Health Insurance Exchanges

Motivation for exchanges Most individuals in the US obtain health insurance through the gov’t (Medicare/Medicaid) or their employer. Remainder can buy insurance directly from insurers/health plans, but many don’t. Plans simply refuse to cover some individuals who are unhealthy. In other cases, individuals choose not to purchase because they judge the price (or transaction cost) to be too high. Individuals without insurance pay for care as they get it, or negotiate partial payment with providers. Recent health care reform aims to create more efficient markets for private insurees, ensure they buy coverage.

Basic plan Individuals are required to purchase a minimal level of health insurance, or pay penalties (mandate) Insurers cannot deny coverage and their ability to price discriminate (adjust premiums based on age, health status, etc.) will be very limited. Federal government will provide (large) subsidies to low-income individuals or households so they can afford to pay premiums.

Outline of Class Theory on health insurance markets Risk selection and potential for market failures. Problems of plan design, competition, etc. Design of insurance exchanges Principles for effective market design Applying the theory to see what might work Risk adjustment and dealing with selection. Potential problems for exchanges

Model of Risk Selection Suppose individuals in the private market are either “high risk” or “low risk”, in equal proportions. Expected cost of providing the insurance High risk person: cH, Low risk person: cL Individual willingness-to-pay to have insurance: High risk person vH, Low risk person vL Note: what do we mean by “high” and “low” risk?

Efficient Coverage Standard definition of an efficient allocation High risks should obtain insurance if vH > cH Low risks should obtain insurance if vL > cL Generally expect these inequalities to hold, provided people are risk-averse – prefer to pay a flat amount up-front rather than a random amount the depends on health events. Is this the right definition of efficiency? If individuals without insurance can still obtain care and maybe not pay for it, possible that v < c, but not insuring creates a social cost. How large is this social cost? Depends on whether insured and uninsured get the same care, and how much uninsured pay.

Discriminatory Pricing Suppose plans can offer different prices based on individual’s expected costs, and “perfect” competition High risk price will be cH Low risk price will be cL Who will buy coverage? High risk individuals if vH > cH Low risk individuals if vL > cL Does this make sense? Is this a likely or a good outcome for the market?

Uniform Pricing Suppose plans cannot distinguish high and low risks, or are required to charge a single “community price”. Again assume that competition is perfect. Suppose plans charge p Low risks enroll if vH > p High risks enroll if vL > p The outcome in the market will depend on the relationship between costs and willingness-to-pay.

Uniform Pricing What happens instead? Possible “full coverage” equilibrium Price p such that vH > p and vL > p Competition for whole risk pool drives p = ½*cL + ½*cH = cAVG Equilibrium works out if vH > cAVG and vL > cAVG. Market “unravelling” : suppose vL < cAVG < vH If a plan offers coverage for p=cAVG, it gets only high risks and faces adverse selection => here, loses money. What happens instead? If vH > cH, equilibrium with only high risks insured, and p = cH. If vH < cH, market breaks down completely, no one is covered.

Uniform Pricing Alternative possibility : suppose cAVG > vL > vH Might be an equilibrium with only low risks insured. If vL > cL > vH, competition drives p=cL, only low risks buy. If vL > vH > cL, competition drives p=vH, only low risks buy. Last case is kind of interesting: “perfect” competition with positive profits because p=vH > cL! This situation is relevant only if relatively low risks have relatively high willingness to pay. Is this a relevant case?

Selection and Mkt Failure $ General version of the model where as price increases, the covered risk pool becomes worse. At competitive equilibrium with p=AC, too few people are insured. Instead should have p = MC. Demand Average cost of enrollees Marginal cost of enrollees Q

Lemon Dropping What if there is a community rating requirement, but plans can refuse coverage? Insurer strategy: Charge p to attract low risks Deny coverage if high risks try to buy Equilibrium with competition Competition drives price to p=cL High risks are denied coverage.

Selection with Plan Design What if insurers can’t identify bad risks or can’t deny coverage, but can offer multiple types of plans? Insurer strategy Offer plan that appeals primarily to low risk individuals, as a way to “cherry-pick” the pool. What types of plans might have this feature? High deductible plans, plans with “less coverage” or higher copayments, plans with “wellness” options, plans with high hassle cost for chronically ill, etc.

Selection with Plan Design Consider “good” equilibrium from before vH>vL>cAVG Benchmark plan offered at p = cAVG Both risk types purchase the plan => full coverage How can an insurer cherry-pick the pool? Suppose it is possible to increase or reduce plan benefits relative to the benchmark plan. If high risks place more value on full benefits, insurer may be able to reduce benefits and skim off low risk enrollees.

Plan Design & Market Failure $ New plan here will get only low risk enrollees New plan here will be adversely selected Benchmark plan Indifference curve for low risks Indifference curve for high risks Plan Benefits

Summary of Selection To provide meaningful insurance, it is necessary to have (at least some degree of) risk pooling. Even with competitive behavior, however, Low risks may not be willing to pay enough for insurance to cross-subsidize the high risks in the pool. Plans may engage in denial of coverage or strategic plan design to try to “lemon drop” or “cherry pick” the risk pool. Analysis abstracts from usual problems of imperfect competition, which can also create problems. Plans may be able to charge p>AC, and this in itself can result in inefficiency just as in standard oligopoly product markets.

Exchange Design Principles Mandated purchase to overcome problem of risk pooling If everyone is required to buy, low risks cannot “opt out” of the market and avoid cross-subsidizing high risks. Limited range of plan designs In PPACA, describes four levels of plans: bronze, silver, gold and platinum, with varying levels of coverage (e.g. 60% vs 90%). But, says almost nothing about details: which physicians can you see, what requirements to see specialists, etc., so could still be considerable scope for plan heterogeity (good or bad?) Community-rated prices, but with “risk adjustment” to deal with selection problems.

Plan Competition Let’s use prior model to see how things might work. Suppose two types of plan, with minimal and enhanced coverage. Costs and willingness to pay are Minimal Plan: vH, vL, cH, cL Enhanced Plan: vH’, vL’, cH’, cL’ (primes are bigger) Suppose it is efficient for high risks to get enhanced coverage, so vH’-cH’ > vH – cH, and also assume high risks willing to pay more for “enhancements”, so vH’-vH > vL’ – vL.

Plan Competition Minimal plan can undermine the enhanced plan. Suppose vH’, vL’ > cAVG’ = ½*(cL’ + cH’). With no minimal plan, competitive outcome has p’=cAVG’ Both low and high risks enroll, everyone is covered. Introduction of minimal plan creates a problem Suppose enhanced plan is priced at p’ = cAVG’ Can price minimal plan at p such that vH’-vH > p’-p > vL’-vL Then high risks prefer enhanced plan: vH’ – p’ > vH – p But low risks prefer minimal plan: vL’ – p’ < vL - p

Plan Competition Sorting equilibrium Under some conditions, there can be an equilibrium in which low risks choose minimal plan, and high risks enhanced plan. Competition means p=cL, and p’=cH’ “Works” as an equilibrium only if high risks are willing to pay a lot for enhancements… for equilibrium, we need vL-cL > vL’-cH’ vH’-cH’ > vH – cL Need more than vH’-cH’ > vH – cH, the condition for high risks to be efficiently in the enhanced plan.

Plan competition Pooling equilibrium There may also be a pooling equilibrium in which both risk types choose the minimal plan. Competition takes p=cAVG = ½ * (cL + cH) This is an equilibrium provided there is no way to price the enhanced plan in a way that picks off consumers and makes positive profit, i.e. provided that vH’ – cH’ < vH - cAVG

Risk Adjustment Risk adjustment is a system of transfers designed to solve the selection problem. A plan that enrolls a low risk must pay T to the adjustment pool, and a plan that gets a high risk gets paid T from the pool. Let’s see if we can support an equilibrium where both types enroll in the enhanced plan. Competition will drive p’ = cAVG’ To attract low types to minimal plan, can price it at p’ such that vL-p = vL’-p’ = vL’-cAVG’. => p = cAVG – (vL’-vL). Before, we said this would be profitable, but may not be profitable if there is a tax T on each low risk enrollee.

Risk Adjustment Risk adjustment might also support a separating eqm High risks choose enhanced plan, low risks minimal plan. Competition means: p’ = cH’ – T and p = cL + T Works as an equilibrium if vL – p > vL’ – p’  vL – cL > vL’ - cH’ – 2T vH’ – p’ > vH – p  vH’ – cH’ > vH – cL + 2T If the problem was high risks being priced out of the enhanced plan, the transfers reduce the price of the enhanced plan, and raise the price of the minimal plan.

Risk adjustment Provided there is competition, Risk adjustment has the effect that it lowers the prices of plans populated by high risks, and raises the prices of plan populated by low risk. Forces a degree of cross-subsidization in the market, even if separating equilibrium! Is it realistic? Requires a good statistical measure of risk, in order to set up the risk-adjustment scheme, and also a wise choice of the transfer.

Competition In practice, a big problem may be getting plans to behave competitively. Many markets have relatively few insurers. Limiting plan design options focuses attention on price rather than other attributes, which promotes price competition But may also limit innovation, or plans that might be very appealing to certain subsets of population.

Mandates and Subsidies A second potential problem is that prices will just be very high because health costs are high and the privately insured risk pool is a high cost set of people. To make the mandate realistic, the gov’t subsidies need to be large, but that creates its own problems People may have a disincentive to work if subsidies phase out very quickly at income thresholds – e.g. if you get a $10,000 benefit if your income is less than $50,000, doesn’t make sense to make $55,000. Firms may have an incentive to drop coverage for their workers, so their workers can have access to the subsidies and obtain insurance in the exchanges.

Summary Health insurance markets are canonical example of situation where competition need not lead to efficient outcomes. Designing markets to mitigate problems of risk selection is challenging, particularly coupled with problems of imperfect competition and need for subsidies. Economic theory does suggest some basic principles, but implementing them effectively is not trivial. After 2014, we’ll at least have a lot of examples to study and see what types of exchange designs are effective.