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Why are entrepreneurs paying too much for health insurance?

Brian O'Connell

Healthcare entrepreneurs, like most business owners, consider themselves good stewards of their own financial fiefdoms.

And that may be true – up to a point. Spending on office leases and company vehicles is pretty routine – and what business owner hasn’t read up on Six Sigma to learn how to cut costs?

But that point ends when it comes to healthcare spending.

Healthcare spending is the pulsating lava of the business capital landscape, forever changing shape and direction and leaving even the brightest bean counters unsure of where their healthcare budgets are going next.

Maybe that’s why so many healthcare business owners spend so much on healthcare for their employees – and they likely don’t even know it.

That’s the conclusion of new research that was freshly published in the American Economic Review (August 2011 edition). The article, titled “Unhealthy Insurance Markets: Search Frictions and the Cost and Quality of Health Insurance,” was penned by James Rebitzer, an economics professor at Boston University School of Management, assisted by Mark Votruba and Randall Cebul (both at Case Western Reserve University’s Weatherhead School of Management), and Lowell Taylor from Carnegie Mellon University.

In it, the authors acknowledge that business healthcare plans, especially ones for small business, are notoriously dynamic, and can change all the time. They also openly wonder why this is so, and why business owners routinely change plans (probably to gain more coherence and get a better price). That “turnover” should open up competition among healthcare plan providers, Rebitzer says.

But business owners likely engage in turnover behavior, and price-chasing tactics, because they’re just not comfortable with how healthcare plans are supposed to work. And they aren’t getting much help from providers. In the end, like a dog chasing its own tail, startup owners usually wind up paying more than they should for a good plan for their workers.

The authors do have an idea why this is so. After all, “if markets are competitive, plans of similar value should be offered at similar prices,” notes Votruba. “It’s costly to switch plans, so if employers are switching plans all the time, it suggests that something is impeding competition.”

What the researchers found was a phenomenon they dubbed “search friction” – a mindset that leads business owners to overplay their financial hand when shopping in the health insurance market.

Essentially search frictions occur when consumers – in this case business owners – cannot adequately compare “all of the options available in the marketplace”.

"Consumers have hundreds, sometimes thousands, of different options, and each plan has its own unique set of benefit details,” Votruba explains. “In this complex environment, it’s hard for consumers to find the plan that offers them the best value. What our paper shows is that this 'shopping problem' has important implications for how market competition plays out. If consumers have a hard time evaluating value, competition becomes less about value, and more about marketing."

Evidently, search friction allows for a “back door” for health insurance providers to collude to drive prices up, and not down.

This from the report:

A hallmark of markets with search frictions is that the law of one price breaks down. Instead of competition forcing all insurers to offer similar plans at a similar low price, frictions enable many insurers to profitably pursue high margin/low volume strategies. The net effect is that consumers end up paying more for their health insurance – 29 percent more on average in the small group market – and insurers spend more on marketing.

There’s more. Search friction can trigger emotional responses from entrepreneurs, who may not feel fully vested in quality programs, but programs with better rates.

"High turnover rates undermine the quality of health plans by reducing insurers’ incentive to finance care that makes their policyholders healthier in the future," Cebul adds. "Why spend money on wellness or disease management programs – programs which yield a return on investment only after several years – for a policyholder who probably isn’t going to stick around long?"

Can ObamaCare, if it ever kicks in, help business owners fight back against search friction? Maybe.

“In theory, it should,” said Rebitzer, “as long as they are designed so that shoppers can easily evaluate the value that they should expect for the prices of different plans. We will know that the exchanges are successful if turnover rates and marketing expenses decrease.”

So stay tuned – more help could be on the way. In the meantime, spend more time calculating your vulnerability to friction over fractions when evaluating healthcare costs.

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