Horizon effects and adverse selection in health insurance markets

This paper highlights the idea that increasing the length of insurance contracts can reduce adverse selection in health insurance markets while preserving community rating. Private health insurance contracts in the United States have short, one-year terms, even though health risks may be serially correlated. Intuitively, because risk is mean-reverting, longer contracts allow for pooling of risk within individuals over time, as opposed to just across individuals with traditional short-term contracts. In equilibrium, such horizon effects lead to lower premiums and greater coverage. The mechanism depends on two key conditions. First, the pooling of risk within individuals is the greatest when mean reversion in risk is intermediate. Second, two-sided commitment is present to preserve community rating. Counterfactual analysis using administrative claims data illustrates that a simple reform that implements two-year instead of one-year contracts could increase equilibrium coverage and yield non-trivial welfare gains on net, in spite of restricting consumer choice.