The Private Health Insurance Market

Insurance Design Insurance is designed to spread risk Individuals can self-insure and face chance of paying for costs themselves or they can pay known premium and push the costs onto an insurer Risk averse individuals join pools to protect against costly random events Expected loss is = (probability of loss) x $ Loss, e.g., a 1% chance of losing $10,000 has expected (average) loss of.01(10,000) = $100

Most individuals are risk averse, i.e., the gain in utility of extra $ is smaller than the loss in utility of the same $ The premium charged by an insurance company will equal the expected cost of loss + load (for administrative costs and profit). Allocative efficiency occurs when the marginal benefits of insurance coverage are > marginal costs (i.e., MB > MC). Insurance plans should not cover high probability events, low cost losses and remote probability events because MB < MC. Private health insurance coverage mirrors MB > MC considerations somewhat. Insurance pays 97% of hospitalization costs, 85% of MDs, 2/3s of Rx drugs, & less than 50% of dental and eyeglasses.

Health Insurance and Market Failure 1. Income tax treatment effects 2.Consumers lack information 3.Premium Setting 4.Adverse Selection 5.Moral hazard 6.Other Supply – Side Failures 7.Insurer Responses 8.The Uninsured

1. Income tax treatment affects the way we buy insurance –94% of private plans are employer based with an employee share usually 25-40% of the total cost –Remainder is funded by wage reductions –Result is over-reliance on employer decision making and overly comprehensive insurance (MB < MC) plans that try to cover all risks –Tax benefits = > $200 Bil./yr. =less income & payroll tax for workers and less payroll tax for employers –Tax benefits accrue most to high income individuals, none to uninsured and low income workers

2.Consumer Ignorance For markets to work efficiently, consumers must be well informed Medical information is difficult to gather and difficult to understand. Little information on prices, quality and appropriate treatments. Health providers & insurers don’t want to provide info. Cost of poor information is very expensive

3.Premium Setting – Community and Experience Rating Community rating –Expected medical benefits - based on the risk characteristics of the entire plan membership Not on the health history or risk status of a particular person –May differ across individuals Geographical location - cost-of-living considerations Type of contract (individual or family) Benefit design (level of copayments, coinsurance, deductibles, and benefits covered).

Experience rating –Individuals - different risk categories based on various identifiable personal characteristics Age, gender, occupation, and prior illnesses. –Premiums - based on Geographical location, type of contract, benefit design Relation between risk category and expected health care costs

4.Adverse Selection Arises because individuals have more information about likely medical spending than insurers. Higher risk groups choose high coverage policies if their premiums are based on average risks (both low & high users),i.e., when community rated. Premiums can be experience rated or community rated, which cross-subsidizes high users by low users.

Low users with community rating will choose cheaper, low coverage plans (or to be uninsured). This leads to undesirable turnover between plans and a race to the bottom in terms of plan quality leading to a loss of choice. High users will end up in pools with few low users, leading to high premiums or lack of insurance. Employer group policies are experience rated, limiting adverse selection effects.

Experience rating effects –Price - closer to the expected medical benefits –More efficient - creates an incentive for people to adopt favorable lifestyles –Can reduce the practice of adverse selection –Low users will be able to purchase both high and low benefit plans –High users won’t be able to afford insurance, which is inequitable

Community Rating Effects –High users have greater access to health insurance –Low users have to cross-subsidize high users, which is inequitable –Low users have to pay higher premiums, which leads to more uninsured –Less diversity in type of plan coverage, i.e., race to the bottom.

5. Moral Hazard Insurance coverage increases medical care spending because it decreases the out of pocket cost Medical care will be demanded as long as MB > MC, but private MC is not the total true cost of care, just the copay. This leads to excessive and wasteful spending. Higher insurance premiums decrease % insured Efficiency requires some kind of cost sharing by consumer, namely copays and deductibles.

14 6. Other Supply Side Market Failures Medical providers are consolidating, i.e., hospitals and specialists –Federal judges have ruled nonprofit mergers are OK even if they result in monopolies State regulations are increasing, because local politicians are more susceptible to industry demands –Mandatory benefits, providers, licensing, training –Community rating, any willing provider laws Patient and/or MD ignorance –Specialists in the same area provide widely differing care to patients with the same diagnoses. Inadequate diagnosis or treatment knowledge ? Fee for service payments

6. Insurer Responses To limit adverse selection and moral hazard problems, insurers Charge deductibles and copays Exclude preexisting conditions Limit choice of hospitals & doctors Charge more for individual than group policies Limit panels to new or only a few specialists Create and market high benefit and low benefit policies to separate high users from low users Implemented managed care and consumer driven health plans

7. Medical Care for the Uninsured

60% of uninsured are working Only 10% of uninsured have preexisting conditions who can’t afford/get coverage Typical spell w/o insurance is about 6 months w/ 1/3 uninsured for > 1 year. Lots of turnover, w/ maybe 85 million w/o coverage at some point over 4 year period. Job lock because of employer-sponsored group health insurance

4 Reasons for Being Uninsured By choice (voluntary) - employer doesn’t offer insurance and individual doesn’t want to pay premium Frictional – individual drifts in and out of jobs offering group health insurance (or part timer, probationary) Structurally uninsured because of chronic illnesses, preexisting conditions, and/or insufficient income. Cyclically uninsured as the macroeconomy normally expands and contracts in the short term

Uninsured and Health Status Research is inconclusive Some research suggests lack of insurance doesn’t seem to affect health status. 2/3s less MD visits and ½ fewer hospitals but same kind of mortality and morbidity statistics. Uninsured are generally younger and healthier. Others find less access w/o insurance leading to poor health.

Uninsured receive emergency care even if they don’t have $. Uncompensated care about $50 billion per year. Paid by municipalities for public hospitals and cost-shifting at private hospitals. It’s getting more difficult to shift costs for uncompensated care as competition increases between providers and insurers. This is creating a crisis for medical care providers, particularly hospitals who treat the uninsured.