The role of insurance in health care, part 1

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The role of insurance in health care, part 1

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

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Unit 3 begins now

• Unit 3 ? health care income redistribution
• Chapter 9 (this week)
• 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
• Parts of Chapter 11
• Social Security issues, including long-run
  problems
• Parts of Chapters 12-13
• Income redistribution issues

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Today

• Begin Chapter 9
• 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

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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

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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
• See also Figure 10.2, p. 207

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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?

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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

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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

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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

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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

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Insurance for your generation

• Todays insurance plans have different methods to
  keep costs down
• Many employees have choices of different plans
  offered by the employer
• HMO plans
• PPO plans
• POS plans

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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

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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

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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

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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

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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

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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)

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Why buy insurance? Example
Insurance Options Income Probability of Staying Healthy Probability of Getting Sick Lost Income if She Gets Sick (A) (B) (C)
Insurance Options Income Probability of Staying Healthy Probability of Getting Sick Lost Income if She Gets Sick 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
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Why buy insurance?
B
UB
Utility
D
UD
UC
C

• Expected Utility
• Risk Smoothing
• Certainty Equivalent

A
UA
Willingness to pay (WTP) for insurance is 50,000
X, which is more than 3,000
Note Graph is not to scale
Income
20,000
X
47,000
50,000
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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

More on risk aversion See Figure 9.3, p. 185
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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

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Example

• 6 people at a firm
• Spending if somebody gets 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

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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 gt 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

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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

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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

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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

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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 lt MC

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Moral hazard issues

• Riskier activities
• Skydiving
• Bungee jumping
• Poor eating habits
• Decreased exercise

• Use of health care that has MB lt MC
• This is due to patient not paying the full cost
  of services provided

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More on moral hazard on Wednesday

• What other problems occur when patients do not
  have to pay the full MC of their care?
• What reforms to health care can be made to solve
  these problems?

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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

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Stay healthy