Comparison Shopping Causes Small Business Employers to Overpay forHealth Insurance

An article in the American Economic Review finds that small
businesses have been over-paying for
health insurance. The article “Unhealthy Insurance
Markets: Search Frictions and the Cost and Quality of Health Insurance”
highlights the difficulties small employers have in searching for health
insurance. The difficulties of comparison shopping increase average health
insurance premiums paid by small businesses by 29%.

When James Rebitzer, Boston University School of Management and research
colleagues Mark Votruba and Randall Cebul, both at Case Western Reserve
University’s Weatherhead School of Management, along with Lowell Taylor,
Carnegie Mellon University, began taking insurance markets’ vital signs a
few years ago, one fact particularly captured their attention: small employer
groups changed plans very frequently.

“If markets are competitive, plans of similar value should be
offered at similar prices,” Votruba stated in a press release. “It is
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.” The study of search frictions is an
important part of the economics of labor markets. This paper is the first to
apply these theories to the operation of health insurance markets.

Search frictions arise whenever consumers are unable to easily compare
all the options available to them in the marketplace. This, Votruba, Cebul,
Rebitzer and Taylor argue, is exactly 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 stated.
“In this complex environment, it is 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% more on average in the small
group market — and insurers spend more on marketing.

Search frictions also 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 — programs which yield a return
on investment only after several years — for a policyholder who probably
is not going to stick around long?”

If search frictions in health insurance markets cause small businesses
to pay too much for low quality policies, can the health insurance exchanges
mandated by the health care reform law do better? This paper’s findings
suggest they probably can.

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

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