Optimal Long-Term Health Insurance Contracts: Characterization, Computation, and Welfare Effects

Abstract

Reclassiffication risk is a major concern in health insurance where contracts are typically one year in length but health shocks often persist for much longer. While most health systems with private insurers pair short-run contracts with substantial pricing regulations to reduce reclassi_cation risk, long-term contracts with one-sided insurer commitment have significant potential to reduce reclassiffication risk without the negative side effects of price regulation, such as adverse selection. We theoretically characterize optimal long-term insurance contracts with one-sided commitment, extending the literature in directions necessary for studying health insurance markets. We leverage this characterization to provide a simple algorithm for computing optimal contracts from primitives. We estimate key market fundamentals using data on all under-65 privately insured consumers in Utah. We find that dynamic contracts are very effective at reducing reclassification risk for consumers who arrive to the market in good health, but they are ineffective for consumers who come to the market in bad health, demonstrating that there is a role for the government insurance of pre-market health risks. Individuals with steeply rising income profiles find front-loading costly, and thus relatively prefer ACA-type exchanges. Switching costs enhance, while myopia moderately compromises, the performance of dynamic contracts.