Academic journal article Journal of Risk and Insurance

Yes, No, Perhaps? Premium Risk and Guaranteed Renewable Insurance Contracts with Heterogeneous Incomplete Private Information

Academic journal article Journal of Risk and Insurance

Yes, No, Perhaps? Premium Risk and Guaranteed Renewable Insurance Contracts with Heterogeneous Incomplete Private Information

Article excerpt

ABSTRACT

The article shows that heterogeneous incomplete private information can explain the limited existence of guaranteed renewable health insurance (GR) contracts in an otherwise frictionless markets. We derive a unique equilibrium that can be of the form that either only a portion of the population or none will cover themselves against premium risk with a GR contract. Increased risk aversion, increased premium risk, and first-order stochastic improvements of the distribution of private information increase the likelihood of positive take-up. In case GR contracts are in demand, increased risk aversion and first-order stochastic improvements of the distribution of private information lead to more individuals purchasing the GR contract.

INTRODUCTION

Premium risk plays an important role in repeated, long-term, or any other future insurance contracts. Premium risk refers to the uncertainty of the future insurance premium due to the evolution of individual risk factors. (1) It has mostly been discussed as related to health insurance although forms of (implicit) protection against premium risk are also observed for long-term care insurance or life insurance. One reason might be that medical expenses are extremely heterogeneous. Strictly speaking, premium risk refers to differences in expected costs. Pauly and Herring (2007) investigate the individual health insurance market and find that high-risk individuals (with above-median expected medical expenses) had approximately four times higher expected expenses than low-risk individuals (with below-median expected medical expenses).

At the same time, we do not observe that private insurance markets succeed to cover the majority of individuals in the United States. Starting in 2014, the Patient Protection and Affordable Care Act forces insurers to give up individual underwriting nearly completely (2) as markets obviously failed to provide a comprehensive protection of premium risk. Our article addresses the question of why this is the case and shows that the distribution of information among individuals can lead to scenarios where a substantial part of the population does not cover their premium risk.

Cochrane (1995) and Pauly, Kunreuther, and Hirth (1995) discuss ways of addressing premium risk in health insurance contracts. They both argue that a prepayment for the premium risk either explicitly in the form of premium risk insurance (PRI) or implicitly within guaranteed renewable long-term health insurance (GR) contracts implies that all individuals are completely covered against premium risk. Besides GR contracts as suggested by Pauly, Kunreuther, and Hirth and stand-alone PRI as discussed by Cochrane, community rating could remedy the premium risk problem (see Kifmann, 2000, 2001). These three ways of addressing premium risk differ in several dimensions. To implement stand-alone PRI, risk types must be observable and contractible, which is not easily satisfied. GR contracts, however, create a lock-in problem as individuals choose insurers early in life and might find it difficult to switch later in life because they would lose the prepayment. Furthermore, borrowing constraints and high levels of impatience could render GR contracts and stand-alone PRI unattractive (Frick, 1998). With community rating it might be hard to ensure efficient provision of medical services and to accommodate heterogeneous preferences over medical care. Consequently, there is no dominant solution.

There are several examples where premium risk is insured by front-loading in guaranteed renewable long-term insurance contracts sold in private insurance markets as life insurance (Hendel and Lizzeri, 2003) and long-term care contracts. In these two markets, early purchases mitigate severe premium risk problems. However, other insurance contracts expose individuals to significant premium risk in the future such as, for example, car insurance contracts and, unfortunately, most individual health insurance contracts in the United States. …

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