Soheil Ghili, Ben Handel (Gilbert Center), Igal Hendel, and Michael D. Whinston

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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 theoretically characterize optimal long-term insurance contracts with one-sided commitment, and use our characterization to provide a simple computation algorithm for computing optimal contracts from primitives. We apply this method to derive empirically-based optimal long-term health insurance contracts using all-payers claims data from Utah, and then evaluate the potential welfare performance of these contracts. We find that optimal long-term health insurance contracts that start at age 25 can eliminate over 94% of the welfare loss from reclassification risk for individuals who arrive on the market in good health, but are of little benefit to the worst age-25 health risks. As a result, their ex ante value depends significantly on whether pre-age-25 health risk is otherwise insured. Their value also depends on individuals’ expected income growth.