Market Failure in Small Group Health Insurance
36 Pages Posted: 25 Jul 2000
Date Written: October 1994
Typically, health insurance premiums depend at least in part on the previous costs of the insuring firm, a factor termed 'experience rating'. This link between health status and future premiums raises concerns of market failure, since it limits the ability of firms to insure the price at which they can purchase insurance in future years. This paper examines the economic factors influencing experience rating. The first part of the paper demonstrates that experience rating is quantitatively important. Premiums at the 90th percentile of the distribution are 2 1/2 times greater than premiums at the 10th percentile of the distribution, and this difference does not appear to be due to the generosity of benefits or the demographic composition of the firm. The second part of the paper then discusses explanations for the prevalence of community rating, including inability to write long-term contracts, lack of demand from firms with below average costs, and public policies that provide subsidies to the uninsured. The last part of the paper examines these predictions empirically. I find evidence that firms with high-wage employees and low turnover have less premium variability than firms with low-wage employees or high turnover, but no evidence that public policies affect premium variability.
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