A Dynamic Model of Health Plan Choice from a Real Options Perspective

This paper develops a dynamic framework for analyzing an individual’s choice between a Preferred Provider Organization (PPO) and a Health Maintenance Organization (HMO) under uncertainty regarding future health. We explicitly model health as a stochastic process whose fluctuations arise from three sources, one deterministic and two stochastic. Health evolves over time with a downward drift over the lifespan. In addition, health is subject to small, mean zero random fluctuations. Finally, there exists a small possibility every period of a serious illness resulting in a large, discrete fall in health. Under this characterization of health uncertainty, we develop a Real Options model valuing flexibility in health plan choice which takes into account the embedded flexibility to receive coverage for out-of-network care if the PPO health plan is chosen. Our model suggests that greater health problems increase the value of the option to go out of network for the PPO enrollee. Copyright International Atlantic Economic Society 2011