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MAY 2010
	 NUMBER 274

Chicag­ Fed Letter
Getting sick and paying for it
by Svetlana Pashchenko, visiting economist

In certain situations, Americans who become chronically ill have to pay higher rates to
continue their health insurance coverage. Indeed, although the majority of Americans
are insured, hardly anyone is fully protected against the risk that their next insurance
policy will cost considerably more than their current one.

Although illness can last for any period

Although illness can last for
any period of time, a typical
health insurance contract
lasts for one year.

of time, a typical health insurance contract lasts for one year. This means that
insurance contracts often have to be renewed while people are sick; and policyholders may be exposed to reclassification
risk—the risk that their premiums will
be increased because they are ill. In this
article, I examine how and to what extent
the current health insurance system in
the U.S. protects individuals against such
reclassification risk, and discuss some
potential solutions.
The textbook solution to insuring persistent medical expenses is a lifetime
health insurance contract. This would
insure individuals against not only the
current costs of their medical treatment,
but also future changes in their premiums due to, say, a chronic health condition. However, in a voluntary health
insurance system, healthy people may
opt out of such contracts, leaving the insurer with only relatively sick customers.
This would make the system unsustainable. In some developed countries (e.g.,
the UK and Italy), this problem is solved
by universal mandatory participation of
individuals in a nationalized health insurance system. In such a system, everyone
can obtain health insurance at a riskindependent rate, i.e., a rate that does
not depend on an individual’s health.
This type of insurance scheme relies on
risk pooling. In other words, the sick
are subsidized by the healthy. And the

universal mandate ensures that there
are always enough healthy participants
in the pool.
In the U.S., the primary source of coverage for non-elderly individuals is private health insurance obtained through
employers or purchased directly. Both
sources of coverage have their own mechanisms to protect individuals against
reclassification risk.
Employer-based insurance

About 63% of non-elderly adults in the
U.S. get their insurance through either
their employer or spouse’s employer.1
Employer-sponsored health insurance
partially protects participants against
reclassification risk because it allows all
employees in a plan to buy insurance at
the same basic rate regardless of their
health status. This is possible because
employer-based pools are usually large
and have enough healthy participants to
make average premiums insensitive to
health fluctuations of some individuals.
The participation of healthy individuals
in employer-based pools is supported by
two factors. First, the major part of the
health insurance premium is contributed
by the employer. In 2009, employers that
provided health benefits to their workers
contributed, on average, 83% of the
premium for single coverage and 73%
for family coverage.2 Second, employerbased health insurance premiums are

tax-deductible, while premiums on policies purchased by individuals in the private insurance market are not. This tax
deductibility of employer-based insurance premiums cost the federal government $200 billion in forgone revenue
in 2008.3
Of course, individuals can rely on riskindependent premiums only as long as
they have access to employer-sponsored

Individual private insurance

In the marketplace, profit-maximizing
insurance firms charge individuals a premium that reflects their expected medical costs conditional on their current
health status and their history of claims.
Currently, most states allow insurance
firms to medically underwrite applications for health insurance, i.e., to check
the medical history and health status

Those most exposed to reclassification risk are people who
have lost their employer-based health insurance.
insurance. Such events as job loss or
divorce can terminate coverage. In addition, the possibility of losing employersponsored health insurance creates a
situation whereby some healthy individuals who cross-subsidize unhealthy participants in an employer-based pool may
not get equivalent subsidies when they
get sick if their coverage is terminated
before they become ill.
One of the reasons behind the instability
of employer-based coverage is the limited number of firms that offer health
benefits to their workers. In 2009, about
60% of firms provided subsidized health
insurance to their employees.4 In order
for a firm to buy into a group insurance
plan that will cover all participants at
the same basic rates without adjusting
for health status, it has to have enough
workers to obtain a sufficiently diversified risk pool. In addition, it has to pay
them enough so that a wage adjustment
for the employer’s health insurance
expenses does not leave the worker with
an income below the minimum wage.
As a result, large firms are more likely
to offer employer-sponsored coverage
and high-wage workers are more likely
to be covered. In 2009, 98% of firms with
200 or more workers offered health insurance; among firms with fewer than
200 workers, the rate was only 59%.5 In
addition, in 2008 only about 19% of individuals with an annual income of less
than $25,000 were covered by employerbased insurance; among those with an
annual income higher than $75,000,
approximately 82% had coverage.6

of applicants. To reduce individuals’
exposure to reclassification risk, federal
regulations require insurers to write insurance contracts with guaranteed renewability. This means that a person cannot
be denied a renewal of health insurance
based on a claims history. This provision
was introduced at the federal level by
the Health Insurance Portability and
Accountability Act (HIPAA) of 1996.
This federal law does not put any restrictions on premiums charged at a renewal.
However, Patel and Pauly7 found that
47 states require premiums at a renewal
to be the same for all individuals within
a risk class.
Guaranteed renewability with limitations
on premium increases on renewal assures
some protection against reclassification
risk. However, this does not represent
full protection, because insurance firms
can legally rescind a policy at a later date.
At some point after a policy has been
issued and claims submitted, an insurance company may choose to conduct
post-claims underwriting. This is a detailed and costly investigation, so it is
usually undertaken on policies that have
become very expensive for the insurer,
e.g., because the insured individuals have
become seriously ill. Post-claims underwriting may result in a policy being retroactively canceled, which means that not
only is the coverage terminated but the
insurance company is no longer responsible for the claims previously submitted.
Insurers can only do this if they discover
new information that would have mattered when the application for the policy

was first considered. In many states, there
is no requirement that the information
be related to the claim that triggered
the insurance company’s investigation.
For example, a person who is diagnosed
with cancer can have his policy rescinded
if the post-claims investigation discovers
that he did not report some health problem that has no connection with the
cancer. The total number of policies
rescinded is not large relative to the number of existing policies. For instance, in
Texas in 2007, fewer than 1% of the total
number of policies in force were rescinded.8 However, because rescissions are
usually concentrated in policies with the
most expensive claims, policy termination
occurrence is higher among people who
experience a health status deterioration.
Transition from employer-based to
individual coverage

Those most exposed to reclassification
risk are people who have lost their
employer-based insurance, usually as a
result of job loss or change, and have to
buy their own insurance in the marketplace. HIPAA guarantees that eligible
individuals who lose their employer-based
insurance (either voluntarily or involuntarily) can obtain coverage in individual
markets, provided that they 1) are not
eligible for another group insurance plan
and 2) have exhausted the continuation
coverage on their previous plan. Continuation coverage is an arrangement that
allows people to maintain the same
group coverage they held through their
previous employer for some fixed period.
At the federal level, continuation coverage is provided through the Consolidated
Omnibus Budget Reconciliation Act
(COBRA) of 1985.
While HIPAA guarantees access to insurance for workers who have lost their
employer-sponsored insurance, it does
not protect them against increases in their
health insurance premiums; in the private
insurance market, their rates will no longer be risk-independent but will be based
on their current health status. Only a few
states restrict the rates that people transitioning from employer-based coverage
may be required to pay for health insurance in the individual market. One option
available for HIPAA-eligible individuals

in many states is to buy coverage through
high-risk pools. High-risk pools were originally designed to provide subsidized
coverage for those who are denied coverage or face too high of a rate in the
individual market. Many states also use
high-risk pools to help those who lose
employer-based insurance to obtain coverage. Out of 33 states that have high-risk
pools, 29 of them cover HIPAA-eligible
individuals.9 The premiums in high-risk

is guaranteed issue, which forbids insurers from denying coverage based on
the individual applicant’s health status.
However, community rating combined
with guaranteed issue may have unintended consequences that would make
the coverage more expensive for everyone. Specifically, healthy people may
wait to buy insurance until their health
status deteriorates, leading to increases
in premiums that encourage additional

Any interruption of health insurance coverage may lead to a
situation where a new health insurance contract can be
obtained only at a significantly higher rate, if at all.
pools are higher than average standard
rates in the individual market—they are
typically capped at a level of 150% to
200% of the standard rates. A second disadvantage of these pools is that people
with pre-existing conditions often face
a waiting period after they enroll. During
the waiting period, any treatment related
to their pre-existing condition is not covered. Enrollment in high-risk pools is
small, constituting, on average, less than
2% of individual market participants.10
Increasing protection against
reclassification risk

Approaches to increasing protection
against reclassification risk fall into two
main categories. The first approach imposes more restrictions on the ability of
insurance firms to risk-adjust premiums
and deny coverage—I call this the regulatory approach. The second approach
eases existing regulations and relies more
on market mechanisms—I call this the
free market approach.
The problem of reclassification risk
arises because insurers charge people
different premiums based on their health
status. The key to the regulatory approach
is forbidding insurers from charging
prices based on health status. This type
of restriction is known as community
rating. The downside of community
rating is that it creates an incentive for
insurers to deny coverage altogether to
high-risk individuals. Because of this,
another regulatory restriction often proposed together with community rating

healthy people to postpone the purchase
of insurance. That is why the regulatory
approach often favors a mandate requiring all individuals to purchase health insurance. In effect, the combination of
community rating, guaranteed issue, and
mandatory participation creates an enforced pooling that complements currently predominant employer-based pools.
Some states have already implemented
some elements discussed in the regulatory
approach. Six states11 have a combination of community rating with guaranteed issue.12 One state, Massachusetts,
has introduced mandatory participation.
The health insurance reform bill approved
by the U.S. House of Representatives
on March 21, 2010, and signed into
law by President Barack Obama on
March 23 includes major elements of
the regulatory approach.
The free market approach, advocated by
John H. Cochrane,13 is based on the idea
that reclassification risk, like any other
risk, can be insured. As proposed by
Cochrane, on top of insurance against
medical expenses incurred within a contract year, people could also buy health
status insurance that protects them
against future higher premiums should
their health deteriorate.14 That is, once
an individual develops a chronic health
condition, he could still get health insurance at the same rate because the
increase in his premiums is paid by health
status insurance.
In essence, health status insurance is a
long-term contract. As such, it requires

an enforcement mechanism because
otherwise, individuals who turn out to
be healthy will drop their health status
insurance coverage. One solution proposed by Cochrane would be the creation of special health status insurance
accounts that could be used only for the
purpose of paying health status and
medical insurance premiums.
Some of the existing regulations of the
health insurance system are not highly
compatible with health status insurance.
First, because of preferential tax treatment, employer-sponsored insurance
dominates other insurance options. An
individual who expects to get an offer of
employer-based coverage is not likely to
commit to a long-term health status insurance contract. At the same time, people who lose employer-based coverage do
not have health status insurance and
thus have to face the full burden of riskadjusted premiums in individual markets.
Because of this, the leveling of the
playing field between employer-based
coverage and individual insurance is one
of the conditions necessary for health
status insurance to represent a viable
approach to addressing reclassification
risk. Furthermore, existing restrictions
on risk adjustment of premiums in individual markets create incentives for insurers to either deny coverage altogether

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Chicago Fed Letter is published by the Economic
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and do not necessarily reflect the views of the
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or provide partial coverage, e.g., excluding treatments related to pre-existing
conditions. Health status insurance protects people against fluctuations in premiums, but it cannot do much in an
environment where premiums are restricted from varying by a wide margin,
with insurance companies denying
coverage to those who are very sick.


The current health insurance system
provides only limited protection against
reclassification risk. Most people obtain
their insurance at a risk-independent
rate through their employer. People
with continuous coverage in individual
markets are mostly protected by the
guaranteed renewability provision.

1	 U.S. Census Bureau, 2008, Current

Health Affairs, August 28, pp. W280–W289,
available at

Population Survey.

2	 Kaiser Family Foundation and Health

Research and Educational Trust, 2009,
“Employer health benefits: 2009 summary
of findings,” report, September, available

	 Hilary Haycock, Meredith King Ledford, and


Peter Harbage, 2009, “Primer on post-claims
underwriting and rescission practices:
Findings from Texas in the individual
health insurance market,” Robert Wood
Johnson Foundation, report, August,
available at

3	 Jason Furman, 2008, “Health reform through
tax reform: A primer,” Health Affairs, Vol. 27,
No. 3, May/June, pp. 622–632.

	 Kaiser Family Foundation and Health

11	 hese states are Maine, Massachusetts, New
Jersey, New York, Vermont, and Washington.

12	 aiser Family Foundation,

13	 ohn H. Cochrane, 2009, “Health status insurJ
ance: How markets can provide health security,” Policy Analysis, Cato Institute, No. 633,
February 18, available at

	While explicit health status insurance con-




However, any interruption of coverage
may lead to a situation where a new health
insurance contract can be obtained only
at a significantly higher rate, if one can
be obtained at all. Given that 86.7 million
non-elderly Americans experienced
some interruption in coverage during
2007–08,15 reclassification risk is an important issue to address.



Research and Educational Trust (2009).


	 U.S. Census Bureau, 2008, Current


Population Survey, Annual Social and
Economic Supplement.

	 Vip Patel and Mark V. Pauly, 2002, “Guaran-


teed renewability and the problem of risk
variation in individual insurance markets,”

tracts are not available, Cochrane (2009)
states that an insurance product with similar
features has recently become available
from UnitedHealth Group.

	 Kaiser Family Foundation,

	Karen Pollitz and Eliza Bangit, 2005, “Federal
aid to state high-risk pools: Promoting
health insurance coverage or providing
fiscal relief?,” Commonwealth Fund, ­
issue brief, November, available at www.

	Families USA, 2009, “Americans at risk: One


in three uninsured,” report, Washington, DC,
March, available at

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