The role of insurance in health care

Today: Why health care is important to study; The advantages and disadvantages of private insurance

Unit 3 begins now

Unit 3 health care & income redistribution Chapter 9 (most of today’s lecture)

Why health care is important to study The role of health care insurance in the United States

Chapter 10 The role of government in the health care industry

Chapter 11 Social Security issues, including long-run problems

Chapters 12-13 Income redistribution issues

Today

Chapter 9 (and a little bit of Chapter 10) Why is health care important? How health insurance is administered in the

United States Advantages and disadvantages

Risk smoothing with health insurance The problems of adverse selection and moral

hazard Deadweight loss of health insurance

Why is health care important? Health care has steadily used up more of the

US GDP percentage share over the last 50 years This trend will likely continue in due to the

retirement of the baby boomer generation Currently, about 1 out of every 7 dollars of

GDP is used to spend on health Estimate for 2017: 1 out of every 5 dollars See also Figure 9.1, p. 181

Why is insurance important to study? Private health insurance provides over a third

of all health care funds in the US Small improvements in efficiency of health

care delivery could lead to billions of dollars of savings Private health insurance provides 35 percent of

health care funds in the United States in 2004 See also Figure 10.2, p. 207

How health insurance works

Insurance premium People buy insurance due to risk aversion and often get

reduced cost through work Working Americans usually buy insurance from employers

Companies sell insurance since they do not have to sell at the actuarially fair price

Specified benefits Full insurance? Co-payments and/or coinsurance? Deductibles?

Growth of employer-provided insurance Policies during WWII

Wage and price controls resulted in non-wage incentives to workers

1940s: Private health insurance grew significantly 9.1% of Americans in 1940 50.3% in 1950

Tax structure Health insurance is not taxed

Growth of employer-provided insurance Adverse selection

If everybody has health insurance, there are no adverse selection problems

Low administrative costs Group plans in a big firm could have one worker

taking care of all employees

Types of insurance

Cost-based reimbursement (fee-for-service) Managed care arrangements

Health Maintenance Organizations (HMOs) Preferred Provider Organizations (PPOs) Point-of-service (POS)

Managed care arrangements try to keep costs down Co-payments, deductibles, coinsurance, oversight

of services

Insurance, the old way

Cost-based reimbursement Most health care administered

this way until the early 1980s Provides payments for all

services Moral hazard problems

No incentive to keep health care costs down

Increased health care costs to society

Leads to higher premiums

Insurance for your generation Today’s insurance plans have different

methods to keep costs down Many employees have choices of one of

many plans offered by the employer More flexibility means higher premiums

HMOs

Little flexibility All services must be approved by the HMO You typically cannot consult the doctor of your

choice in case of catastrophic illness Lower in cost than other comparable options Often accepts fixed payment per patient

Known as capitation-based reimbursement Example: Kaiser Permanente

PPOs

More flexibility in choice of doctors “In-network” costs are lower

A doctor in the network accepts a lower fee Doctor gets steady supply of patients

“Out-of-network” costs are much higher Higher deductibles and/or co-payments You can often use a world-class hospital if you are

willing to pay part of it

POS plans

Similar to a PPO Main differences from a PPO

Each patient has a primary physician Primary physician oversight keeps costs down relative to

a PPO The primary physician provides referrals to see

specialists

Dealing with job lock

Job lock If a new job does not offer insurance due to a pre-

existing condition, the worker will stay at the old job

Health Insurance Policy Portability and Accountability Act of 1996 (Kennedy-Kassenbaum Act) Provides provisions to reduce job lock Mixed success

New directions for health insurance? As health care costs continue to increase,

consumers must pay for it one way or another

New methods to keep premiums down Explicit reductions in benefits More drug tiers

See readings on class website for more on this Restructuring of benefits

One idea on restructuring benefits Sharing costs between patient and insurer can help

keep costs down A health insurance model to try to reduce health

care demand Provide a yearly fund to each person or family

Carries over to the following year if not used After the yearly fund is used, up to $5,000 of expenses

must be made out-of-pocket After out-of-pocket expenses are paid, 90% of expenses

are covered Insurance for years with truly high expenses

Pooling and risk

Pooling Risk of a single person or family is high Risk of insuring a big population is low

Note Law of Large Numbers Assumes independent risk from person to person

Recall expected value Expected value (EV) = (probability of outcome 1) *

(Payout in outcome 1) + (probability of outcome 2) * (Payout in outcome 2) + … + (probability of outcome n) * (Payout in outcome n)

Expected value example

Draw cards from deck of cards Draw heart and receive $12 Draw spade, diamond or club and lose $4 Probability of drawing heart is 13/52 = ¼ Probability of drawing spade, diamond or club

is 39/52 = ¾ EV = (1/4)($12) + (3/4)(-$4) = $0

Why buy insurance? ExampleInsurance Options

Income Probability of Staying Healthy

Probability of Getting

Sick

Lost Income if She Gets

Sick

(A) (B) (C)

Income if She Stays

Healthy

Income if She Gets

Sick

Expected Value

Option 1: No Insurance

$50,000 9 in 10 1 in 10 $30,000 $50,000 $20,000 $47,000

Option 2: Full Insurance ($3,000

premium to cover $30,000

in losses

$50,000 9 in 10 1 in 10 $30,000 $47,000 $47,000 $47,000

Actuarially Fair Insurance Policy

Expected values are equal

Why buy insurance?

Income

Util

ity

20,000 47,000 50,000

UA

UC

UD

UBD

C

B

A

• Expected Utility

• Risk Smoothing

• Certainty Equivalent

Note: Graph is not to scale

X

Willingness to pay (WTP) for insurance is 50,000 – X, which is more than $3,000

Loading fee

In the last example, the actuarially fair premium is $50,000 – $47,000, or $3,000

Insurers charge a loading fee, which is the amount over $3,000 in this case

Average loading fee: 20 percent

See Figure 9.3, p. 185 Panel A uses a person

that is relatively less risk averse

Panel B uses a person that is relatively more risk averse

WTP is higher for the person with more risk aversion

Another problem: Adverse selection Adverse selection problem: Suppose no

employer health benefit When potential insurance buyers have a choice of

whether or not to buy insurance, people that are more likely to need the benefits will buy the insurance

Insurance companies do not know who will be in a high risk category

Example

6 people at a firm Spending if sick: $10,000 3 people have a high risk of getting sick

10% each Expected spending is $1,000 3 people have a low risk of getting sick

5% each Expected spending is $500 Notice average probability of getting sick is

7.5% No employer-provided contributions to health

care

A naïve offer

Suppose the insurer offers a premium that is 7.5% of $10,000 $750

Who gets insurance under these conditions? High-risk people with certainty ($1,000 > $750) Low-risk people?

Only if WTP for insurance is at least $750

What happens? Insurer loses money due to some low-risk people

not insuring

What really happens?

The high-risk people will be the only people willing to buy insurance in equilibrium

The insurer offers a premium above $1,000 that gets all three high-risk people to insure Premium above $1,000 can be charged due to

risk aversion Loading fee helps the firm pay its administrative

expenses

Solving the adverse selection problem Suppose that the employer offers a $350

contribution to each person that buys insurance

Avg. spending if everyone gets insured: $750

Insurer only needs to charge $400 to break even (excluding administrative costs)

What if the insurer offers a premium of $480? Everyone will now insure, since the expected

spending of each person is at least $500

Un-solving the adverse selection problem The opposite of the above situation occurred

at Harvard in 1995 Reduced contributions to generous health plan “Death spiral” led to the eventual elimination of the

generous health plan Does this mean that government intervention

should occur? Pro: More equity Con: Not efficient

One more problem: Moral hazard Moral hazard problem: People are more

likely to use health care when their share of payments is small or zero

Two moral hazard issues Riskier activities Use of health care that has MB < MC

Moral hazard issues

Riskier activities Skydiving Bungee jumping Poor eating habits Decreased exercise

Use of health care that has MB < MC This is due to patient not

paying the full cost of services provided

Health care

Suppose that Angela has been admitted to the hospital after being in a car accident

She has a substantial MB for the first night in the hospital, due to the care that she needs

Health care

As Angela’s condition improves, her MB declines

When the demand hits the horizontal axis, she is completely better

Think of demand like MB

Think of supply like MC

20 percent co-insurance

Assume that Angela pays 20% of her costs This is also known as coinsurance

Angela will then decide to stay in the hospital as long as MB for each night exceeds its MC She will want to stay in the hospital as long as her

benefit is at least 20% of the hospital’s cost

What about a percentage co-payment? What if Angela had to

pay 20% of her costs while in the hospital Her PRIVATE MC is

two-tenths of MC curve (See dashed line)

Equilibrium is at the yellow circle

0.2 MC

Only a co-payment

Suppose that Angela’s insurance only mandates that she makes a co-payment

Angela’s PRIVATE MC is zero after being admitted

If hospital lets Angela stay in the hospital as long as she wants, equilibrium occurs at Q2 MB and private MC are

both zero here

What is optimal?

Angela’s optimal length of hospital stay occurs when the PUBLIC MC equals MB This occurs at point A

Deadweight loss due to 20% coinsurance

Flat-of-the-curve medicine

Flat-of-the-curve Spending that occurs with low MB

Is the US practicing this type of medicine? Likely in some cases, due to insurance

Analysis across countries is more complicated Countries with nationalized medicine may not

provide some services with MB > MC Malpractice costs

See Figure 9.5, p. 200, to see how rapidly health care costs have increased in the US since 1960

Some final issues

Externalities Graying of the population

Longer life expectancy Retiring baby boomers

Improved technology Reimbursement policies

Externalities

Externalities of health care exist in limited cases

Examples Vaccination (positive) Overuse of antibiotics (negative) Staying home when sick (positive)

Graying of the population

The average age of the population is increasing for two reasons Longer life expectancy Retiring baby boomers

Older people generally have higher health care costs per person This can increase premiums for everyone working for the

same firm More on this topic in later lectures

Government-provided health care Social Security

Improved technology

Old methods of health care are often not expensive Aspirin first marketed over 100 years ago

Modern drugs can have monthly price tags over $1,000 Should someone that is unable to afford a new

drug be left out of using it? Commodity egalitarian arguments have led to price

discrimination by pharmaceutical companies Prices slightly above MC are charged to poor people

Reimbursement policies

Reimbursement policies for medical services to try to keep costs down Review boards Discharge criteria from hospitals

Summary

Health care spending is a significant part of GDP New methods are being used to try to keep costs

down Many health care options exist for workers People buy health care insurance due to risk

aversion Adverse selection and moral hazard are

problems that prevent efficient use of health care