Small Businesses Overpay for Health Insurance, Researchers Find

Will health insurance exchanges cure what ails the individual and small group markets?

By Stephen Miller, CEBS Sep 1, 2011

Small businesses in the U.S. have been overpaying for health insurance, according to research published in the August 2011 issue of American Economic Review. The article, “Unhealthy Insurance Markets: Search Frictions and the Cost and Quality of Health Insurance,” finds that the difficulties of comparison shopping increase average health insurance premiums paid by small businesses by 29 percent.

The article is by James Rebitzer, a professor of management, economics and public policy at Boston University's School of Management; Mark Votruba, an associate professor of economics and medicine at Case Western Reserve's Weatherhead School of Management; Randall Cebul, a professor of medicine at Case Western Reserve’s School of Medicine and director of the Center for Health Care Research & Policy at MetroHealth Medical Center in Cleveland; and Lowell Taylor, a professor of economics at Carnegie Mellon's Heinz College and former senior economist for President Bill Clinton’s Council of Economic Advisers.

High Plan Turnover Rates

As the researchers 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 Votruba. “It’s costly to switch plans, so if employers are switching plans all the time, it suggests that something is impeding competition.”

The researchers concluded that they observed a phenomenon economists refer to as “search frictions,” which arise whenever consumers are unable to easily compare all the options available to them in the marketplace. This, they argue, is 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,” Votruba said. “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."

A hallmark of markets with search frictions is that the “law of one price” breaks down. Instead of competition forcing all 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 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, which yield a return on investment only after several years, for a policyholder who probably isn’t going to stick around long?"

Health Insurance Exchanges Help, in Theory

If search frictions in health insurance markets cause small businesses to pay too much for low-quality policies, can the state-run health insurance exchanges mandated by the health care reform law, set to launch beginning in 2014, do better?

“In theory, they should,” said Rebitzer, “as long as they 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.”

In Massachusetts, however, the state-run exchange has not been embraced by small businesses, according to Sandy Reynolds, executive vice president of Associated Industries of Massachusetts, an employer group. Speaking at the 2011 Society for Human Resource Management's Employment Law & Legislative Conference last March in Washington, D.C., she remarked that the expectation had been that small employers would use the "Health Connector"—the state-run insurance exchange that Massachusetts launched in October 2006—to purchase group policies.

"That hasn't happened," Reynolds said. One reason: "Employers want to keep working with a broker who brings them options, explains the differences among policies and makes recommendations," she pointed out. "Employers have very strong relationships with their brokers" that they want to maintain, the Massachusetts' experience revealed.

"It's been hard for the Connector to compete with the private market," Reynolds added. She said the state was planning to revise its rules for the Connector, seeking to make it more user-friendly.

The Affordable Care Act defines a small employer as an employer having at least one but no more than 100 employees. However, it provides states the option of defining small employers as having at least one but not more than 50 employees in plan years beginning before Jan. 1, 2016.

Generally, if you have fewer than 100 employees (using the definition for full-time equivalents) you will be purchasing coverage in the small group market.

Stephen Miller
, CEBS, is an online editor/manager for SHRM.

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