Analyzing the Effects of Insuring Health Risks

September 2016
Harold L. Cole, Soojin Kim, and Dirk Krueger

This paper quantitatively evaluates the trade-off between the provision of social insurance and the incentives to maintain good health through costly investments of labor market and health insurance policies. Our study is motivated by recent US legislation that has tightened regulations on wage discrimination against workers with poorer health status (such as the 2008 amendment of the Americans with Disability Act from 1990, the ADAAA) and that prohibits health insurance companies from charging different premiums for workers of different health (a provision in the Patient Protection and Affordable Care Act, PPACA, that went in effect in 2014). To do so we construct and estimate (using PSID and MEPS data) a dynamic model of health investments and health insurance in which the cross-sectional health distribution evolves endogenously and is shaped by labor market and health insurance policies.

The static gains from better insurance against poor health induced by these policies are traded off against their adverse dynamic incentive effects on household efforts to lead a healthy life. In our quantitative analysis we find that although the competitive equilibrium features too little consumption insurance and a combination of both policies is effective in providing such insurance period by period, it is suboptimal (from an ex-ante welfare perspective) to introduce both policies jointly since such a policy innovation severely undermines the incentives to lead healthier lives and thus induces a more rapid deterioration of the cohort health distribution over time. This effect more than offsets the static gains from better consumption insurance so that expected discounted lifetime utility is lower under both policies, relative to implementing one policy in isolation.