Chapter 10 The Supply of Private Health Insurance

ABC’s of the Business of Insurers: Functions Risk bearing Marketing and underwriting Claims processing Loss Prevention

Measuring Financial Strength of Insurers: Income Statement and Balance Sheet Income statement Balance sheet: liabilities; unearned and earned premiums Incurred but not reported (IBNR) loss and purpose of IBNR reserves

Insurer Cash Flow Timing of insurer’s revenue and expense Investment income: higher investment income lead to lower premiums on underwriting side of insurer’s business

Reinsurance What it is and its purpose Types of reinsurance: quota share; aggregate stop-loss; excess-of-loss Reinsurance layers

Underwriting Cycles What is meant by underwriting? What are characteristics of underwriting cycles? Causes of underwriting cycles: errors in loss projection; underpricing of insurance by existing insurers and market entrants; premium regulation and overpricing of insurance

Are Insurers’ Premiums and Returns Excessive? Reasons premiums would be judged to be excessive: (1) insurer losses are excessive; (2) returns on equity to investment in insurance company excessive What is meant by “excessive” in these contexts? What is non-diversifiable risk and what is its role in a competitive insurance market? Describe non-diversifiable risk in terms of investment risk, underwriting risk. Describe insolvency risk? Contrast with non- diversifiable risk.

Private and Public Provision of Health Insurance Coverage U.S. by far the highest among OECD countries in share of total expenditures on personal health care services financed by private health insurance. Second to fourth are: Netherlands; Canada; and France See Fig on relationship between share of health expenditures financed out-of-pocket by patients an private health insurance share. What are implications to be drawn from the graph?

Fig Shares of Health Expenditures Financed by Out-of-Pocket Payment versus Countries’ Private Health Insurance Shares

Case For Relying on Private Provision of Health Insurance For-profit insurers have greater incentive to be sensitive to variation in consumer preferences in risk and in benefit package design. Private and public provision can coexist. They are not mutually exclusive.

Case Against Relying on Private Provision of Health Insurance Cons: Much insurance, e.g., in the U.S., is provided on a group basis through employers. There must be heterogeneity in preferences within employer groups, especially large ones. Private insurers may free-ride on public insurance plans. U.S. Medicare supplemental coverage an example. High administrative cost of private health insurance. Why so high? Churning of enrollees in private plans reduce individual insurer’s incentive for loss prevention. High seller concentration of insurance in some geographic areas  reduced competition among private health insurers

Employer-Based Private Health Insurance: Advantages Economies of scale in provision: marketing/underwriting; claims processing; possibly loss prevention Reduce adverse selection problem in choice of health insurance plan by individuals (employees) In U.S. employer-provided health insurance subject to Federal law but exempt from state-law. Discuss disadvantages of state law/regulation (may be advantages as well) Ability to self-insure against underwriting loss

Who Pays for Employment- Based Health Insurance? The employer? The employee? Both? See Fig Assess both wage and employment effects of providing coverage as fringe benefit

Fig The Wage and Health Insurance Trade-off HAHA Insurance O Wages Worker C Worker B Worker A Π1Π1 wAwA wBwB wCwC N M Π0Π0

Empirical Evidence: Who Pays for Employer-Provided Health Insurance? Question must be answered empirically. Econometric problem arises that fringe benefits including health insurance as fringe benefit and wages are jointly determined, which violates assumptions of ordinary least squares. One solution is to use instrumental variables (IVs) One possible IV is whether or not employee’s spouse has health insurance through his/her place of employment. Explain rationale for this IV. Empirical findings from Olson (2002)

Government Regulation of Private Health Insurance: Rationale Prevent bankruptcies Prevent insurers from exercising market power in pricing of insurance coverage Assure availability of insurance coverage to consumers Improve information flows to consumers

Insurance Mandates: Public Regulation of Private Health Insurance Mandates that require that insurers offer certain benefits in their health insurance plans Mandates that require that employers provide health insurance as a fringe benefit to all employees

Rationale for Health Insurance Mandates Everyone should have access to health insurance coverage as a right. Lack of health insurance leads to payment shortfalls when people obtain non-elective care and cannot pay for this. Mandating private coverage reduces deadweight loss from tax increases needed to fund public health insurance programs.

Fig Cost of Mandate Exceeds Employees’ Valuation of Mandated Benefit

Fig Case in Which the Cost of the Mandate Equals Employees’ Valuation of Mandated Benefits

Empirical Evidence on Mandates’ Effects Schmidt (2007): Mandates to include cost of fertility treatment increased fertility rates. Klick and Markowitz (2006): Mandated mental health benefit had no effect on suicide rates. Effects of mandates seem to vary with type of benefit mandated.

Community Rating What it is and the rationale for community rating Some U.S. states require insurers to set premiums on a community rated basis. What would you expect to be the effect on community rating on the percent of persons without health insurance coverage? What does the empirical evidence show?

Managed Care Managed care defined Concept of “selective contracting” Financial incentives faced by consumers and providers under managed care Types of managed care in U.S. : (1) capitation; (2) contractual arrangements between health plans and providers, e.g., independent practice associations (IPAs); and (3) contractual arrangements, e.g., preferred provider organizations (PPOs)

Effect of Managed Care on Market Structure and Providers’ and Patients’ Incentives Limiting the network of providers Negotiated discounts Effects of managed care on provider concentration Relative efficiency of managed care organizations in provider search

(10.1) Effect of Capitation on Physician Incentives

Effect of Capitation on Physician Incentives, cont. Payers can design incentive to elicit desired behavior from provider by selecting appropriate combination of fixed revenue R and fee for the variable revenue proportion. Quantity is contractible and quality is not. Optimal solution for choice of quantity satisfies condition that marginal benefit received by the MD equals MC borne by the MD. In principle, possible to design payment scheme, i.e., combination of revenue and variable revenue portion.

Managed Care and Health System Performance Effects on spending on 4 mechanisms: (1) MCO use of selective contracting; (2) MCOs might reduce quantity of services provided by enrollees; (3) MCOs might save money through offering lower quality at lower cost.; and (4) MCOs might reduce growth of health care spending by reducing rate of technology adoption. Empirical evidence