Search frictions and health insurance markets

Moderating a panel yesterday at the University of Chicago Law School, I had occasion to read a fantastic paper by Cebul, Rebitzer, Taylor, and Votruba which offers a nice mental health break from the campaign season. Their award-winning paper, “Unhealthy Insurance Markets: Search Frictions and the Cost and Quality of Health Insurance,” exemplifies the way relatively simple mathematical models can enrich our understanding of messy markets. Such models help us see patterns and causal mechanisms we might otherwise overlook. They draw our attention to fruitful underlying similarities between very different markets that might otherwise escape notice.

This paper concerns the market for health insurance among small employers. (Large employers typically self-insure; these firms face different challenges.) Small employers who “fully insure” are relatively unsophisticated participants in the health insurance market. They also face important search frictions. It’s hard for the muffler shop owner or the local McDonald’s franchisee to really know the quality of what they buy, or whether they are getting a fair price compared with what another insurance company might offer. An employer contracts with a particular insurer, but might switch as some other insurer emerges to offer a better deal.

It’s obvious that individuals often switch coverage because they change jobs, switch plans during open enrollment periods, or go on a spouse’s employer-based health plan. It’s more surprising to see how common it is for small employers to switch policies. Cebul, et al, use data from the Community Tracking Study and from a large insurer to examine these patterns. I would never have guessed that annual cancellation rates reach 20%. The authors find that “approximately 38 percent of cancellations among group policyholders are due to employer group cancellations.”

Because firms can’t readily purchase a standardized product or readily compare quality and prices, there is a notable spread in insurer prices for similar products. Although there are many buyers and sellers, search frictions still allow insurers to set prices above marginal costs. Moreover, insurers face interesting strategic choices as they decide how to market and price their products for small employers. Some charge high prices, and market aggressively in the hope of encountering small employers willing to work with them. Others charge low prices, and can spend less money on marketing because they offer a better deal. Other firms fall in-between. In equilibrium, insurers find themselves in a marketing arms race, spending more money on marketing than makes sense from the broader social perspective.

Summing 1997 numbers for 73 million full-insurance policy holders, Cebul and collaborators find some pretty big inefficiencies: “The implied aggregate surplus transfer to insurers resulting from market frictions was $34.4 billion in 1997.” Search frictions also lead to excessive turnover rates, as firms switch policies in the hope of finding an insurer willing to offer coverage at lower prices. These excess turnover rates have various implications, including reduced incentives to make investments in future health.

The authors then make tentative comments about policy. Policies within health insurance exchanges and elsewhere that reduce search frictions are likely to improve efficiency. They would reduce turnover, would moderate prices through competition, and would temper unproductive investments in marketing.

More intriguing, the authors argue that a public insurance option–of somewhat lower quality than private options but offered at a lower price—would also improve efficiency. By providing a market backstop, this sort of public option would make it less attractive for private insurers to offer high-cost, heavily-marketed plans. The ripple effect, as predicted within this mathematical model, is to promote a more efficient and disciplined insurance market.

For sure, elegant mathematical models can’t be mechanically applied to government action. Libertarian scholar Richard Epstein fairly noted many practical challenges and limitations of the public option.

Economic models resemble biblical parables; they can be used and misused in similar ways. They also underscore how the simple econ 101 supply-demand diagrams we teach our students are really the entry tickets into a broader conversation. Especially within our $2.7 trillion health economy, things are much more complicated.

In any event, this parable is a pretty good one.

Post-script: Great TIE minds think. See here.

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