EDITOR’S NOTE: Two economists have independently explored the individual and group markets to explain why employer-sponsored plans present the best option for health insurance. This article is adapted from a study conducted by Keith Crocker, a leading U.S. economist in the insurance field, and health economist John Moran. Both are professors at Pennsylvania State University. The study was published in the Winter 2003 issue of the Rand Journal of Economics.

With group health insurance likely to come under attack next year with the arrival of a new administration in Washington, we are publishing this, the most compelling research in the group benefits industry, in the hopes that government regulators will understand the importance of employer sponsored plans and their affect on the quality of health insurance.

Why is it so easy to purchase an individual life insurance policy, but extremely painful to purchase an individual health insurance policy? If you answer that question, you begin to understand the reasons behind the economics of group health insurance—especially employee groups sponsored by a business.

Employer-sponsored health insurance remains the dominant means of providing private health insurance in the U.S. In 2006, about 90% of privately insured, non-elderly Americans received coverage through an employer-sponsored plan. While employer-sponsored insurance is encouraged through federal tax policy (it’s a business expense), group plans are almost always less costly than individual plans because they mitigate adverse selection and the costly underwriting practices that it engenders.

In contrast to individual life insurance, the demand for individual health insurance is quite small and attracts only a modest fraction of insurers. In 2003, for example, only about a quarter of the roughly 20% of Americans without access to an employer plan or public health insurance were covered by an individual policy.

The absence of a large, well-functioning market for individual health insurance is a key distinction between health insurance and virtually every other type of insurance.

There are several explanations for this:

· The business tax subsidy;

· A low level of consumer demand that results from either high premiums or younger adults’ myopic behavior;

· The “crowding out” of the private market by public health insurance programs such as Medicaid and State Children’s Health Insurance Program; and,

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· The greater likelihood of adverse selection in the individual market.

Blame the Healthy

To this list we want to add another problem—one that is fundamental to providing insurance where individual risk profiles evolve over time. To get a feel for the problem, consider for argument’s sake that all consumers start out in perfect health. Over time, some stay healthy, others come down with chronic conditions that are costly to treat. These chronic conditions become part of the individual’s medical record and indicate to the insurer a likelihood of higher future medical expenses.

As a result, consumers face two sources of risk. The first is that in any given year they will become ill and incur large medical expenses. The second, known as “classification risk,” is that they will be charged higher insurance premiums in the future, reflecting the higher cost of insuring them if they develop a chronic illness.

In an ideal world, consumers would be able to purchase insurance against both risks up front, when everyone was in good health. (For example, think life insurance.) Down the road, when the unlucky develop chronic conditions, the healthier consumers would end up subsidizing the less healthy members of the risk pool. This is the simple definition of an insurance pool.

While this would be a good deal for everyone initially (after all, nobody knows who the unlucky people are going to be), those who eventually find out that they are healthy have the incentive to jump ship. The problem is that, absent some means of tying the healthy individuals to the initial risk pool, the healthier individuals will, over time, find it advantageous to be re-underwritten by rival insurance companies at a premium that more accurately reflects their desirable health status. The only way this premium can be matched by the current insurer is by raising premiums on the individuals who have developed a chronic illness. As a result, attrition of good risks from the insurance pool can destroy insurance against the classification risk that is a natural consequence of evolving health status.

Obvious Solutions Abound

The problem is that consumers cannot credibly commit to remain with an insurer at a community-rated premium if they turn out to be healthier than the average member of the risk pool. One solution would be to have consumers sign long-term contracts that created a legal obligation to pay community-rated premiums for a specified period. But this is not feasible since courts have refused to enforce such contracts.

A second solution, which is common in term life insurance, is to charge front-loaded premiums in which a portion of the premium serves as a de-facto severance penalty should the insured individual switch to another insurer. Under this arrangement, purchasers would be rewarded for a willingness to prepay a portion of their future premiums with a contractual promise by the insurer to renew their policies at a community rate—regardless of any change in the insured individual’s health status. This provision, known as “guaranteed renewability,” is a standard feature of many life insurance policies.

Indeed, the Health Insurance Portability and Accountability Act (HIPAA) of 1996 mandates that individual health insurance policies include a renewal guarantee. The law does not, however, constrain the premium increases insurers may impose upon renewal. Many states have either prohibited or limited premium increases based on changes in the subscriber’s underlying health. Still, enforcement and compliance remain large question marks in light of the well-publicized difficulties that many with chronic medical conditions have encountered when attempting to purchase or maintain coverage in the individual market.

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Guaranteed renewability, however, faces more problems in health care than in other insurance settings. Many health insurers use financial incentives to restrict their customers to the use of a specified network of providers. Given the limited geographic scope of many networks, it’s possible that a person who relocated to another region would need to contract with a different insurer, in the process forfeiting both the prepaid portion of their premium as well as the protection against health-related increases in premiums guaranteed by their original insurer. In addition, premium prepayment creates a captive set of customers for the insurer.

In the case of life insurance, this lock-in creates few problems because the nature of the coverage is straightforward. By contrast, health insurers can behave opportunistically, because health insurance and medical care delivery are highly integrated. This can result in fewer network physicians, more restrictive drug formularies, longer waiting times and more stringent preauthorization reviews for expensive procedures.

This brings us to a third solution: Find another means of creating and maintaining stable risk pools in which individuals who remain in good health do not choose to exit the pool to obtain a lower premium. In a world where health insurance is tied to employment—and consequently where healthy individuals would typically have to leave their employer to avoid subsidizing the less healthy members of the pool—the link between health insurance and employment can create and perpetuate a stable risk pool for insurers.

Tying Workers to Their Insurance

A healthier-than-average person in an employer-sponsored health plan would need to find another employer with a healthier workforce to avoid subsidizing the less healthy. Finding such an employer (one that is equally desirable and which values him as much as his current employer), presumably requires some effort. Switching employers is costly and deters changing jobs to find a healthier risk pool.

In the absence of this deterrent, insurers would need to find other means of keeping premiums low enough to retain healthy workers in the pool. One way would be trimming insurance benefits. This reduces the payouts to the higher risk customers and, consequently, the premium charged by the insurer.

Insurance coverage is less valuable, relatively speaking, to healthy consumers than to the chronically ill who will use it more. So providing less coverage at a lower cost can prove more attractive to the healthy than carriers offering more extensive coverage that is above their actuarially fair rate.

This strategy is commonly observed in dental benefit plans, where the high copayments and restrictions on coverage for crowns and braces serve to keep the premiums low enough so that even those not needing such expensive procedures find it worthwhile to enroll in the program.

The degree to which insurers must trim benefits to keep the low-risk customers in the pool depends on the ease with which the customer can change employers. If switching jobs (and, by implication, insurers) is fairly easy, then the insurer needs to cut benefits a lot to keep premiums down to a level that the low-risk customers are willing to pay. Alternatively, if workers find it very difficult to change jobs, then the insurers do not have to worry so much about the good risks leaving, and the insurance plans offered can contain more generous benefits.

So there should be a positive relationship between the difficulty of moving between jobs, which we term job attachment, and the generosity of the health insurance offered.

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You would expect the degree of job attachment to increase with more specialized job skills. Ditch diggers or retail clerks, for example, have more potential employers close to home. Therefore, they will likely face similar working conditions on each job. They also have skills that are largely transferrable across employers, implying similar wages across employers.

By contrast, the manager of a manufacturing facility, a portion of whose skills may be specific to the products the facility produces or the people he or she manages, may be less valuable to another firm. A portion of the manager’s skills may be firm- or industry-specific, making it more difficult to find an employer who will pay a comparable salary.

Testing the Theory

The fact that job attachment varies significantly across occupations (and by extension, across employers with different occupational mixes) provides an opportunity to test the hypothesis that the long-term stability of an employment-based risk pool plays a role in determining the overall quality of the insurance coverage for workers. If true, this provides evidence that employer-sponsorship of health plans provides a mechanism for keeping good risks in the pool. This, in turn allows insurers to provide more complete coverage than might otherwise be the case.

To test this hypothesis for our 2003 RAND Journal article, we gathered data from the Department of Health and Human Service’s 1987 National Medical Expenditure Survey (NMES) on two measures of the overall amount of insurance provided through employer-sponsored health plans:

· The lifetime limit on benefits, which is arguably the best measure of the extent to which long-term, costly medical conditions are insured, and

· The annual stop loss, which is the level of expenditures above which a policyholder is no longer required to make copayments in a given year.

Data from the NMES on these measures were then matched to a numerical index of worker-level job attachment from the Department of Labor’s 1977 Dictionary of Occupational Titles, known as specific vocational preparation (SVP). (The SVP is defined as “the amount of time required to learn the techniques, acquire information and develop the facility needed for average performance in a specific job-worker situation.”)

A list of representative occupations by SVP quartile is displayed in Table 1. You can see how the job attachment relationship increases as the specific vocational preparation becomes greater.

The average SVP of a firm’s employees provides a measure of the average degree of job attachment in these firms.

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We then compared the two measures of insurance coverage, adjusting for other factors such as average income that might be related to both skill specialization and the amount of insurance purchased. Controlling for these other factors, we found that both the predicted lifetime benefit and the size of the stop-loss provision is strongly affected by the degree of employees’ attachment to their jobs. Those with the lowest level of job attachment in our sample have a predicted lifetime insurance benefit of $659,216, while those with the highest have a predicted benefit of $1,087,458.

Similarly, the lowest job attachment employees have a predicted annual stop loss of $3,060, while those at the highest level enjoy a stop loss of only $1,797.

We should note that our samples include only individuals with access to employer-sponsored health care, so the risk pools in our study already met a threshold level of job attachment. In other words, individuals with levels of job attachment so low as to preclude the offering of employer-sponsored health care are not even in our data.

What Does It All Mean?

As a result, we found there is a clear and strong relationship between the stability of the risk pool, as measured by job attachment, and the ability of insurers to offer more generous health care coverage. Thus the prevalence of employer-sponsored health plans is not solely an artifact of the preferable tax treatment or of the distributional economies associated with underwriting large groups but, rather, is in part a consequence of the fact that employee groups provide stable underwriting pools.

To the extent that attachment to your job within an employee group permits carriers to craft more generous employer-sponsored health insurance plans, the government should be very cautious about considering individual alternatives that might someday supplant the dominant model of employer-sponsored health care.

Keith Crocker, is the William Elliott Chaired Professor of Insurance and Risk Management at the Smeal College of Business at The Pennsylvania State University. kcrocker@psu.edu

Professor John Moran is a health economist in the Department of Health Policy and Administration at The Pennsylvania State University. Jrm12moran@psu.edu

Why Health Insurance Is Different

Underwriting, risk and carrier control all differ for health insurance.

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· Auto Insurance: Purchasers are reclassified annually on the basis of driving records and more often if the insured vehicle changes (reflecting differing probabilities of accident or repair costs). This reclassification is generally based on criteria that can be controlled by the insured.

· Life Insurance: This is generally issued for many years, well in advance of the death of the applicant. The insured is placed in a risk class at the time the policy is issued, and front loading of premiums with guaranteed renewability is common. While the contract may last for many years, the benefit is clearly defined and triggered by an easily verified event.

· Homeowners Insurance: Issued on an annual basis, and with risk reclassification based upon changing circumstances (such as the purchase of a pit bull or a trampoline, or the addition of a garage or a security system) that affects the actuarial cost of providing the coverage. Again, these reclassification criteria are generally within the control of the insured, and the insurance benefit is capped by the stipulated policy limits.

· Health Insurance: Generally issued on an annual basis with guaranteed renewability. Group plans are underwritten based on the loss experience of the group as a whole, but individuals are not reclassified based upon their own health status. Plans offered in the individual market may have reclassification, which in this case is often based on events (such as the occurrence of a chronic illness) that may be non-reversible and are beyond the control of the insured.

Proving Employer Benefits Are the Best Delivery System

Economists’ groundbreaking study is first to show employer sponsorship of health plans is the key to quality health insurance.

Economists Keith Crocker and John Moran collected data on employment-based health insurance contracts, along with information on key firm and worker characteristics, for roughly 2000 U.S. employers drawn from the 1987 National Medical Expenditure Survey, a large, nationally representative sample of the civilian, non-institutionalized population of the United States sponsored by the U.S. Department of Health and Human Services. These data were combined with a proxy for job attachment from the 1977 Dictionary of Occupational Titles, a publication of the U.S. Department of Labor which provides information on the physical demands, environmental conditions, and educational and vocational preparation associated with each of 12,000 occupations.

Using multivariate linear regression methods to control for firm- and worker-level factors that might otherwise confound the relationship between job attachment and the quality of health insurance, they found that firms with more job attachment offered more generous health insurance benefits, as measured by two key contract provisions: the maximum lifetime dollar benefit and the annual stop loss. To test the validity of their initial findings, they conducted a number of specification checks, including one based on a control group of firms that would not be expected to exhibit as strong a relationship between job attachment and insurance generosity. In each case, the data were consistent with a simple economic model of how group health insurance contracts adapt to differences in the long-term stability of employer-sponsored risk pools.

Their article, titled Contracting with Limited Commitment:Evidence from Employment-Based Health Insurance Contracts, can be read in its entirety in the Winter 2003 issue of the Rur

Blame It on the Healthy

Individual market is more expensive, more taxing, more misunderstood.

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By Molly Butler Hart

Don Quixote sang of the impossible dream in the Broadway musical “Man of La Mancha” to explain to Dulcinea his quest for the unreachable star. Today he could just as easily have been describing the quest to find an affordable health insurance policy in the individual market—for if not an impossible dream, it is at the least an anxiety attack for those who are in the market.

Conquering the individual health insurance market is daunting and drives home the point of how important employer group plans are to insuring most Americans.

“For anyone who is not young and healthy already, securing health insurance in the individual market is the impossible dream,” says lawyer Jennifer Jaff, founder of Advocacy for Patients with Chronic Illness.

Several years ago Jaff was housebound following surgery for an intestinal blockage related to Crohn’s disease. She went through the challenge of finding her own health insurance, settling on the Municipal Employees Health Insurance Program, offered by the state of Connecticut to cover small-business owners as part of a plan for state employees. But premiums doubled from $400 to $800 a month in just three years. She, like many Americans, worries about what will happen when next year’s premium increase rolls around. “My health could bankrupt me,” she says.

Jaff is full of horror stories of chronically ill individuals who are unable to obtain coverage or who are finding their carriers curtailing coverage. Her stories put a face on the problem of the individual market versus the employer-backed group market.

“Employers see the benefits of health care coverage in terms of productivity and recognize that lack of medical care is more deleterious to long-term profits,” explains Brian Klepper, a health care analyst based in Atlantic Beach, Fla. He sees an inherent conflict between public policy desire and what carriers see as good business. Klepper’s research shows that, while employers want to control the cost of health care, they do not want to opt out of helping provide it.

A major issue in the individual market is re-underwriting. As in the group market, individuals are placed into large pools when they are first underwritten for individual health insurance policies. As in group plans, some in the pool stay healthy while others grow ill. While it is illegal to re-underwrite an individual once they are established in the pool, there is nothing illegal about a healthy individual voluntarily jumping ship in search of a less expensive plan. And in contrast to the employer-sponsored group plans, there is no attachment to the risk pool—no job is holding a healthy individual back from leaving the group to seek less expensive insurance.

What is left in the old pool are the less healthy individuals, who watch their premiums continue to rise as the group becomes collectively less healthy.

And that’s where employer-sponsored plans have the advantage over the individual market.

Hart is a contributing editor. Molly.Hart@LeadersEdgeMagazine.com