Guaranteed Renewability in Health Insurance : How Much Frontloading?

In their seminal contributions, Pauly, Kunreuther and Hirth (1995) as well as Cochrane (1995) addressed the feature of time consistency and guaranteed renewability (GR) in insurance contracts. GR means an insurer's unilateral commitment to the continuation of the contract after the occurrence of loss; inreturn, the contract is frontloaded in order to generate the necessary reserves. As pointed out by Frick (1998), however, frontloading may be excessive. The empirical evidence presented by Herring and Pauly (2006) suggests frontloading to be less important than originally thought.The present contribution adds to the debate by introducing the full set of relevant transition probabilities. Whereas PKH consider only the likelihood of a favorable risk turning into an unfavorable one in the course of the planning period, the possibility of returning to favorable risk status is accounted for. This can be shown to reduce the amount of frontloading, with the extent of the reduction positively depending on the probability of returning to the low risk state. Premiums depend on the difference between a weighted average of both favorable and unfavorable less favorable risks' expected expenditure. Moreover, if the Markov process is complemented by death as a terminal state, the amount of frontloading decreases even more. A small illustration comparing the PKH-premium with the premium calculated in this model serves to show a significant reduction even over a five-year period. In conclusion, GR can be said to mitigate the problem of risk selection (in the sense of Newhouse (1996) that even high-risk individuals are offered contracts) in health insurance ceteris paribus to an even greater extent than previously claimed once the underlying Markov model is specified more completely