Reclassification risk is a major concern in health insurance where contracts are typically one year in length but health shocks often persist for much longer. While most health systems with private insurers emphasize short-run contracts paired with substantial pricing regulations to reduce reclassification risk, long-term contracts with one-sided insurer commitment have significant potential to reduce reclassification risk without the negative side effects of price regulation, such as adverse selection. In this paper, we theoretically characterize optimal long-term insurance contracts with one-sided commitment, extending prior models of this form in several key directions that are important for studying health insurance markets. We leverage this characterization to provide a simple algorithm for computing optimal contracts from primitives. We estimate key market fundamentals using data on all under-65 privately insured consumers in Utah and pair these estimates with our model to study comparative statics related to contract design and welfare. We find that the welfare value of a system that effectively implements these long-term contracts depends crucially on (i) the degree of public insurance pre-system health risk (ii) the distribution of expected lifetime income gradients in the population (iii) the stochastic process governing life-cycle health shocks (iv) the extent of consumer switching costs and (v) the degree of consumer myopia.
Reclassification risk is a major concern in health insurance where contracts are typically one year in length but health shocks often persist for much longer. We use rich individual-level medical information from the Utah all-payer claims database to empirically study one possible solution: long-term insurance contracts. We characterize optimal long-term contracts with one-sided commitment theoretically, derive the contracts that are optimal for consumers in Utah, and assess the welfare level that a full implementation of these contracts could achieve relative to several key benchmarks. We find that dynamic contracts perform very well for the majority of the population, for example, eliminating over 94% of the welfare loss from reclassification risk for individuals who arrive on the market at age 25 in good health. However, dynamic contracts instead provide very little benefit to the worst pre-age-25 health risks. Their value is also substantially lower for consumers whose income growth with age is relatively high. With pre-age-25 insurance in place, consumers with flat net income prefer dynamic contracts to an ACA-like environment, but consumers with steeper income profiles prefer the ACA-like environment. Overall, we show that there are scenarios in which dynamic contracts can provide substantial welfare benefits, but that complementary policies are crucial for unlocking these benefits.