Adverse selection and the capped premium subsidy in the Federal Employees Health Benefits Program

This article examines the relationship between adverse selection and the capped premium subsidy in the Federal Employees Health Benefit Program (FEHBP). Understanding this relationship is important, not only because the FEHBP is the largest employer-sponsored health program in the United States, but also because it has been proposed as a market-based model for the reform of both Medicare and the market for nongroup private coverage. We present a theoretical model of the FEHBP that we then test using enrollee data. In particular, we exploit the natural experiment that arises from variation in the premium subsidy cap across Metropolitan Statistical Areas (MSAs). Although the nominal subsidy cap is constant across MSAs, its real value varies greatly across MSAs with different price levels. The empirical analysis herein supports the contention that the premium subsidy in the FEHBP helps reduce adverse selection.