May 2007
Risk and Regulation: A New Look at the Individual Health Insurance Market
Providing health insurance for the 45 million Americans without coverage will be one of the leading domestic issues in the next election. Most people who are uninsured do not have the opportunity to purchase coverage through an employer, and have access to coverage only through the individual insurance market. That market has been the subject of controversy. At one extreme, it is described as a failed market that must be reformed through extensive regulation or replaced by the expansion of government programs. At the other extreme, it is held out as the best hope for providing cost-effective coverage for the uninsured and many of those now covered through their employers or public programs.
Participants at this health policy discussion presented new research on the actual performance of this important but often misunderstood part of the health-care system. In a new article published in Health Affairs in early May, Mark V. Pauly of the University of Pennsylvania and Bradley Herring of Emory University present new findings on how insurance companies pool risk in the individual market and how various state regulations affect premiums and the degree of coverage. Based on this research, the authors used these findings to discuss how policymakers might use individual health insurance as a more effective tool to expand coverage.
Mark V. Pauly
Wharton School, University of Pennsylvania
AEI
Our study addressed two features of the individual health insurance market: how premiums vary with health status and how coverage varies with health status--and how those two relationships exist in states with community rating regulations through which an insurer must charge the same premium for the same policy to everyone in a community.
While the individual health insurance market is imperfect, our findings dispel some common misconceptions. For example, we did not find that health insurance premiums are proportional to risk, that community risk rating greatly reduces risk pooling, or that state regulations either protect many high-risk people or prompt adverse selection that could completely undermine the insurance market.
We did find that individual health insurance premiums display patterns strongly consistent with guaranteed renewability--a multi-period insurance contract by which individuals' premiums are comprised of two parts: one that pays for expected care in the present, less risky period; and a second that is saved to keep premiums affordable in the future when there is a higher probability of claims. One important implication of guaranteed renewability is that a component of premium cross-subsidization--whereby premiums of low-risk individuals subsidize those of high-risk individuals--actually comes from low-risk individuals' premiums in the previous period, when everyone was low-risk. In addition, we found that even in the absence of community rating regulations, individual health insurance effectively pools 85-89 percent of chronic condition risk.
Our present study is an improvement over the former. Not only do we have better data, but we also examine the possibility of self-selection bias by which the high-risk individuals in the data set may not actually be a random group of high-risk people. We also investigate how rising health-care costs affect the amount of risk pooling. Although insurers may be more careful in writing insurance policies, individuals may be more effective policy shoppers.
State rating regulations in the individual market appear to limit variation in premiums and coverage due to health condition-related expenses, but not by much. In states with no rating regulation, there is a negative effect of condition-related expense on coverage and probably a positive effect on premiums. Regulation does, however, increase the proportion of uninsured.
Neither rating regulation nor unfettered risk rating appears to have large adverse consequences in the individual market. Moreover, rating regulations may not be overwhelmingly necessary, as there is considerable pooling without such regulations. Policy might be best aimed at subsidizing premiums to account for the front-loading of premiums and the higher administrative costs of the individual health insurance market.
Bradley Herring
Emory University
Evidence for our study came from three data sets: the Medical Expenditure Panel Survey for 1996-2002, the Community Tracking Study's Household Survey for 1999 and 2001, and the National Heath Interview Survey for 1999-2004. From these data we created an expected medical expense for a person based on certain chronic conditions.
The results of our inquiry indicate that premiums increased with risk, but much less than proportionally. The most important risk factors in predicting higher premiums are the person's age and gender; the presence of chronic conditions has only a small effect on premiums relative to its effect on risk.
In the analysis of how regulation affected the relationship between risk and premiums, we found that there was a small but positive effect of health conditions on premiums only in the unregulated states. There was no statistically significant relationship between risk and premiums in regulated states. Concerning the effect of rating regulation on the relationship between risk and coverage, we found that regulation increased the likelihood of coverage for high-risk individuals by 7.1 percent to 8.5 percent relative to unregulated states. In other words, high-risk people in unregulated states were 91.5-92.9 percent more likely than an average-risk person to obtain coverage; in regulated states, there was no difference in the likelihood of coverage by risk level. This modest difference, however, did not mean that regulation helps the uninsured. In fact, it pushed low-risk people out of coverage through the increase in premiums while drawing high-risk people into coverage. Overall, regulations reduced the proportion of eligible people in the individual market with insurance by 6.0 percent to 7.4 percent.
John Bertko
Humana
Two key components of individual health insurance rating are rating at policy issue and rating at policy renewal. In most states, when a policy is first issued, the applicant undergoes a detailed underwriting process with questionnaires and sometimes medical tests. The three possible outcomes are acceptance at standard individual health insurance rates, acceptance with higher premiums in the presence of certain conditions or exclusion of payment for pre-existing condition treatments, or denial of coverage. When the policy expires, active life reserves are established to compensate for the fact that the medical loss ratio increases over time as people's probability of illness approaches the population's mean probability of illness. This concept is analogous to guaranteed renewability.
Actuaries are able to extract profit as long as there is stability and rationality in whatever regulatory burdens the state imposes. Because employers typically cover around 75 percent of the cost of health insurance, subsidizing the premiums of those purchasing health insurance in the individual market would be an effective way to promote its uptake. Participation rates in Medicare Part D indicate the positive effects of premium subsidies in the individual market.
Mark Hall
Wake Forest University Law School
Pauly and Herring's work shows us that the individual market can work well. It tells us what is happening by citing the evidence rather than by speculating or just pointing to the most distasteful aspects of the market. There is more risk-pooling going on in this market than one might expect, and that certainly has policy relevance. We need more information about measures of chronic illness, about impact of chronic disease on health expenses, and about the accuracy of premium measurements.
There are still problems in the individual market. Pauly and Herring have not shown that risk selection and underwriting are not occurring. Their findings are consistent with entry into the individual market being low risk and carefully selected, with chronic conditions emerging over time. This can occur through natural aging of the population, regression to the mean, or adverse retention (whereby sicker people keep their policies and healthy people go elsewhere). The turnover rate in the individual market is very high.
The market does work well for those who get in at a good stage and stick with it. We ought to compare the level of risk pooling for those in the individual market with the level of risk pooling for those in the group market; there is probably not as much risk pooling in the latter as in other market structures. The finding that regulation cannot fix the market because it drives out low risks as well as brings in high risks is discouraging. The individual market serves an important adjunct function, but it is not working well enough to become the basis for a new health system.
Thomas P. Miller
AEI
The standard view of the individual market is that the insurer and the insurance agent have their way with the innocent consumer. There is, however, not enough risk rating going on in this market to negate substantial risk pooling. At the margin, underwriting will cost more than it is worth to an insurer in lower future claims costs. Insurers need repeat business and they face competition, so they have to sell to less-than-perfect consumers, too. All of this helps maintain substantial risk-pooling within the individual market. Even some insurance at a risk-rated premium is better than paying for large medical bills out-of-pocket. Risk classification does not eliminate all pooling, but it may reduce its scale and scope.
Guaranteed renewability is a hybrid because it allows for initial risk rating of individuals, then pools the risk experience of an entire class or book of business at periods of renewal. There are good and bad incentives to being implicitly locked into a single insurance issuer for many years. There may be interesting theories for improving the guaranteed renewability or long-term pooling of individual insurance products, but they have not been demanded or supplied thus far, which suggests that the current market is working well enough.
State-based regulation can change the product mix and distribution of payers, but it appears to work out as neutral or negative in terms of the total number of insured. It also distracts regulators from addressing more important issues of affordability and value.
There are three basic problems in the individual market, but they are being addressed in the wrong order. We should focus first on bringing down load factors, then on the tax financing structure, and finally on the uncertainty of risk variation, which currently gets the most focus. Informational components in the insurance market also need improvement. Rather than encouraging more regulation, we should target subsidies on the basis of risk and income, then reduce non-price barriers to individual insurance purchasing. Providing consumers with better comparative information about what is actually available in the individual insurance market and how to access it may be just as effective as modest subsidies in expanding coverage.
AEI health policy program manager Elizabeth Walker and research assistant Jonathan Stricks prepared this summary.
