Social Norms as Market Regulation: The Case of Pre-PPACA Nongroup Health Insurance

The debate over pre-PPACA (Obamacare) nongroup health insurance has heated up again recently, particularly on the issue of rescissions (cancellations of policies). John Goodman claims that before the PPACA, rescissions almost never happened except in cases of fraud.

Nevertheless, one problem with the nongroup market in many states was denial of applications for coverage from those who had prior health problems. Denial of coverage happened frequently even in states without onerous community rating provisions that gave health insurers a clear incentive to deny coverage to high risks. Why did health insurers choose to deny coverage altogether to these applicants rather than charge them a higher rate or offer more restricted coverage?

In some cases, government regulation was to blame. The “managed care” revolution of the 1990s introduced certain innovations designed to control health care costs, such as “elimination riders,” which would remove coverage from pre-existing conditions, and requirements to obtain referrals from primary-care physicians for access to specialist care. Managed care apparently worked to control health care costs, up to about 1-1.5% of U.S. GDP had it been allowed to take its long-run course. But it was unpopular, as constraints always are, and many states passed laws banning elimination riders and mandating direct specialist access.

Even without government regulation, however, social pressure caused the disappearance of some of these practices. On this point, there are two fascinating, complementary pieces of research: “The Death of Managed Care: A Regulatory Autopsy” by Mark Hall of Wake Forest University and “Risk Pooling and Regulation: Policy and Reality in Today’s Individual Health Insurance Market” by Mark Pauly of the Wharton School at the University of Pennsylvania and Bradley Herring of Emory University.

Hall investigates the role state laws played in the death of managed care, and found, surprisingly, that most health insurers abandoned their more unpopular practices even before legislation. One of the explanations he considers he calls the “symbiotic thesis” (431):

One example documented elsewhere is the ability of law to stimulate or reinforce social and industry norms that convey a sense of inappropriateness in engaging in prohibited practices (Cooter 2000; Hall 1999; Posner
2000). Ceasing or changing such practices is not done solely because it is illegal, because compliance is more extensive than actual enforcement would predict. Instead, compliance is also driven by social and industry norms that are shaped in part by the legal sanction. Regulations might either change industry norms or strengthen existing ones, for instance by highlighting noncompliance by marginal firms. Another example is the rise of PPOs. This might be seen as a market-driven preference for lighter managed care or instead as the market ascendancy of a type of managed care organization that is subject to less regulation or that has more flexibility in responding to regulatory constraints (Draper et al. 2002).

Hall interviews CEOs and other high-ranking officials of health insurance companies about their practices and their reasons for those practices. (He also interviews regulators, consumer advocates, and “industry observers.”) For instance, health insurers dramatically scaled back “medical necessity” reviews and cited avoiding public “backlash” and improving “public image” as more important reasons than legal changes (443). In other cases, both law and social pressure were irrelevant to changes that insurers simply made for market reasons. Finally, some large, nationwide insurers made significant changes to their business model nationwide when only a few states had passed new regulations. Thus, regulations in some states may have had some impact elsewhere.

The “symbiotic thesis” takes on greater plausibility, I think, when we turn next to the Pauly and Herring piece from 2007. Pauly and Herring examine “risk pooling” in the nongroup market in both highly and lightly regulated states. They find very significant risk pooling even in less regulated states. In other words, even where insurers were allowed to charge higher risks much more, they didn’t charge them what they cost the insurer. Instead, insurers made their money on lower risks.

Why did insurers adopt these underwriting practices, seemingly at odds with profitability? Presumably because of public image and informal industry norms. To deal with adverse selection, especially in the absence of elimination (or benefit-exclusion) riders, insurers had to reject especially high risks (Pauly and Nichols (PDF) use confidential data from an insurer to show how risk-pooling and nonuse of elimination riders led to higher rates of rejection). Moreover, especially low risks saw the high cost of nongroup coverage and went without.

The pre-PPACA nongroup health insurance market shows how strong social norms can frighten firms into adopting inefficient policies: in this case, pricing and coverage policies that left some potential consumers unwilling to buy insurance and others unable to. Repealing the PPACA and state-level regulations on health insurance will not be enough to create a functioning nongroup health insurance market without also changing people’s attitudes toward cost-control mechanisms and market-based underwriting.

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