Information Costs and Health Insurance Contracts

Abstract

ABSTRACT This article develops an equilibrium pricing model examining the nature of health insurance contracts by considering the relationship between information about risk types and equilibrium prices. Both community-rated (pooling) and risk-rated (separating) premia may co-exist under certain conditions, given that the insurer can observe the real risk type of the insured by spending some fixed amount on information. The higher the costs of determining risk class, the more heterogeneous will be the risk types offered insurance at the same (or pooling) premium. Also, the higher the mean and variance of the risk type distribution for the population, the more relatively healthy insureds would prefer risk-rated contracts to community-rated contracts. INTRODUCTION The issue of equilibrium pricing under adverse selection has received much attention. Most studies show different equilibria of either community-rated (pooling) contracts or risk-rated (separating) contracts based on sorting of risk types (Akerlof, 1970; Rothschild and Stiglitz, 1976; Wilson, 1977; Miyazaki, 1977). An equilibrium pricing policy taking the form of community-rated contracting means that each member of the community pays the same premium independently of whether the individual is perceived to be a high health risk or a low health risk. Risk-rated contracts establish a premium appropriate for each insured's expected medical costs. In American voluntary health insurance markets, premium setting is risk-rated for individuals and groups on the basis of indicators such as age, sex, occupation, and previous health condition. [1] Also, the risk-rated structure differs in terms of individual, small group, and large group plans (Light, 1992; Gauthier et al., 1995). Unlike with large groups organized for purposes other than health insurance, there is no reason to pool individual plans except for purposes of health insurance. Providers of individual plans try to avoid adverse selection by taking steps to screen potential insureds--e.g., examining medical records, excluding pre-existing conditions from coverage, and limiting the provider's maximum exposure. In the limit, risk-rated contracts establish a premium for each insured appropriate to that insured's expected medical costs during the life of the contract. Thus, in the individual market the insurer would tend to charge very expensive plans for those few disadvantaged by poor health. [2] This result might explain the fact that risk-rated policies tend to result in a growing number of uncovered medical conditions and uninsured doctor and hospital bills. Like individual plans, small group plans make it more difficult to diffuse risks than do large plans. When a group gets larger, the average expected medical cost would be less likely to vary. According to Aaron and Bosworth, insurance premium for groups of fewer than 10 employees commonly are 25 to 30 percent above those for groups of 50 or more. Also, around 73 percent of small firms with fewer than 10 employees did not offer health insurance in 1990. In contrast, only 2 percent of large firms with more than 100 employees did not provide health insurance (Aaron and Bosworth, 1994). This article develops an equilibrium pricing model examining the nature of health insurance contracts by considering the relationship between information about risk type and price equilibrium, given different assumptions about individual health states, risk types, and adverse selection. The author shows that either a pooling or a mixed equilibrium is possible, based on the assumption of equilibrium concept suggested by Wilson (1977). [3] The assumption of asymmetric information at the time of contracting means that information costs are critical to determining the type of equilibrium policy because it is costly to collect detailed information on the riskiness of individual customers. [4] Between a community-rated policy without verification costs and a risk-rated policy with verification costs, insureds will choose the policy with the smaller premium. …