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Health InsuranceHealth InsuranceOctober 19, 2006October 19, 2006

Insurance is defined as a means of protectingagainst risk.

Risk is a state in which multiple outcomes are possible and the likelihood of each possibleoutcome is known or can be estimated.



K ey behind insurance: means of K ey behind insurance: means of protecting against risk.protecting against risk.

T he Market for Health InsuranceT he Market for Health InsuranceIt¶s impossible to determine whether one particular It¶s impossible to determine whether one particular individual will suffer from a medical condition, suchindividual will suffer from a medical condition, suchas a heart attack or stroke.as a heart attack or stroke.When individuals are combined into large enoughWhen individuals are combined into large enoughgroups, or risk pools, the probability that someone ingroups, or risk pools, the probability that someone inthe group will suffer from a heart attack or strokethe group will suffer from a heart attack or strokecan be estimated.can be estimated.T he estimated probability of an event is based on theT he estimated probability of an event is based on thehistorical frequency of the event occurring in thehistorical frequency of the event occurring in the

past. T he larger the group, the greater the accuracy past. T he larger the group, the greater the accuracyof the prediction.of the prediction.



M arket for Health Insurance (con.)M arket for Health Insurance (con.)Ex perience rating: Basing health insuranceEx perience rating: Basing health insurance

premiums on the utilization e x perience of a specific premiums on the utilization e x perience of a specificinsured group. Premiums may vary by age, se x , or insured group. Premiums may vary by age, se x , or other risk factors and are often taken intoother risk factors and are often taken intoconsideration prior to use of medical services.consideration prior to use of medical services.Community rating: Basing health insuranceCommunity rating: Basing health insurance

premiums on the health care utilization of the entire premiums on the health care utilization of the entire population of a specific geographic area. Premiums population of a specific geographic area. Premiumsare the same for all individuals regardless of age,are the same for all individuals regardless of age,sex , risk, or prior use of health care services.sex , risk, or prior use of health care services.



Indemnity insurance:Indemnity insurance:

Reimbursement for certain e x penditureReimbursement for certain e x penditure

Higher risk persons pay higher premiumsHigher risk persons pay higher premiums(Key idea here the insurance is based on(Key idea here the insurance is based onthe principle that someone suffering anthe principle that someone suffering an

economic loss receives a paymenteconomic loss receives a paymentappro x imately equal to the size of theappro x imately equal to the size of theloss.)loss.)



U nited States:U nited States:Mostly group insuranceMostly group insurancewith the same rates within groupswith the same rates within groups

(varying by size of family)(varying by size of family)Rates reflect e x pected rate of use of theRates reflect e x pected rate of use of themedical system.medical system.

Group rates vary depending on pastGroup rates vary depending on pastclaims.claims.Ex perience rating across groupsEx perience rating across groups

Community rating within groupsCommunity rating within groups



Social insurance:Social insurance:

Basis of all government redistributionBasis of all government redistribution programs programs

Financed by ta x revenuesFinanced by ta x revenuesAvailable to all persons regardless of Available to all persons regardless of ability to payability to payEx amples in the U.S. are Medicare andEx amples in the U.S. are Medicare andMedicaidMedicaid



Health Insurance and M arketHealth Insurance and M arket

FailureFailureT he dominant feature of U.S. medicalT he dominant feature of U.S. medicalmarket place is the reliance on the thirdmarket place is the reliance on the third

party payment mechanism. party payment mechanism.T he ta x subsidy to insurance has shapedT he ta x subsidy to insurance has shapedthe market for medical health insurance.the market for medical health insurance.T

he subsidy is estimated to be over $100T

he subsidy is estimated to be over $100 billion. billion.Information problemsInformation problems



E conomics of M oral HazardE conomics of M oral Hazard

When writing contracts and there is a differenceWhen writing contracts and there is a differencein information between the parties to thein information between the parties to thecontract. All contracts involve e x pectations aboutcontract. All contracts involve e x pectations aboutfuture behavior.future behavior.One party cannot monitor the other party¶sOne party cannot monitor the other party¶s

behavior. behavior.Ex

ploiting the informational problems leads to anEx

ploiting the informational problems leads to anincreased probability of use and increasedincreased probability of use and increasedex penditures given use.ex penditures given use.Keep in mind consumers are viewed as weighingKeep in mind consumers are viewed as weighing

x tra n fits an x tra c sts in makin ax tra n fits an x tra c sts in makin a



M oral HazardM oral Hazard

T he fact a person has insurance coverageT he fact a person has insurance coverageincreases the e x pected health e x penditures.increases the e x pected health e x penditures.

Having insuranceHaving insurance1. increases the likelihood of purchasing1. increases the likelihood of purchasing

medical services.medical services.

2. induces higher ex penditures in the event of 2. induces higher e

x penditures in the event of an illness.an illness.



M oral HazardM oral Hazard

T hese information problems affect theT hese information problems affect thestructure of insurance contracts. T he personstructure of insurance contracts. T he personwith insurance recognizes that the service iswith insurance recognizes that the service is³sale priced.´ ($0.10 to $0.20 on the $1)³sale priced.´ ($0.10 to $0.20 on the $1)



A dverse SelectionA dverse Selection

arises because consumers have morearises because consumers have moreinformation about e x pected medicalinformation about e x pected medical

ex penditures than do insuranceex penditures than do insurancecompaniescompanies



T he ability of prospective insuranceT he ability of prospective insurancecustomers to conceal their true risks cancustomers to conceal their true risks canresult in some insurance groups having aresult in some insurance groups having a

disproportionate number of high users.disproportionate number of high users.Ex ample: assume people within aEx ample: assume people within a

particular group have the same risk particular group have the same risk

preferences. preferences.



L ow risk group, self insured:L ow risk group, self insured:

4% chance of a $50,000 loss4% chance of a $50,000 lossWhat¶s the e x pected value of the loss inWhat¶s the e x pected value of the loss in

this case?this case?



High risk group, self insured:High risk group, self insured:

3 0% chance of a $50,000 loss3 0% chance of a $50,000 lossWhat¶s the e x pected value of the loss inWhat¶s the e x pected value of the loss in

this case?this case?



Suppose we pool these two groups,Suppose we pool these two groups,each comprising 50% of theeach comprising 50% of the

population.population.

What is the e x pected value of the loss inWhat is the e x pected value of the loss in

this case?this case?Who gains from pooling these two groups?Who gains from pooling these two groups?What incentives will be given to those whoWhat incentives will be given to those whohave only a 4% chance of the $50,000 loss?have only a 4% chance of the $50,000 loss?



It can be shown in the pooled e x ampleIt can be shown in the pooled e x amplethat lowthat low--risk patients are subsidizing highrisk patients are subsidizing highrisk patients.risk patients.

Low risk persons choose not to groupLow risk persons choose not to groupinsure under this community rating case,insure under this community rating case,leaving the pooled group including onlyleaving the pooled group including only

the high risk persons.the high risk persons.



R esponse to M oral HazardR esponse to M oral Hazard

Coinsurance (typically 10 % Coinsurance (typically 10 % -- 20% )20% )coco--pays (e.g. UD policies $15 for GPs pays (e.g. UD policies $15 for GPs

and $25 for specialists)and $25 for specialists)Deductibles (typically $100Deductibles (typically $100 - - $3 00)$3 00)



R esponses to A dverse SelectionR esponses to A dverse Selection

Look at prior usage (e.g. physical e x aminationsLook at prior usage (e.g. physical e x aminationsand/or questionnaires).and/or questionnaires).Ex isting conditions may not be covered.Ex isting conditions may not be covered.T he health portability and accountability act passed in 1996T he health portability and accountability act passed in 1996modified the provision of insurance to those with pree x istingmodified the provision of insurance to those with pree x istingconditions somewhat. An individual who has insurance andconditions somewhat. An individual who has insurance andsubsequently becomes ill may not be denied continuedsubsequently becomes ill may not be denied continuedcoverage under any circumstances. T he policy is portablecoverage under any circumstances. T he policy is portableacross plans. Individuals without insurance coverage who areacross plans. Individuals without insurance coverage who aresick may still be denied coverage.sick may still be denied coverage.



C onclusionC onclusion

Lack of information causes problems in healthLack of information causes problems in healthcare related to moral hazard and adversecare related to moral hazard and adverseselection.selection.Keep these concepts in mind when we hear Keep these concepts in mind when we hear about the Australia private health insuranceabout the Australia private health insurance

plans. (which are supplements to the state plans. (which are supplements to the state provided health system) provided health system)

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