Chapter 6: The Demand for Medical Insurance Health Economics 4/21/2017 Chapter 6: The Demand for Medical Insurance Health Economics Notes to fix: 1) Brent - felt that utility function should differ when ill vs. when sick. 2) Note the insurance company collects $5000 to cover expected medical expenses of $4000 averaged OVER THE ENTIRE POPULATION, whether they are sick or not. Those who get sick will cost $20,000, while those who don’t cost nothing. This does NOT mean that one person can spend $4,000 to cover their illness costs and get healthy. 3) Peter wanted to call the whole utility function a risk function. Clarify definition of risk aversion. 4) People though bar graph didn’t tell the whole story--who was losing insurance for what reason--add more, or throw it out.

Topics to cover: A theoretical model of health insurance. 4/21/2017 Topics to cover: A theoretical model of health insurance. When theory meets the real world...

4/21/2017 Logic The consumer pays insurer a premium to cover medical expenses in coming year. For any one consumer, the premium will be higher or lower than medical expenses. But the insurer can pool or spread risk among many insurees. The sum of premiums will exceed the sum of medical expenses.

Characterizing Risk Aversion 4/21/2017 Characterizing Risk Aversion Recall the consumer maximizes utility, with prices and income given. Utility = U (health, other goods) health = h (medical care) Insurance doesn’t guarantee health, but provides $ to purchase health care. We assumed diminishing marginal utility of “health” and “other goods.”

In addition, let’s assume diminishing marginal utility of income. 4/21/2017 In addition, let’s assume diminishing marginal utility of income. Utility Income

4/21/2017 Assume that we can assign a numerical “utility value” to each income level. Also, assume that a healthy individual earns $40,000 per year, but only $20,000 when ill. Income Utility Sick $20,000 70 Healthy $40,000 90

A B Utility when healthy Utility 90 70 Utility when sick $20,000 4/21/2017 Utility when healthy Utility 90 A B 70 Utility when sick $20,000 $40,000 Income

Individual doesn’t know whether she will be sick or healthy. 4/21/2017 Individual doesn’t know whether she will be sick or healthy. But she has a subjective probability of each event. She has an expected value of her utility in the coming year. Define: P0 = prob. of being healthy P1 = prob. of being sick P0 + P1 = 1

4/21/2017 An individual’s subjective probability of illness (P1) will depend on her health stock, age, lifestyle, etc. Then without insurance, the individual’s expected utility for next year is: E(U) = P0U($40,000) + P1U($20,000) = P0•90 + P1•70

4/21/2017 For any given values of P0 and P1, E(U) will be a point on the chord between A and B. Utility A 90 B 70 $20,000 $40,000 Income

Assume the consumer sets P1=.20. 4/21/2017 Assume the consumer sets P1=.20. Then if she does not purchase insurance: E(U) = .80•90 + .20•70 = 86 E(Y) = .80•40,000 + .20•20,000 = $36,000 Without insurance, the consumer has an expected loss of $4,000.

4/21/2017 Utility 90 • A • 86 C B • 70 $20,000 $40,000 Income $36,000

4/21/2017 The consumer’s expected utility for next year without insurance = 86 “utils.” Suppose that 86 “utils” also represents utility from a certain income of $35,000. Then the consumer could pay an insurer $5,000 to insure against the probability of getting sick next year. Paying $5,000 to insurer leaves consumer with 86 utils, which equals E(U) without insurance.

• A • • B • Utility 90 D 86 C 70 $20,000 $40,000 Income $35,000 4/21/2017 Utility 90 • A D 86 • • C B • 70 $20,000 $40,000 Income $35,000 $36,000

$1,000  loading fee  price of insurance 4/21/2017 At most, the consumer is willing to pay $5,000 in insurance premiums to cover $4,000 in expected medical benefits. $1,000  loading fee  price of insurance Covers profits administrative expenses taxes

Determinants of Health Insurance Demand 4/21/2017 Determinants of Health Insurance Demand Price of insurance In the previous example, the consumer will forego health insurance if the premium is greater than $5,000. Degree of Risk Aversion Greater risk aversion increases the demand for health insurance.

If there is no risk aversion, utility = expected utility, and there is no demand for insurance. B $20,000 $40,000 Income

Probability of ILLNESS Income Larger income losses due to illness will increase the demand for health insurance. Probability of ILLNESS Consumers demand less insurance for events most likely to occur (e.g. dental visits). Consumers demand less insurance for events least likely to occur. Consumers more likely to insure against random events.

The horizontal distance between the utility function and the chord represents the insurance premium the consumer is willing to pay. Utility Income

Consumers bear the full cost of their own health insurance. Assumptions underlying the theoretical model of health insurance demand Consumers bear the full cost of their own health insurance. Insurance companies can appropriately price policies. Individuals can afford health insurance/health care. The above 3 assumptions do not always hold in the real world.

The majority of Americans have employer-provided health insurance. Employer-paid health insurance is exempt from federal, state, and Social Security taxes. Employee will prefer to purchase insurance through work, rather than on his own.

Example: Cost of insurance when income is $1,000 per week and income tax rate is 28% Employee Purchased $1,000 28% tax <280> after tax 720 insurance <50> net pay 670 Employer Purchased $1,000 insurance <50> subtotal 950 28% tax <266> net pay 684

Employer Health Insurance Coverage of U.S. Population (percent) *Projected. Source: Altman et al. 1998, Health Admin. Press

Consequences for costs “Too many” services were covered by insurance. Coverage of more small claims increased administrative costs. Employers offering more than 1 plan often fully subsidized the more expensive plans.

Empirical Evidence Santerre & Neun, page 129. Long & Scott (1982) Regression analysis of the determinants of % of compensation paid to employees as health insurance. Annual U.S. data 1947-1979. N=32.

Empirical Evidence PCTHLINS = -8.64 + .0284 MTR + .0498 RFRAMINC (6.22) (3.98) (1.14) -.0094 UNION + .088 PCTFEM + .1283 PCTSERV (.57) (3.72) (5.52) R2 = .9968 PCTHLINS = % of compensation as health insurance MTR = average marginal tax rate RFAMINC = average real family income UNION = % of labor force unionized PCTFEM = % employees female PCTSERV = % employees in service industries

Empirical Evidence How does an increase in the marginal tax rate affect the worker’s compensation package? The implied elasticity of PCTHLTINS with respect to MTR is 0.41. If the proposed Republican tax cut is passed, will demand for health insurance rise or fall?

Physicians & Managed Care Traditional fee-for-service gives physicians incentive to “overutilize” medical services. Managed care: A broad set of policies designed by 3rd-party-payers to control utilization and cost of medical care: utilization review alternative compensation schemes quality control

Managed care and Physician Incentives HMOs are a type of managed care organization, but there are a variety of HMOs. Staff model: Physicians employed by HMO on a salary basis. No incentive to over-provide care. Group model: HMO contracts w/ group practice, which is paid by capitation. Incentive to limit services.

Network model: HMO contracts w/ >1 group practice, all paid by capitation. Incentive to limit services. IPA model: HMO contracts w/ multiple docs in various practices; paid by discounted fee-for-service. Some incentive to over-utilize.

Types of Managed Care Orgs

Preferred Provider Organization Insurer contracts w/ multiple physicians: but enrollees can pay higher deductible or copay to see physician outside network. Discounted fee-for-service. Some incentive to over-utilize.

Point-of-Service Plan (POS) Insurer contracts w/ multiple physicians: but enrollees can pay higher deductible or copay to see physician outside network. Like a PPO However, enrollees are also assigned a primary caregiver who acts as a gatekeeper to specialists and inpatient care.

Practice Question If you had a choice between a traditional fee-for-service (FFS) plan with a 10% copay, vs. a staff HMO plan with no copay, which plan would you expect to have a higher monthly health insurance premium? If you were elderly and/or sick, which plan would you prefer if they cost the same amount? Why?

Provider Management Strategies Selective contracting. MCOs will contract with an exclusive set of providers. Based on quality or cost-effective practice patterns. Physician profiling. MCOs monitor physicians’ track record regarding referrals, quality, patient satisfaction.

Provider Management Strategies Utilization review “determine whether specific services are medically necessary and whether they are delivered at an appropriate level of intensity and cost. Practice guidelines Inform providers of the appropriate medical practice in certain situations. Formularies restricted list of drugs physicians may prescribe.

Performance of MCO’s: Are they “good” or not?? Ideally, MCOs should encourage preventive and coordinated primary care, which reduces the need for more expensive specialty/inpatient care. But most MCOs are concerned with short-term profitability. Why pay for cholesterol-lowering pills when the enrollee is likely to leave your HMO years before he has a heart attack?

Performance of MCO’s: Are they “good” or not?? In general, studies show that HMOs provide medical cost savings of 15-20%, mostly through reduced hospital care. The impact of HMOs on quality of care is less definite. Health care providers treat patients belonging to a variety of plans.