The bad economics of switching health-care plans.

The search for better economic policy.
Sept. 7 2007 7:29 AM

Taking Our Medicine

The bad economics of switching health-care plans.

Checking blood sugar.
Patients and insurers often haggle over diabetes-management supplies

In the long-simmering argument over what's wrong with American health care, recent polls show that many people blame our market-based system of private health insurance. Private insurance companies are faulted for, among other things, failing to do enough to prevent disease. They have no incentive to do so, argue advocates for reform, ranging from Michael Moore in Sicko to some of the current presidential candidates. And yet if preventive measures today result in savings on treatment tomorrow, then what's good medicine should also be good business.

Diabetes management is a case in point. If they get help early on in managing blood-sugar levels, diabetics can stave off later medical complications that may result in expensive hospital stays. Yet many of these preventive measures aren't covered or encouraged by insurers. Instead, patients are forced to haggle over reimbursement for insulin pumps, and most are rationed only four test strips per day to monitor their blood sugar (sometimes enough, but often not). If better access to insulin pumps and blood-sugar monitoring will save money in the long run, why are insurers so miserly with their diabetes customers?

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A recent study (not yet published) by researchers from Case Western Reserve and Carnegie Mellon University explains that the culprit in poor diabetes management—and the lack of preventive care in general—may be the very high rate at which Americans switch among insurance plans. It takes about a decade for insurers to recoup their investment in early diabetes treatment, and by then odds are that their customer has moved on to another health plan.Alas, a lot of this turnover may be built in to the way Americans get health insurance. And it's the doing not of individual patients so much as their employers, who are always on the lookout to switch plans for lower-cost coverage.

How often do Americans switch plans? Using data from the Community Tracking Study, a national household survey on health-care delivery, the authors estimate that 20 percent of policyholders switch insurers each year. Based on more-detailed data from a large regional insurer, they calculate that annual turnover may run as high as 30 percent, far too high to make back the cost of pre-emptive diabetes care, or subsidized gym memberships, or other front-loaded investments in good health.

High turnover of insurance plans isn't news to health-care providers. With coverage tied to an employer (or a spouse's employer), every time someone gets married, divorced, or moves to a new job, odds are he'll switch to a new insurance plan. But the five economists who conducted the new study show that this accounts for only half of all turnover—a surprisingly small share. The rest comes from entire employer groups switching among insurers.

Explaining the promiscuous relationship between employers and their health insurance providers presents a challenge to economic theory. Lots of insurance companies are out there vying for employers' business, and in that competitive economic landscape we would expect the "law of one price" to prevail. That is, all insurance companies should provide the same low-priced health coverage. If prices go up, insurers would be expected to undercut one another in an attempt to steal customers, driving prices back down.

But the real-world market for health insurance contracts falls far short of this theoretical ideal. The "law of one price" assumes that health insurers are all peddling a similar product, and that it's easy for customers to learn about and compare the various offerings available. But shopping for health insurance isn't like buying a stack of 2-by-4s—you make a few phone calls to find the lowest price. It's difficult and time-consuming to weigh the costs and benefits of insurance plans with different reimbursement rates for thousands of procedures, diverse physician networks, and differences in quality of patient care. In economists' terms, the insurance market has "search frictions." Since the search for alternative plans is expensive, companies get locked into a relationship with whoever happens to be their current provider.

What's a costly headache for insurance buyers is a profit-making opportunity for insurance sellers. Insurers know that it's hard for their customers to leave them, so they push up prices secure in the knowledge that employers will have trouble breaking free. So much for the law of one price—because of search frictions, big price differences across plans don't get whittled away by rivalry.

The authors of the new study argue, somewhat counterintuitively, that it's precisely these price differences that lie behind the high rate of employer switching. An employer may not be able to evaluate all competing choices, but it'll look for ones that present particularly promising alternatives to its current plan. And every few years, it'll find one. For large companies that effectively run their own insurance programs with the assistance of an insurance provider, this doesn't happen very often. But the authors calculate that smaller companies that require full insurance coverage make a change on average every five years. In other words, while the law of one price doesn't work well as a result of high switching costs, those costs are not so high as to prevent switching altogether.

Now that we've diagnosed the problem, can we develop health-care policies that will encourage preventive medicine? We could move to a system of universal health coverage, like Canada, France, Italy, and every other rich country on earth. That would get rid of turnover altogether. But it would also require fundamental changes to a system that has resisted major reform until now. And so as an alternative, the authors of this study suggest ways to tinker with the current model to reduce the search frictions that are responsible for much of the turnover problem.

Employers are tempted into switching because of price disparities across plans. A partial solution would be to legislate away these differences by capping what insurance companies can charge. This should reduce price differences between plans, and the incentive for employers to shop around for cheaper options. But where should the government set the ceiling? If it's too low, the government could end up destroying insurance companies' incentives to stay in business at all.

Another option is to make available a simple, easily understood, and reasonably priced health insurance plan. The authors argue that this would simplify an employer's search for good insurance and as a result, reduce the amount of switching. They suggest that the federal government could create a plan that all employers could choose to offer their workers. The authors wager that while most employers wouldn't use the federal plan, it would create the competition needed to drive down prices of private insurance. This modest proposal for government intervention won't satisfy Michael Moore or others pushing for a complete overhaul of American health care. But it may help to make Americans healthier while we wait for more ambitious reforms that are promised every electoral cycle but so far never delivered.

Ray Fisman is a professor of economics at the Columbia Business School and co-author of The Org: The Underlying Logic of the Office. Follow him on Twitter.

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