Health Insurance Health Insurance October 19, 2006October 19, 2006

Insurance is defined as a means of protecting against risk.

Risk is a state in which multiple outcomes are possible and the likelihood of each possible outcome is known or can be estimated.

Key behind insurance: means of Key behind insurance: means of protecting against risk.protecting against risk.

The Market for Health InsuranceThe Market for Health Insurance It’s impossible to determine whether one particular It’s impossible to determine whether one particular

individual will suffer from a medical condition, such individual will suffer from a medical condition, such as a heart attack or stroke. as a heart attack or stroke.

When individuals are combined into large enough When individuals are combined into large enough groups, or risk pools, the probability that someone groups, or risk pools, the probability that someone in the group will suffer from a heart attack or stroke in the group will suffer from a heart attack or stroke can be estimated.can be estimated.

The estimated probability of an event is based on The estimated probability of an event is based on the historical frequency of the event occurring in the the historical frequency of the event occurring in the past. The larger the group, the greater the accuracy past. The larger the group, the greater the accuracy of the prediction.of the prediction.

Market for Health Insurance (con.)Market for Health Insurance (con.) Experience rating: Basing health insurance Experience rating: Basing health insurance

premiums on the utilization experience of a specific premiums on the utilization experience of a specific insured group. Premiums may vary by age, sex, or insured group. Premiums may vary by age, sex, or other risk factors and are often taken into other risk factors and are often taken into consideration prior to use of medical services.consideration prior to use of medical services.

Community rating: Basing health insurance Community rating: Basing health insurance premiums on the health care utilization of the entire premiums on the health care utilization of the entire population of a specific geographic area. Premiums population of a specific geographic area. Premiums are the same for all individuals regardless of age, are the same for all individuals regardless of age, sex, risk, or prior use of health care services.sex, risk, or prior use of health care services.

Indemnity insurance:Indemnity insurance:

Reimbursement for certain expenditure Reimbursement for certain expenditure Higher risk persons pay higher premiums Higher risk persons pay higher premiums (Key idea here the insurance is based on the (Key idea here the insurance is based on the

principle that someone suffering an principle that someone suffering an economic loss receives a payment economic loss receives a payment approximately equal to the size of the approximately equal to the size of the loss.)loss.)

United States:United States: Mostly group insuranceMostly group insurance with the same rates within groups (varying by with the same rates within groups (varying by

size of family)size of family) Rates reflect expected rate of use of the Rates reflect expected rate of use of the

medical system.medical system. Group rates vary depending on past claims.Group rates vary depending on past claims. Experience rating across groupsExperience rating across groups Community rating within groups Community rating within groups

Social insurance:Social insurance:

Basis of all government redistribution Basis of all government redistribution programsprograms

Financed by tax revenuesFinanced by tax revenues Available to all persons regardless of Available to all persons regardless of

ability to payability to pay Examples in the U.S. are Medicare and Examples in the U.S. are Medicare and

Medicaid Medicaid

Health Insurance and Market Health Insurance and Market FailureFailure

The dominant feature of U.S. medical The dominant feature of U.S. medical market place is the reliance on the third market place is the reliance on the third party payment mechanism.party payment mechanism.

The tax subsidy to insurance has shaped The tax subsidy to insurance has shaped the market for medical health insurance.the market for medical health insurance.

The subsidy is estimated to be over $100 The subsidy is estimated to be over $100 billion.billion.

Information problemsInformation problems

Economics of Moral HazardEconomics of Moral Hazard When writing contracts and there is a difference in When writing contracts and there is a difference in

information between the parties to the contract. All information between the parties to the contract. All contracts involve expectations about future contracts involve expectations about future behavior.behavior.

One party cannot monitor the other party’s behavior.One party cannot monitor the other party’s behavior. Exploiting the informational problems leads to an Exploiting the informational problems leads to an

increased probability of use and increased increased probability of use and increased expenditures given use.expenditures given use.

Keep in mind consumers are viewed as weighing Keep in mind consumers are viewed as weighing extra benefits and extra costs in making a decision.extra benefits and extra costs in making a decision.

Moral HazardMoral Hazard

The fact a person has insurance coverage The fact a person has insurance coverage increases the expected health expenditures.increases the expected health expenditures.

Having insuranceHaving insurance

1. increases the likelihood of purchasing 1. increases the likelihood of purchasing medical services.medical services.

2. induces higher expenditures in the event of 2. induces higher expenditures in the event of an illness.an illness.

Moral HazardMoral Hazard

These information problems affect the These information problems affect the structure of insurance contracts. The person structure of insurance contracts. The person with insurance recognizes that the service is with insurance recognizes that the service is “sale priced.” ($0.10 to $0.20 on the $1)“sale priced.” ($0.10 to $0.20 on the $1)

Adverse SelectionAdverse Selection

arises because consumers have more arises because consumers have more information about expected medical information about expected medical expenditures than do insurance expenditures than do insurance companiescompanies

The ability of prospective insurance The ability of prospective insurance customers to conceal their true risks can customers to conceal their true risks can result in some insurance groups having a result in some insurance groups having a disproportionate number of high users.disproportionate number of high users.

Example: assume people within a Example: assume people within a particular group have the same risk particular group have the same risk preferences.preferences.

Low risk group, self insured:Low risk group, self insured:

4% chance of a $50,000 loss4% chance of a $50,000 loss What’s the expected value of the loss in What’s the expected value of the loss in

this case?this case?

High risk group, self insured: High risk group, self insured:

30% chance of a $50,000 loss30% chance of a $50,000 loss What’s the expected value of the loss in What’s the expected value of the loss in

this case?this case?

Suppose we pool these two groups, Suppose we pool these two groups, each comprising 50% of the each comprising 50% of the

population.population. What is the expected value of the loss in this What is the expected value of the loss in this

case?case? Who gains from pooling these two groups?Who gains from pooling these two groups? What incentives will be given to those who What incentives will be given to those who

have only a 4% chance of the $50,000 loss?have only a 4% chance of the $50,000 loss?

It can be shown in the pooled example It can be shown in the pooled example that low-risk patients are subsidizing high that low-risk patients are subsidizing high risk patients.risk patients.

Low risk persons choose not to group Low risk persons choose not to group insure under this community rating case, insure under this community rating case, leaving the pooled group including only leaving the pooled group including only the high risk persons. the high risk persons.

Response to Moral HazardResponse to Moral Hazard

Coinsurance (typically 10% - 20%)Coinsurance (typically 10% - 20%) co-pays (e.g. UD policies $15 for GPs co-pays (e.g. UD policies $15 for GPs

and $25 for specialists)and $25 for specialists) Deductibles (typically $100 - $300) Deductibles (typically $100 - $300)

Responses to Adverse SelectionResponses to Adverse Selection

Look at prior usage (e.g. physical examinations Look at prior usage (e.g. physical examinations and/or questionnaires).and/or questionnaires).

Existing conditions may not be covered.Existing conditions may not be covered. The health portability and accountability act passed in 1996 The health portability and accountability act passed in 1996

modified the provision of insurance to those with preexisting modified the provision of insurance to those with preexisting conditions somewhat. An individual who has insurance and conditions somewhat. An individual who has insurance and subsequently becomes ill may not be denied continued subsequently becomes ill may not be denied continued coverage under any circumstances. The policy is portable coverage under any circumstances. The policy is portable across plans. Individuals without insurance coverage who are across plans. Individuals without insurance coverage who are sick may still be denied coverage.sick may still be denied coverage.

ConclusionConclusion

Lack of information causes problems in health Lack of information causes problems in health care related to moral hazard and adverse care related to moral hazard and adverse selection.selection.

Keep these concepts in mind when we hear Keep these concepts in mind when we hear about the Australia private health insurance about the Australia private health insurance plans. (which are supplements to the state plans. (which are supplements to the state provided health system)provided health system)