Research published in the August issue of the American Economic Review finds that small businesses have been overpaying for health insurance. The collaborative research paper “Unhealthy Insurance Markets: Search Frictions and the Cost and Quality of Health Insurance” highlights difficulties that small employers have in searching for health insurance.
The difficulties of comparison shopping increase average health insurance premiums paid by small businesses by an estimated 29 percent, according to researchers at Case Western Reserve, Carnegie Mellon and Boston universities.
When researchers at Case Western Reserve University’s Weatherhead School of Management and School of Medicine began taking insurance markets’ vital signs a few years ago, one fact particularly captured their attention: small employer groups changed plans very frequently.
This turnover was something of a puzzle. “If markets are competitive, plans of similar value should be offered at similar prices,” said co-author Mark Votruba, associate professor of economics and medicine. “It’s costly to switch plans, so if employers are switching plans all the time, it suggests that something is impeding competition.”
The Case Western Reserve researchers, including Randall Cebul, professor of medicine and director of the Center for Health Care Research and Policy at MetroHealth Medical Center, and James Rebitzer, past chairman of economics at the Weatherhead School (now at Boston University School of Management), along with colleague Lowell Taylor, professor of economics at Carnegie Mellon’s Heinz College, concluded that they observed a phenomenon economists refer to as “search frictions.”
The study of search frictions is an important part of the economics of labor markets, leading to last year’s award of the Nobel Prize in Economics to Peter Diamond (Massachusetts Institute of Technology), Dale Mortensen (Northwestern University) and Christopher Pissarides (London School of Economics). The current paper is the first to apply these theories to the operation of health insurance markets.
Search frictions arise whenever consumers are unable to easily compare all the options available to them in the marketplace. This, Votruba, Cebul, Rebitzer and Taylor argue, is exactly the case for purchasers of individual and small group health plans.
“Consumers have hundreds, sometimes thousands, of different options, and each plan has its own unique set of benefit details. In this complex environment, it’s hard for consumers to find the plan that offers them the best value. What our paper shows is that this ‘shopping problem’ has important implications for how market competition plays out. If consumers have a hard time evaluating value, competition becomes less about value and more about marketing,” Votruba said.
A hallmark of markets with search frictions is that the law of one price breaks down. Instead of competition leading insurers to offer similar plans at a similar low price, frictions enable many insurers to profitably pursue high margin/low volume strategies. The net effect is that consumers end up paying more for their health insurance—29 percent more on average in the small group market—and insurers spend more on marketing.
Search frictions also give employers an incentive to change insurers in search of better rates. “High turnover rates undermine the quality of health plans by reducing insurers’ incentive to finance care that makes their policyholders healthier in the future,” Cebul said. “Why spend money on wellness or disease management programs—programs which yield a return on investment only after several years—for a policyholder who probably isn’t going to stick around long, especially if the program increases premiums and other insurers reap the benefits of your investment?”
If search frictions in health insurance markets cause small businesses to pay too much for low quality policies, can the health insurance exchanges mandated by health care reform law do better? This paper’s findings suggest they probably can.
“In theory, they should,” said Rebitzer, “as long as the exchanges are designed so that shoppers can easily evaluate the value that they should expect for the prices of different plans. We will know that the exchanges are successful if turnover rates and marketing expenses decrease.”
The research described in American Economic Review was financed by an award by Case Western Reserve’s Presidential Research Initiative in 2005, with matching funds by the Weatherhead School of Management and The MetroHealth System, a major affiliate of Case Western Reserve University School of Medicine. The PRI was designed to foster cross-school collaboration in research.
The American Economic Review is the premier scholarly journal in economics. Benjamin Bernanke, the current head of the Federal Reserve Bank, formerly served as its editor-in-chief. View the August issue online.
Rebitzer is a professor of management, economics and public policy at Boston University’s School of Management, having recently joined the faculty after 11 years at Case Western Reserve. He is a research associate in the National Bureau of Economic Research.
Votruba is an associate professor of economics and medicine in Case Western Reserve’s Weatherhead School of Management and School of Medicine.
Cebul is a professor of medicine at Case Western Reserve’s School of Medicine, and he also is director of the Center for Health Care Research & Policy at MetroHealth Medical Center in Cleveland.
Taylor, a professor of economics at Carnegie Mellon’s Heinz College, has served as senior economist for President Clinton’s Council of Economic Advisers.