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By DANIEL ALTMAN, DAVID M. CUTLER, AND RICHARD J. ZECKHAUSER*
Most employers providing health insurance offer a menu of plans and allow employees to choose the plan they prefer. As a result, the demographic mixes of insureds and, consequently, costs differ dramatically across plans. The average 60-year-old, for example, spends more than twice as much annually as the average 30-year-old. A single high-cost individual can incur costs equal to the total of several hundred low-cost insureds. Because of this variability, insurers are deeply concerned about how people choose their plans, as are employers and governments that finance and monitor them, and analysts who study them. We seek to understand who insures in which health-insurance plan, and why they do it. This information will enable us to correctly calculate cost differentials between plans, and to set premiums accordingly.
The mix of people in a plan in a particular year depends on who began there, and who moves in and out. Economists have long been fascinated by the movers. The tendency for sick (healthy) people to join plans offering rich ( lean ) services at high ( low ) cost is termed "adverse selection" (Michael Rothschild and Joseph Stiglitz, 1976; Charles Wilson, 1987). Most discussion of adverse selection, concentrating on the decision of whether to purchase insurance, focuses on high risks moving to very generous plans, with the low risks choosing to go without insurance coverage. But for mandatory or heavily subsidized insurance, such as employer-provided health care, everybody will be insured, and thus other groups might be important as well: low-risk movers seeking lower prices, new enrollees, and people who stay put.
We focus in this paper on why premiums differ so much across health-insurance plans. We show that adverse selection is quantitatively important, but that it is more a result of low-risk people moving out of generous plans than of high-risk people moving into those plans. We then document the opposite of adverse selection, a concept we term "adverse retention." Adverse retention is the tendency for people who stay put to magnify cost differentials between plans, as they will if they differ in age and costs are more than linear with age. We show that adverse retention has about 60 percent as large an...