How private health insurance pools risk.

• Author: Pauly, Mark
• Position: Research Summaries

Introduction and Theory

Most Americans obtain their health insurance in the private sector, in both group and non-group settings, and from for-profit, non-profit, and self-insured arrangements. A matter of concern to both consumers and policymakers is how the premiums that will (in some fashion) be paid for this insurance--and even the availability of insurance at any premium--vary with the insured unit's risk level. There is tension here: to cover their costs and to avoid adverse selection, insurers need to collect premiums tailored to each buyer's expected expense. But policymakers tend to regard payment of higher premiums by higher risks as unfair, and individual consumers realize that their risk level may change over time, as chronic (though not necessarily permanent) illnesses strike.

Along with several colleagues, I have been investigating both theoretical models of efficient insurance markets when risk varies (both across individuals at a given point in time and for a given individual over time) and empirical evidence on how premiums and the securing of coverage vary with risk. The theoretical point of departure is that, from a lifetime perspective, the great bulk of people who are initially low risk will want protection against large current costs and protection against "premium risk," the risk that premiums will jump at the onset of chronic illness. Howard Kunreuther, Richard Hirth, and I (1) have shown, as has John Cochrane, (2) that there is a theoretical solution to this problem: markets can furnish incentive-compatible insurance with % longer time perspective," in Kenneth Arrow's words using the policy provision labeled "guaranteed renewability at class average premiums." We also have been interested in pursuing another of Arrow's insights: that institutional arrangements other than explicit and direct market transactions may emerge to deal with this problem as with others in health care and health insurance; the main candidate for this role is employment-based group health insurance. We therefore have been investigating the extent to which premiums paid vary with risk in competitive, largely unregulated insurance markets, and the underlying arrangements that support risk pooling. This investigation has largely been one of first discovering some empirical evidence and then working backwards to understand the supporting arrangement and the theory that explains their existence.

Individual Insurance Markets

Our primary empirical finding is that, in both group and non-group insurance, premiums actually paid for insurance in the United States pool the risk to a very great extent. That is, in both markets, actual premiums paid are not even close to being proportional to risk. To be specific: although total premiums do rise with risk in both individual and group markets, primarily in terms of reflecting the higher risk that accompanies older age (especially above age 50), they do not reflect the full amount of additional risk that characterizes individuals and families. Moreover, in both markets the premiums do not increase with the onset of chronic conditions at rates close to the expected expenses associated with those conditions Although risk pooling is present (but far from complete) in employment-based group markets, even in individual insurance markets there...