Contracting with limited commitment: evidence from employment-based health insurance contracts.

Impediments to worker mobility serve to mitigate the attrition of healthy individuals from employer-sponsored insurance pools, thereby creating a de facto commitment mechanism that allows for more complete insurance of health risks than would be possible in the absence of such frictions. Using data on health insurance contracts obtained from the 1987 National Medical Expenditure Survey, we find that the quantity of insurance provided is positively related to the degree of worker commitment. These results illustrate the importance of commitment in the design of long-term contracts, and provide an additional rationale for the bundling of health insurance with employment.

1. Introduction

* The recent debate over the use of annual re-underwriting in the context of individual health insurance policies highlights the difficulties that insurers face when attempting to craft a stable insurance pool.

Shaneen and Tom Wahl were paying $417 a month for health insurance when Mrs. Wahl was diagnosed with breast cancer in 1996. Their premiums began rising steadily, and by August 2000, the Wahls were told that their new rate would be $1,881 a month. Mrs. Wahl, whose cancer was in remission, tried to find out why. Unsatisfied with answers they got on the phone, the ... couple visited the ... offices of the insurer. There ... an executive explained why her premium was soaring: "because of your dread disease" ... It's called reunderwriting ... A key challenge in individual health insurance is keeping the healthier people enrolled. Their premiums are needed to subs d ze those who get sick. The problem, under the traditional approach, is that the healthiest tend to drop out as rising medical costs gradually drive up premiums ... Advocates of reunderwriting argue that because it gives smaller rate increases to the healthy, it keeps more of them enrolled and paying premiums ...

Chad Terhune. Wall Street Journal, April 9, 2002, p. A1

In a setting where an individual's health status is observable but evolving over time, the key to maintaining a successful insurance arrangement is to have healthier members of the group commit to cross subsidize members who experience adverse health outcomes. In the absence of a precommitment mechanism, however, those who turn out to be healthier than average may find it advantageous to leave the risk pool and to purchase alternative coverage at a premium that more accurately reflects their own, observable, health status. (1) This erodes the actuarial integrity of the pool and, consequently, the ability of insurers to offer insurance against both the financial losses associated with a particular illness episode and the classification risk that results when insurance premiums are adjusted to reflect changes in one's health status over time.

This article examines a theoretical model of insurance contract design in which impediments to worker mobility may serve to mitigate the attrition of healthy individuals from employer-sponsored insurance pools, thereby creating a de facto commitment mechanism that allows for more complete insurance of health risks than would be possible in the absence of such frictions. We characterize optimal health insurance contracts in an environment where a worker's evolving health status is publicly observable, and in which employees vary in the transactions costs that they must incur when switching to an alternative employer. Using data on employment-based health insurance plans, we find that the structure of insurance contracts observed in practice is consistent with the predictions of the model, providing empirical documentation for the importance of precommitment in the design of health insurance contracts.

Traditional analyses of contracting in insurance markets have tended to emphasize the role of informational asymmetries, which engender problems of adverse selection (Rothschild and Stiglitz, 1976; Crocker and Snow, 1986) or moral hazard (Shavell, 1979). A recent article by Cardon and Hendel (2001), however, finds no evidence of adverse selection in health insurance markets, suggesting instead that the lack of commitment in long-term contracts examined by Cochrane (1995) may be a more relevant source of market failure in health insurance settings. Accordingly, we consider a full-information model in which insureds are initially identical but anticipate receiving a public signal that will provide information about their expected future health care costs. As a consequence, the risk-averse purchasers of health insurance face two potential sources of uncertainty: the financial loss associated with adverse health outcomes and the classification risk that results when their future insurance premiums reflect the publicly available information on each individual's likely health-related expenses.

In such a setting, an optimal insurance contract would entail full compensation for all the losses suffered from illness as well as a constant, ex ante actuarially fair, premium charged to all individuals independently of the state or their observed health status. Although such a package provides full insurance against both types of uncertainty, the cross subsidy from low- to high-risk individuals in the future, which is inherent in the non-experience-rated premiums required to cover the classification risk, gives those with lower expected health care costs the incentive to exit the insurance pool and to purchase independent coverage at a price that more accurately reflects their own, observable, expected health care costs. As others have noted (Cochrane, 1995; Pauly, Kunreuther, and Hirth, 1995), it is this inability of insureds to precommit to remain in the pool in light of favorable information on health status that provides an impediment to the insurability of classification risk.

Paradoxically, the ability to insure against such risks is enhanced if there exist obstacles to the mobility of insureds that mitigate the erosion of the insurance pool caused by the departure of lower-risk individuals. In an environment where employer-sponsored health insurance is the norm, one of the largest impediments to insured mobility is the cost of switching jobs. To the extent that health insurance is bundled with employment, any frictions associated with employee mobility across occupations or employers necessarily translate into a de facto commitment to one's employer, which results in a more stable, and hence more insurable, risk pool. Thus, the existence of frictions that impede worker mobility between alternative employments may have heretofore unappreciated beneficent effects through their impact on the insurability of health risks.

The validity of this approach, of course, depends crucially on the requirement that insureds switch jobs in order to obtain alternative insurance coverage. This would appear to be a reasonable proposition in practice, since the vast majority of insured individuals receive their health coverage through employer-sponsored plans. The difficulties associated with the offering of private health insurance are well known, and they include the traditional problem of adverse selection with nongroup insurance (Pauly, 1986) as well as the high fixed costs generally encountered in the administration of individual policies (Diamond, 1992). As a result, the terms associated with independently purchased health insurance, to the extent that it is available, are less than attractive when compared to the employer-sponsored alternative (Gruber and Madrian, 1994).

The role of precommitment in the design of efficient multiperiod contracts has received increasing attention in the literature (Chiappori, 2000). The most germane for this study is a recent article by Hendel and Lizzeri (2003) who, in the context of life insurance, examine the use of "front-loaded" premiums as a mechanism through which insureds can commit credibly to remain in the insurance pool. Theirs is a model of symmetric information in which the purchasers of insurance may face classification risk based on their evolving actuarial status, and in which those who turn out to have a lower risk of mortality may, in the absence of precommitment, exit the life insurance pool. While the prepayment of premiums may be an effective tool to "lock in" customers in life insurance, Cutler and Zeckhauser (2000) note that it is less likely to provide a solution to the commitment problem in health insurance settings due to the greater complexity of that market. (2) Thus, health insurers must use other commitment devices--such as employer sponsorship of health plans--to craft stable insurance pools.

The article proceeds as follows. In Section 2 we examine a model of employer-sponsored health insurance in which the publicly observed health status of employees changes over time. Under the assumption that the insured workers incur a financial cost when switching jobs to obtain alternative insurance coverage, we characterize the structure of efficient employer-sponsored health insurance contracts. Our model offers several predictions concerning the relationship between these switching costs, which we term "job attachment," and the amount of insurance coverage available through employment-based groups. We find that when employers offer the same contract to all their workers, the optimal contract exhibits a coverage limitation that is inversely related to the amount of job attachment present in the firm. In addition, if employers are able to offer multiple contracts that induce self-selection by insureds, the contracts exhibit more complete coverage of medical expenditures, albeit at premiums that partially reflect the health status of plan participants.