Horizon Effects and Adverse Selection in Health Insurance Markets

We study how increasing contract length affects adverse selection in health insurance markets. While health risks are persistent, private health insurance contracts in the U.S. have short, one-year terms. Short-term, community-rated contracts allow patients to increase their coverage only after risks materialize, which leads to market unraveling. Longer contracts ameliorate adverse selection because both demand and supply exhibit horizon effects. Intuitively, longer horizon risk is less predictable, thus elevating demand for coverage and lowering equilibrium premiums. We estimate risk dynamics using data from 3.5 million U.S. health insurance claims and find that risk predictability falls significantly with horizon. Nesting these estimates in an equilibrium model of insurance markets, we find that a reform implementing two-year contracts (e.g., by lowering the frequency of open enrollment periods) would increase coverage by 12-19 percentage points from its initial level and yield average annual welfare gains of $600–$900 per person (between 20% and 30% of the insured risk). A third of these effects is driven by insurers’ response and the rest by changes in consumer expectations.