Unhealthy Insurance Markets: Search Frictions and the Cost and Quality of Health Insurance

We analyze the role of search frictions in the market for commercial health insurance. Frictions increase the cost of insurance by enabling insurers to set price above marginal cost, and by creating incentives for inefficiently high levels of marketing. Frictions also lead to price dispersion for identical products and, as a consequence, to increases in the rate of insurance turnover. Our empirical analysis indicates that frictions increase prices enough to transfer 13.2% of consumer surplus from employer groups to insurers (approximately $34.4 billion in 1997), and increase employer group turnover by 64% for the average insurance policy. This heightened turnover reduces insurer incentives to invest in the future health of their policy holders. Our analysis also suggests that a publicly-financed insurance option might improve private insurance markets by reducing distortions induced by search frictions.

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This paper was revised on July 13, 2009

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