Jonathan Gruber Public Finance and Public Policy Chapter 15 Health Insurance I: Health Economics and Private Health Insurance Jonathan Gruber Public Finance and Public Policy Aaron S. Yelowitz - Copyright 2005 © Worth Publishers

Introduction The field of health care has made great strides during the last century. This increase in quality has been accompanied by a much greater share of GDP devoted to the health sector. 1950: 4% of GDP devoted to health care 2003: 15% of GDP devoted to health care 2075: 38% of GDP devoted to health care

Introduction Is growing health care spending a problem? There are certainly benefits. Treatment for many ailments has improved dramatically. Knee surgery that used to be very invasive and took months to recover is now a quick and easy procedure. The number dying from heart attacks has fallen by half. The infant mortality rate has fallen by 75%. Individuals can permanently improve their vision with LASIK surgery, that takes less than two hours, and be up and running within a day.

Introduction There are some problems with the health care system however. Disparities in health outcomes exist by race and income. The white infant mortality rate is 6 per 1000, in line with countries like the United Kingdom and Australia. The black infant mortality rate is 14 per 1000, more than double. It is higher than some developing countries.

Introduction Access to health care also varies. 15.6% of the U.S. population, or 45 million people were uninsured in 2003. The number of uninsured has remained high during both economic booms and busts.

Introduction Although the U.S. health care system is perceived to be “private,” the government accounts for almost one-half of all health spending. This spending takes up more than one-fifth of the budget of the federal, state, and local government. The spending will continue to grow as the U.S. population ages.

AN OVERVIEW OF HEALTH CARE IN THE U.S. In 2003, the U.S. spent more than $1.6 trillion on health care, or 15% of GDP. This share of GDP is nearly twice as much as countries like Japan and the United Kingdom. It corresponds to more than $5,800 for each person in the U.S. See Figure 1.

Figure 1 Spending in the U.S. averages $5,800 per person, and nearly 15% of GDP. Countries like the United Kingdom and Japan spend a much smaller share on health care.

AN OVERVIEW OF HEALTH CARE IN THE U.S. Table 1 shows health insurance coverage in the United States in 2002. These statistics come from the Current Population Survey (CPS). The questions of the CPS refer to insurance coverage over the entire previous year; thus being uninsured means no coverage at any point during the calendar year.

Americans’ Source of Health Insurance Coverage, 2002 Table 1 Americans’ Source of Health Insurance Coverage, 2002 People (millions) Percentage of population Total population 288.6 100.0% Private 177.8 61.6% • Employment-based 161.0 55.8% • Individually purchased 16.8 5.8% Public 83.0 28.8% • Medicare 40.5 14.0% • Medicaid 42.8 14.8% • TRICARE/CHAMPVA 6.9 2.4% Uninsured 43.3 15.0% Roughly 44 million individuals were uninsured for the entire 2002 calendar year, or 15% of the population.

How Health Insurance Works: The Basics To understand how health insurance works, there are some “basics” of its structure that must be understood. Firms or individuals pay “premiums” to insurance companies. In return, the insurance company pays health care providers when the individual has claims.

How Health Insurance Works: The Basics Individuals often pay for part of the cost of their actual utilization, in one of three ways: Deductible: A person faces the full cost of care to some limit, and the insurance pays for costs after that. Copayment: A person pays a fixed payment when they get a medical good or service. Coinsurance: A person pays a percentage of each medical bill rather than a flat dollar amount.

Private Insurance The private market provides nearly three-quarters of health insurance coverage in the U.S. The nongroup insurance market is the market through which individuals or families buy insurance directly rather than through a group, such as the workplace. 9 out of every 10 privately insured individuals gets their health insurance through their employer.

Private Insurance Employers who offer health insurance often have requirements related to taking it up. Length of service Employee premiums Some employees choose not to take-up health insurance that they are offered.

Private Insurance A risk pool is a group of individuals to whom an insurance plan is offered. One motivation for employers to offer coverage is the nature of “risk pools.” Insurers try to create large insurance pools with a predictable distribution of medical risk. Two features increase the predictability of medical risk distributions: The absence of adverse selection Large group sizes Employers have a good chance of meeting these conditions.

Private Insurance Individuals are not likely to meet these conditions. Although large groups of individuals could be formed, the concern about adverse selection remains. That is, is the group looking for health coverage simply because they are sick.

Private Insurance Some administrative costs of running a health insurance plan are fixed; thus, the larger the pool, the smaller the per-enrollee costs. This also reinforces the preference for providing insurance through large firms.

Private Insurance Overall, adverse selection, group size, and fixed costs lead to vast differences in the odds of being offered health insurance. 98% of firms with 200 or more employees offer health insurance to at least some of their employees. Only 55% of firms with fewer than 10 employees offer health insurance. Even one costly health risk (such as a cancer or AIDS patient) can lead to losses for small groups.

Private Insurance The tax subsidy to employer provided health insurance refers to the fact that workers are taxed on their wage compensation but not on their compensation in the form of health insurance, leading to a subsidy to health insurance provided through employers. This is a second motivation for employers to offer the coverage.

Private Insurance The effective price of offering $1 of health insurance is only ($1-J), where J is the cumulative federal, state, and payroll tax rate. Table 2 illustrates this incentive. In this example, even though it is cheaper to purchase health care outside of the employer, the tax subsidy more than offsets these savings.

Illustrating the Tax Subsidy to Employer-Provided Insurance Table 2 Illustrating the Tax Subsidy to Employer-Provided Insurance Marginal product, wage Employer health insurance spending Pre-tax wage After-tax wage Personal health insurance spending After-tax, after-health insurance income Jim $30,000 $25,500 $4,500 $21,000 Peter $5,000 $25,000 $21,250 Although Jim buys less expensive health insurance on his own, his net income is lower!

Private Insurance The subsidy in this case is to employees purchasing health insurance in the employment setting. From the employer’s perspective, the way in which it pays the employee is irrelevant; $5000 of health insurance is as costly as $5000 in wages. Any type of employee compensation is deductible from corporate taxes.

Private Insurance The non-group market (e.g., privately-purchased plans) is relatively small. This is explained by the problems of adverse selection and administrative costs. These problems make the non-group market a poorly functioning market. Some individuals are denied coverage entirely. Often, policies have “preexisting conditions exclusions.”

Medicare Medicare is the federal program that provides health insurance to all people over age 65 and disabled persons under age 65. 35 million elderly were eligible in 2003, as well as 6 million disabled persons. Every citizen who has worked for 10 years in Medicare-covered employment (or their spouse) is eligible. Financed with an uncapped payroll tax totaling 2.9%.

Medicaid Medicaid is the federal and state program that provides health care for the poor. It is financed with general revenues. It targets several groups: Those who qualify for cash welfare Low-income children and pregnant women (for expenses with pregnancy only) Low-income elderly and disabled (for non-Medicare costs and long-term care)

Medicaid The young, poor population, particularly mothers and children, make up nearly 70% of the programs recipients. On the other hand, over two-thirds of program expenditure is devoted to long-term care, which is largely spent on the elderly and disabled.

TRICARE/CHAMPVA TRICARE and CHAMPVA are health insurance programs targeted toward those currently or formerly in the military, and their dependents. Together they provide coverage for nearly 7 million Americans.

The Uninsured 44 million individuals in the U.S. are without any insurance coverage at all. They tend to have below-average incomes. Nearly two-thirds of the uninsured are in families with incomes below 200% of the poverty line. 70% of the uninsured are in families with a head of household who is a full-time, full-year worker. Over one-fifth of the uninsured are children.

The Uninsured Why should we care about the uninsured? Physical externalities associated with communicable diseases. Financial externalities: Uncompensated care is the costs of delivering health care for which providers are not reimbursed. $35 billion delivered in uncompensated care, roughly 2% of total spending. Inappropriate delivery of care (e.g., through emergency rooms). Paternalism and equity–individuals may irrationally underinsure themselves by miscalculating the odds of getting sick. Finally, becoming uninsured is a concern for many.

The Uninsured This final concern, becoming uninsured, is an issue because of the great reliance on employer-provided health insurance. Job lock is the unwillingness to move to a better job for fear of losing health insurance. This can lead to a mismatch between workers and jobs, and can lower overall productivity.

The Uninsured Example of job lock: Brigitte gains utility from two goods: consumption and health insurance. Her utility function is of the form U=U(C,HI), where HI equals 1 if insured, and 0 otherwise. In well-functioning labor market, she is paid her marginal product of labor in total compensation. She has a lower marginal product on job 1 than job 2, MP1< MP2, so it would be efficient for her to change jobs. If job 1 was at a large firm with relatively cheap health insurance ($P), then her utility on job 1 is U(MP1-P,1). If job 2 was a small firm which did not offer health insurance, her utility is U(MP2,0). If Brigitte values health insurance above its cost, she might stay at her old job. Thus, health insurance availability may inhibit productivity increasing job switches.

Health insurance and mobility Empirical Evidence The most convincing evidence of job lock relies on “difference-in-difference” estimators. One strategy examines mobility rates for those who are covered/uncovered and those who value health insurance highly/or not (rather than simply making comparisons based on coverage alone). Another strategy uses state-law changes that loosened job lock with “COBRA continuation coverage.” Studies have found evidence of job lock and “retirement lock.”

HOW GENEROUS SHOULD INSURANCE BE TO PATIENTS? As with other insurance, the optimal generosity will be determined by the trade off between consumption-smoothing and moral hazard. Generosity represents the share of medical spending that will be reimbursed by the health insurer. This generosity can be measured with respect to the patients and with respect to the providers.

HOW GENEROUS SHOULD INSURANCE BE TO PATIENTS? Risk-averse individuals will value health insurance as a means of smoothing their consumption with respect to the cost of medical events. Some events, like a check-up, are minor and predictable, while others, like a heart attack, are more expensive and unpredictable. Expected utility theory suggests that insurance is much more valuable for expensive, unpredictable events.

HOW GENEROUS SHOULD INSURANCE BE TO PATIENTS? The most generous insurance plans are ones that provide first-dollar coverage, reimbursing providers fully with little or no cost to the patient. Thus, first dollar coverage does not provide much more consumption smoothing than a plan that only pays for the higher costs of major medical events (catastrophic care).

Consumption Smoothing Benefits of Health Insurance for Patients The consumption smoothing benefits of first dollar coverage for minor and predictable events is small because: Risk-averse individuals gain little utility from insuring small risks. And individuals are much more able to self-insure.

Consumption Smoothing Benefits of Health Insurance for Patients Consider the following example. Sam faces an actuarially fair premium for a minor risk. He has $30,000 in income, and faces a 1% chance of a relatively minor $100 loss. His utility function is:

Consumption Smoothing Benefits of Health Insurance for Patients Without any insurance, Sam’s utility is: With actuarially fair insurance, Sam’s utility is:

Consumption Smoothing Benefits of Health Insurance for Patients Thus, Sam’s utility does not measurably increase if he buys insurance against a minor risk like this. Technically, the consumption-smoothing gains from insuring small risks is small because there is no diminishing marginal utility for small changes in consumption. The losses from reducing consumption by $1 are roughly equal to the gains from increasing consumption by $1.

Moral Hazard Costs of Health Insurance for Patients Offsetting the consumption-smoothing benefits of health insurance to individuals is the risk of moral hazard. Feldstein (1973) analyzes the problem, as illustrated in Figure 2.

The “right” amount of health care is where D=S. Deadweight Loss Figure 2 Price of each visit The “right” amount of health care is where D=S. Deadweight Loss A B $100 S=MC Health insurance shifts the consumers’ demand, leading to more consumption. This over-consumption leads to deadweight loss. C $10 D Number of visits to doctor’s office Q1 Q2

Moral Hazard Costs of Health Insurance for Patients The private marginal cost is lower than the social marginal cost, resulting in deadweight loss. The fundamental trade-off of health insurance, then, is the gains in terms of consumption smoothing versus the costs in terms of the overuse of medical care.

Moral Hazard Costs of Health Insurance for Patients Moral hazard might then lead to “flat of the curve” medicine. Consider the relationship between an additional $1 of total spending on health care and the amount of marginal benefit from that spending. Initially, the marginal benefit is very high (e.g., influenza shots for the elderly, etc.), but it declines. Figure 3 illustrates such a curve.

Further spending has diminishing returns. Figure 3 Further spending has diminishing returns. Initially, dollars of spending lead to high benefits. $ of Marginal Health Benefits A $5 B $1 C $0.10 $1,000 $2,000 $5,000 $ of Medical Spending

Moral Hazard Costs of Health Insurance for Patients Productivity dwindles as spending on health care rises. From a societal perspective, spending should stop when the additional health benefit is smaller than the additional health cost. If individuals paid the full cost of their health care, the socially optimal amount, point B would be chosen. Moral hazard means that the last $1 of private spending will equal $1 of marginal health benefit, potentially far greater than the socially efficient amount. If individuals do not pay much for their additional health care, they will demand health care as long as the effectiveness curve is not perfectly flat. The “flat of the curve” area is therefore beyond point B, where each $1 of medical care buys less than $1 in improved health.

How Elastic Is the Demand for Medical Care How Elastic Is the Demand for Medical Care? The RAND Health Insurance Experiment A critical question becomes: To what extent does moral hazard actually cause patients to consume more health care? Or, how elastic is the demand for health care? The RAND Health Insurance Experiment (HIE) was a true social experiment with random assignment of health plans with different policy parameters. The coinsurance rate varied from 0% to 95%. The out-of-pocket maximum was $1,000 for all participants (even the ones in the less generous plans). In addition, all families were given $1,000 to participate, so no one was made worse off from the experiment.

How Elastic Is the Demand for Medical Care How Elastic Is the Demand for Medical Care? The RAND Health Insurance Experiment The HIE found that overall, each 10% rise in the price of medical care to individuals led them to use 2% less care, a small elasticity of -0.2. That is, medical utilization is fairly insensitive to price. On the other hand, even with this low elasticity the implied deadweight loss from insurance coverage in the United States is in the range of $125 to $400 billion in current dollars.

Optimal Health Insurance The findings of a non-zero elasticity (e.g., moral hazard) and the significant deadweight loss that goes with it, suggest that the optimal health insurance policy is one in which, Individuals bear a large share of the medical costs within some affordable range, and Individuals are fully insured when costs become unaffordable.

Health savings accounts Application A recent attempt at this are Health savings accounts (HSA). HSAs are a type of insurance arrangement whereby patients face large deductibles, and they put money aside on a tax-free basis to pre-pay these deductibles. It is too soon to know whether HSAs will prove attractive to the insured, or whether they will decrease moral hazard.

Optimal Health Insurance One example of a plan like this is Feldstein’s (1973) “Major Risk Insurance” plan in which: Individuals make a 50% copayment on all services until they reach 10% of their income on medical care, and Receive full insurance thereafter.

Why Is Insurance So Generous in the U.S.? In general, insurance in the U.S. is much more generous than Feldstein’s proposal. See Figure 4.

Quality of Health Insurance Figure 4 Quality of Health Insurance Except for the uninsured, most Americans have generous health coverage. Population 44 million

Why Is Insurance So Generous in the U.S.? Tax subsidy: Eliminating the tax subsidy may not be the most appropriate policy today, however. Rather capping the subsidy for a “basic” plan might be more sensible. Access motive: Offering health insurance has both income and substitution effects. Both result in increased expenditure, but only the increased expenditure from the substitution effect is a deadweight loss. Psychological motivations: There may be motivations for holding insurance beyond the expected utility model; health insurance may serve as a commitment device, for example.

HOW GENEROUS SHOULD INSURANCE BE TO MEDICAL PROVIDERS? There is also moral hazard on the provider side. Even if an insurer could perfectly assess a patient’s true level of illness, the cost to treat that illness can vary considerably. Thus, insurers have often reimbursed medical providers according to their reported costs of treatment.

HOW GENEROUS SHOULD INSURANCE BE TO MEDICAL PROVIDERS? Patient-side moral hazard refers to the extra care demanded for illness because insurers cover the cost of medical treatment. Provider-side moral hazard refers to the extra care provided for illness because insurers reimburse health care providers based on costs.

HOW GENEROUS SHOULD INSURANCE BE TO MEDICAL PROVIDERS? Retrospective reimbursement is a payment arrangement reimbursing physicians for the costs they have already incurred. This system removes any incentive for providers to treat their patients cost-effectively. If a physician’s objective is to maximize health of the patients, then this system will likely yield “flat of the curve” medicine. In addition, if physicians are also concerned about income maximization, this sort of reimbursement only exacerbates the moral hazard.

Managed Care and Prospective Reimbursement Patient cost-sharing did not slow the growth in health care spending, so the private market turned to managed care in the late 1980s and 1990s. Managed care is a private market approach to controlling costs using supply-side controls. Manage care comes in two forms: PPOs and HMOs.

Managed Care and Prospective Reimbursement Preferred provider organizations (PPOs) are health care organizations that lower care costs by shopping for health care providers on behalf of the insured. PPOs form a restricted network of health care providers, and offer a discount if the employer restricts its employees to using that network.

Managed Care and Prospective Reimbursement Health maintenance organizations (HMOs) are health care organizations that integrate insurance and delivery of care. For example, HMOs may pay its own doctors and hospitals a salary independent of the amount of care they deliver. In the classic staff model, HMOs hire their own physicians and may have their own hospitals.

Managed Care and Prospective Reimbursement More commonly, the HMO contracts with independent providers within a restricted network to deliver care to its enrollees. This model is known as the Independent Practice Association (IPA). Prospective reimbursement is the practice of paying providers based on what treating patients should cost, not on what the provider actually spends. HMOs with the IPA model uses prospective reimbursement to counteract provider moral hazard.

Managed Care and Prospective Reimbursement Prospective reimbursement completely reverses the financial incentives of physicians. Now when physicians deliver less care, profitability goes up. This could create financial incentives to give insufficient care. The HMO often gives incentives for a physician to limit the care he delivers, and to restrict the use of specialists as well.

The Impacts of Managed Care Has managed care improved the functioning of the insurance market? Existing research suggests managed care has controlled costs. Empirically, the selection of low-cost individuals into HMOs means that there is not a simple comparison between HMOs and traditional insurance plans. Even if HMOs didn’t change the delivery of medical care, their costs would be lower because they have the healthiest enrollees. The most convincing study accounting for this sort of selection is the RAND Health Insurance Experiment, where enrollees at one site were randomly assigned to HMOs or traditional plans.

The Impacts of Managed Care There is no clear evidence that quality of care has suffered, even though prospective reimbursement might lead to the under provision of care in HMOs. There is not a consensus one way or another. Roughly equal numbers of studies find that HMOs deliver care that is better, worse, or the same as traditional health insurance.

Recap of Health Insurance I: Health Economics and Private Health Insurance Overview of health care in U.S. How generous should insurance be to patients? How generous should insurance be to medical providers?