Health Insurance October 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 protecting against risk. The Market for Health Insurance It’s impossible to determine whether one particular individual will suffer from a medical condition, such as a heart attack or stroke. It’s impossible to determine whether one particular individual will suffer from a medical condition, such as a heart attack or stroke. When individuals are combined into large enough groups, or risk pools, the probability that someone in the group will suffer from a heart attack or stroke can be estimated. When individuals are combined into large enough groups, or risk pools, the probability that someone in the group will suffer from a heart attack or stroke can be estimated. The estimated probability of an event is based on the historical frequency of the event occurring in the past. The larger the group, the greater the accuracy of the prediction. The estimated probability of an event is based on the historical frequency of the event occurring in the past. The larger the group, the greater the accuracy of the prediction.

Market for Health Insurance (con.) Experience rating: Basing health insurance premiums on the utilization experience of a specific insured group. Premiums may vary by age, sex, or other risk factors and are often taken into consideration prior to use of medical services. Experience rating: Basing health insurance premiums on the utilization experience of a specific insured group. Premiums may vary by age, sex, or other risk factors and are often taken into consideration prior to use of medical services. Community rating: Basing health insurance premiums on the health care utilization of the entire population of a specific geographic area. Premiums are the same for all individuals regardless of age, sex, risk, or prior use of health care services. Community rating: Basing health insurance premiums on the health care utilization of the entire population of a specific geographic area. Premiums are the same for all individuals regardless of age, sex, risk, or prior use of health care services.

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

United States: Mostly group insurance Mostly group insurance with the same rates within groups (varying by size of family) with the same rates within groups (varying by size of family) Rates reflect expected rate of use of the medical system. Rates reflect expected rate of use of the medical system. Group rates vary depending on past claims. Group rates vary depending on past claims. Experience rating across groups Experience rating across groups Community rating within groups Community rating within groups

Social insurance: Basis of all government redistribution programs Basis of all government redistribution programs Financed by tax revenues Financed by tax revenues Available to all persons regardless of ability to pay Available to all persons regardless of ability to pay Examples in the U.S. are Medicare and Medicaid Examples in the U.S. are Medicare and Medicaid

Health Insurance and Market Failure The dominant feature of U.S. medical market place is the reliance on the third party payment mechanism. The dominant feature of U.S. medical market place is the reliance on the third party payment mechanism. The tax subsidy to insurance has shaped the market for medical health insurance. The tax subsidy to insurance has shaped the market for medical health insurance. The subsidy is estimated to be over $100 billion. The subsidy is estimated to be over $100 billion. Information problems Information problems

Economics of Moral Hazard When writing contracts and there is a difference in information between the parties to the contract. All contracts involve expectations about future behavior. When writing contracts and there is a difference in information between the parties to the contract. All contracts involve expectations about future 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 increased probability of use and increased expenditures given use. Exploiting the informational problems leads to an increased probability of use and increased expenditures given use. Keep in mind consumers are viewed as weighing extra benefits and extra costs in making a decision. Keep in mind consumers are viewed as weighing extra benefits and extra costs in making a decision.

Moral Hazard The fact a person has insurance coverage increases the expected health expenditures. The fact a person has insurance coverage increases the expected health expenditures. Having insurance Having insurance 1. increases the likelihood of purchasing medical services. 2. induces higher expenditures in the event of an illness.

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

Adverse Selection arises because consumers have more information about expected medical expenditures than do insurance companies arises because consumers have more information about expected medical expenditures than do insurance companies

The ability of prospective insurance customers to conceal their true risks can result in some insurance groups having a disproportionate number of high users. The ability of prospective insurance customers to conceal their true risks can result in some insurance groups having a disproportionate number of high users. Example: assume people within a particular group have the same risk preferences. Example: assume people within a particular group have the same risk preferences.

Low risk group, self insured: 4% chance of a $50,000 loss 4% chance of a $50,000 loss What’s the expected value of the loss in this case? What’s the expected value of the loss in this case?

High risk group, self insured: 30% chance of a $50,000 loss 30% chance of a $50,000 loss What’s the expected value of the loss in this case? What’s the expected value of the loss in this case?

Suppose we pool these two groups, each comprising 50% of the population. What is the expected value of the loss in this case? What is the expected value of the loss in this case? Who gains from pooling these two groups? Who gains from pooling these two groups? What incentives will be given to those who have only a 4% chance of the $50,000 loss? What incentives will be given to those who have only a 4% chance of the $50,000 loss?

It can be shown in the pooled example that low-risk patients are subsidizing high risk patients. It can be shown in the pooled example that low-risk patients are subsidizing high risk patients. Low risk persons choose not to group insure under this community rating case, leaving the pooled group including only the high risk persons. Low risk persons choose not to group insure under this community rating case, leaving the pooled group including only the high risk persons.

Response to Moral Hazard Coinsurance (typically 10% - 20%) Coinsurance (typically 10% - 20%) co-pays (e.g. UD policies $15 for GPs and $25 for specialists) co-pays (e.g. UD policies $15 for GPs and $25 for specialists) Deductibles (typically $100 - $300) Deductibles (typically $100 - $300)

Responses to Adverse Selection Look at prior usage (e.g. physical examinations and/or questionnaires). Look at prior usage (e.g. physical examinations and/or questionnaires). Existing conditions may not be covered. Existing conditions may not be covered. The health portability and accountability act passed in 1996 modified the provision of insurance to those with preexisting conditions somewhat. An individual who has insurance and subsequently becomes ill may not be denied continued coverage under any circumstances. The policy is portable across plans. Individuals without insurance coverage who are sick may still be denied coverage. The health portability and accountability act passed in 1996 modified the provision of insurance to those with preexisting conditions somewhat. An individual who has insurance and subsequently becomes ill may not be denied continued coverage under any circumstances. The policy is portable across plans. Individuals without insurance coverage who are sick may still be denied coverage.

Conclusion Lack of information causes problems in health care related to moral hazard and adverse selection. Lack of information causes problems in health care related to moral hazard and adverse selection. Keep these concepts in mind when we hear about the Australia private health insurance plans. (which are supplements to the state provided health system) Keep these concepts in mind when we hear about the Australia private health insurance plans. (which are supplements to the state provided health system)