new health plan. Data from the Community Track Study in 1996/7, 1998/9, 2001 and 2003 show that average annual insurance cancellations are about 21%. More than one third of the turnover is caused by employers switching health plans. Small employers were more likely to switch insurance plans than larger employers. Why don’t they just stay with one plan?

The search friction model is developed from a labor economics paper by Burdett and Mortensen (1998). The authors argue persuasively that extending the model to the case of health insurance makes perfect sense.

“The market for health insurance is a natural place to expect search frictions. Health insurance is a complex, multi-attribute product and this complexity makes it difficult for clients to meaningfully compare more than a handful of proposals. Informal discussions with insurers suggest that they offer customers hundreds if not thousands of different policies. This complexity also makes the marketing of insurance costly so that companies can make only a limited number of appeals to employer groups in a period.”

The authors explain how the price friction mechanism works. The price of the insurance policy is p, the marginal cost of the policy is c, and the firm’s reservation price for buying insurance is pR.

Suppose all firms made the same price offers p=c and so earned zero profit. Then one maverick firm could clearly increase profits by charging some discretely higher price (less than or equal to the reservation price pR). This high offer would be rejected more frequently than the going price because any potential client who fielded more than one offer in a period would obviously reject the high offer. But on occasion the contacted client would have no other offers, and a policy would be sold. This would produce positive profit for the firm. Similarly, in a candidate equilibrium in which all firms were charging the same price (a price such that c<p<pR ), a maverick firm could always increase profit by undercutting slightly the price charged by competitors, thereby increasing the number of clients while reducing by profit per client by only a trivial amount. In short, an equilibrium must entail a distribution of price offers.

Once market friction reach a sufficient level, in equilibrium we will observe a churning of employers going through different insurance policies each year. Introducing the issues that come along with adverse selection is likely to only increase market frictions because insurance companies now will want to screen employees.

Possible Solutions

The authors offer arguments made that may be solutions to the problem.

  • Patient-financed health investments. Health care investments (i.e.: preventative care) should be financed by the client. This way, the person reaping the rewards from preventative care will also incur the costs. If the patient switches insurance plans, this will not be a problem since they will be eligible for lower premiums because of their preventative care history. On the other hand, determining what type of care is an expense and what is an investment may be very difficult practically. Further, shifting more risk onto the patient is the antithesis of what insurance is supposed to do. Finally, when switching insurers, it will be very difficult to verify the actual amount of preventative care received without a nation-wide standard for electronic medical records.
  • Long term contracts. Another simple solution is just for employers to purchase long term contracts from insurance companies. This way, insurers will be able to reap more of their rewards from earlier years’ health investments. On the other hand, “given constantly-evolving medical technology and treatment protocols, as well as hard to predict changes in governmental regulation and mandates, it is difficult to see how long-term contracts might be implemented.”
  • Price Caps. Government set price caps are probably the worse option. As Slate states, “But where should the government set the ceiling? If it’s too low, the government could end up destroying insurance companies’ incentives to stay in business at all.”
  • Legislate a basic insurance package. The authors conclude the paper with the following: “It follows from this that much of the distortions resulting from frictions could be mitigated if there were a simple, easily understood and reasonably priced alternative insurance policy that would be available to all market participants. In the context of our search models, we believe we can prove that by making this alternative insurance available on a voluntary basis to all purchasers the inefficiencies resulting from search frictions could be greatly reduced.” Another option would be to offer everyone the choice of a nationalized health plan (a la Medicaid). People who did not want Medicaid, could choose to have vouchers (see Healthcare Vouchers) used to pay towards a private insurance plan of their choice. Many of the basic private insurance plans will likely mimic the nationalized Medicaid, but some plans will offer alternatives which will be more flexible and easier to adapt to new technology advances.

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  1. Truman says:

    I find it incredible that, for all that is burdensome, irrational and unfair about employer-based health insurance, we continue to hang “reforms” on this relic from a different time and circumstance. I believe that real healthcare system reform – reform that provides healthcare coverage for all, constrains the growth in healthcare costs and promotes continually improving quality in delivery – will not be possible so long as the employer remains an integral part of the system.

    A Voucher system would obviate the need for employer or employee mandates, would provide absolute mobility and would reduce the administrative overhead entailed in any of the mixed reform packages being promoted by some of the leading presidential candidates. At the core of the Voucher plan is a legislated basic health insurance package, such as called for in your blog. This standard plan would form the foundation for all healthcare coverage and provide the basis on which insurance companies and healthcare organizations would compete.

    The HealthCare Voucher system is both a radical departure from the current system while at the same time preserving much that is familiar, namely the private delivery system. The key to its implementation will be its success in moving the public away from its dependence on the current employer-provided system.