24/09/2018

The Economics of Health Insurance

Health Economics and Economics of Health Care

UPCT

The Economics of Health Insurance

Part 1
Demand side

Methods for covering health risks

 Savings
 Allow to smoothe consumption over time
periods
 Consume less today, but consume more in the
event of a health bill
 Limited, because an individual only trades with
himself

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Methods for covering health risks

 Family and friends
 Trade based on the principle of reciprocity
 Help someone in my circle, I will get help if I need
to
 Limited by how large the circle, by meddling
etc.
 Charity
 Limited by availability of funds and meddling

Methods for covering health risks

 Health Insurance
 Pay a premium to an insurance company
 Contract that specifies which health care costs
will be funded by the company
 Based on the predictability of risk in large
numbers of people
 It’s impossible to know whether a particular
individual will have a heart attack this year
 But it’s known that 1%, say, of the population will
have a heart attack this year

Methods for covering health risks

 Health Insurance
 Insurance pools losses, that is, it spreads the
costs of the health carefor for one person over
a large group of people who buy insurance
 These losses are paid by means of the
premiums, which also include the
administrative costs plus the profits to the
owners of the insurance company

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Methods for covering health risks

 Actuarially fair premium (AFP) and Loading Factor
 For a risk of X% of a loss of Y€, the AFP is X*Y €
 For example, a risk of 1% of a loss of 50000 € has
an AFP of 500 €
 The difference between the premium and the AFP
is called the Loading Factor
 The Loading Factor includes the administrative
costs for the company plus its profits

Methods for covering health risks

 For example, a company might insure 1000
individuals, each having a 1% risk of needing 50000
€ worth of health care after a heart attack during any
one year period.
 If it charges a premium of 600 € per year
 Revenue=1000*600=600000 €
 Expected loss=0.01*1000*50000=500000 €
 If it has a fixed administrative cost of 50000 € then
 Expected profit=600000-500000-50000=50000 €

Methods for covering health risks

 The actual profit could be larger or smaller
than the expected profit depending on how
many people actually suffer a health shock
during the period
 The company will want to insure as many
people as possible
 It reduces the uncertainty of expected costs
 It increases profits

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Risk aversion
 People are willing to pay more than an AFP to
buy health insurance if they are not covered
by some social/public scheme
 Very often, people buy complementary or
supplementary health insurance on top of
their social/public insurance
 The reason is that many health shocks can
cause catastrophic costs

Risk aversion
 Imagine that you have a 1% risk of having a
heart attack in any one year period, which will
cost you 50000 € in treatment
 How much would you be ready to pay for an
insurance policy covering such hypothetical
cost?
 If you are willing to pay more than the AFP of
500 € per year then you are risk averse
 If you are willing to pay less than the AFP you
are risk loving

Risk aversion
 Most people are risk averse
 They prefer to pay a steady premium (larger
than the AFP) to avoid an uncertain large loss
 But people are sometimes risk loving when
playing lotteries
 Because the cost of a lottery ticket is always
greater than the the expected gain of the
lottery

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Risk aversion
 And some people are risk averse but they
cannot afford health insurance
 That is why health insurance is very often
provided as social/public insurance,
 Even if private, it receives large tax subsidies

Insurance and access to health care

 Apart from the benefits for risk averse people,
insurance often determines whether a person can
have access to a necessary treatment or not
 Following the previous example, many people could
not afford the 50000 € of a heart attack treatment
 So the benefits of insurance are greater than those
derived of avoiding uncertain losses,
 For many, there would be loss of life or limb rather
than financial loss

Adverse selection
 The risk of a heart attack in the population
might be 1%,
 but suppose that you know that you have a
weak heart and you know that you have a
20% chance of having a heart attack in any
one year period (you are a bad risk)
 You would be willing to pay much more than
the 600 € set by the insurance company

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Adverse selection
 Now suppose that you know that you have a strong
heart and you know that you have a 0.1% chance of
having a heart attack in any one year period (you are
a good risk)
 Perhaps you would not be willing to pay the 600 € set
by the insurance company and will not buy insurance
 If all or some “good risks” decided not to buy
insurance then the risk of the people who buy
insurance will be greater than the 1% in the overall
population

Adverse selection
 For example, the previous company will now insure
900 individuals, with a 2% risk of needing 50000 €
worth of health care after a heart attack during any
one year period.
 If it charges a premium of 600 € per year
 Revenue=900*600=540000 €
 Expected loss=0.02*900*50000=900000 €
 If it has a fixed administrative cost of 50000 € then
 Expected profit=540000-900000-50000=-410000
€

Adverse selection
 So the company will have losses unless it increases
the premium. In order to restore the previous level of
profits it will need to apply a premium of 1111 € per
year
 But this will further reduce the number of good risks
in the pool of insurees…
 …so the premium will have to increase
 Eventually the company is left with only very bad
risks …
 …and it closes down

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Adverse selection
 Adverse selection occurs when the information
available to the insuring company is different to the
information that the individual possesses about
his/her health risks
 In some cases this will make it impossible for an
insurance market to exist
 A solution to the problem of adverse selction is
making insurance obligatory. This means that the
good risks and bad risks are pooled together and, in
effect, the premums of the former subsidise the costs
of the latter
 E.g. obligatory traffic accident insurance

Moral hazard
 People with health insurance are more likely
to go to the doctor than other people all other
things held equal
 When they go to hospitals they tend to
choose better rooms
 They also tend to consume more medicines

Moral hazard
 The problem of moral hazard is more
important for treatments whose consumption
is more responsive to price (price elastic)
 A liver transplant is unlikely to be affected by
moral hazard
 A family doctor visit to consult about a
common cold is very likely to be affected by
moral hazard

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Moral Hazard Costs of Health Insurance for

Patients
 The problem of moral hazard offsets the
consumption-smoothing and access benefits of
health insurance
 Feldstein (1973) analyzes the problem, as illustrated
in the following figure

Figure 2

Price of
each visit

The “right” amount of

health care is where D=S. Deadweight Loss

A B
$100 S=MC

Health insurance shifts the

consumers’ demand, leading
This over-
to more consumption.
consumption leads
C
$10 to deadweight loss.
D
Number of visits
Q1 Q2 to doctor’s office

Moral Hazard Costs of Health Insurance for

Patients
 The private marginal cost is lower than the social
marginal cost, resulting in deadweight loss.
 The fundamental trade-off of health insurance, then,
is the gains in terms of consumption smoothing
versus the costs in terms of the overuse of medical
care.

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Moral Hazard Costs of Health Insurance for

Patients
 Moral hazard might then lead to “flat of the curve”
medicine.
 Consider the relationship between an additional $1
of total spending on health care and the amount of
marginal benefit from that spending.
 Initially, the marginal benefit is very high (e.g.,
influenza shots for the elderly, etc.), but it declines.
 The following figure illustrates such a curve.

Figure 3
Initially, dollars of
Further spending
$ of Marginal spending lead to
has diminishing
Health Benefits high benefits.
returns.

A
$5

B
$1

C
$0.10

$1,000 $2,000 $5,000 $ of Medical

Spending

Moral Hazard Costs of Health Insurance for

Patients
 Productivity dwindles as spending on health care rises. From
a societal perspective, spending should stop when the
additional health benefit is smaller than the additional health
cost.
 If individuals paid the full cost of their health care, the
socially optimal amount, point B would be chosen.
 If individuals do not pay (or do not pay much) for their
additional health care, they will demand health care as long as
the effectiveness curve is not perfectly flat.
 The “flat of the curve” area is therefore beyond point B,
where each $1 of medical care buys less than $1 in improved
health.

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How Elastic Is the Demand for Medical Care?

The RAND Health Insurance Experiment
 A critical question becomes: To what extent does moral
hazard actually cause patients to consume more health care?
 Or, how elastic is the demand for health care?
 The RAND Health Insurance Experiment (HIE) was a true
social experiment with random assignment of health plans
with different policy parameters. The coinsurance rate varied
from 0% to 95%.
 The out-of-pocket maximum was $1,000 for all participants
(even the ones in the less generous plans). In addition, all
families were given $1,000 to participate, so no one was made
worse off from the experiment.

How Elastic Is the Demand for Medical Care?

The RAND Health Insurance Experiment
 The HIE found that overall, each 10% rise in the
price of medical care to individuals led them to use
2% less care, a small elasticity of -0.2.
 That is, medical utilization is fairly insensitive to
price.
 On the other hand, even with this low elasticity the
implied deadweight loss from insurance (moral
hazard) coverage is estimated to be substantial

Optimal Health Insurance

 The findings of a non-zero elasticity (e.g., moral

hazard) and the significant deadweight loss that goes
with it, suggest that the optimal health insurance
policy is one in which,
 Individuals bear a large share of the medical costs
within some affordable range, and
 Individuals are fully insured when costs become
unaffordable.

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Optimal Health Insurance

 One example of a plan like this is Feldstein’s (1973)

“Major Risk Insurance” plan in which:
 Individuals make a 50% copayment on all services
until they reach 10% of their income on medical
care, and
 Receive full insurance thereafter.

Different contracts for Health Insurance

 In fact, individuals often pay for part of the cost of

their actual utilization, in one of three ways:
 Deductible (franquicia): A person faces the full cost of
care to some limit, and the insurance company pays
for costs after that.
 Copayment (copago): A person pays a fixed payment
when they get a medical good or service.
 Coinsurance (coaseguramiento/subsidio): A person pays a
percentage of each medical bill rather than a flat
dollar amount.

Summary of part 1
 How insurers are able to spread the risk over many
insurees
 Why being able to buy health insurance is good for
consumers
 Risk aversion
 Access to health care
 Adverse selection
 Moral hazard
 Rand Experiment
 Types of contract to avoid patient moral hazard

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The Economics of Health Insurance

Part 2
Supply side

Public and Private Health

Insurance
 Health Insurance can be private or
social/public
 Private
 A voluntary agreement with an insurance
company who charges a premium
 Social/Public
 A statutory regime, usually obligatory and usually
funded by taxes or Social Security contributions

Private Insurance
 Private health insurance has a supplementary role in Spain, as the public
insurance system is comprehensive and universal
 However, this is not the case in other countries: The private market
provides a large share of health insurance coverage in the U.S.
 The nongroup insurance market is the market through which
individuals or families buy insurance directly rather than through a group,
such as the workplace.
 In Spain, about one fifth of the population is covered by private
insurance in addition to public insurance
 One third of these get private insurance through their employer as
part of the remuneration package

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Source: Bernal-Delgado E, García-Armesto S, Oliva J, Sánchez Martínez FI,

Repullo JR, Peña-Longobardo LM, Ridao-López M, Hernández-Quevedo C.
Spain: Health system review. Health Systems in Transition, 2018;20(2):1–179.

Available at:
http://www.euro.who.int/en/about-us/partners/observatory/publications/health-
system-reviews-hits/full-list-of-country-hits/spain-hit-2018
(accessed on 24 september 2018)

Why is private insurance often offered via

the employer?
 One motivation is the nature of “risk pools.”
 Insurers try to create large insurance pools with a predictable
distribution of medical risk. Two features increase the
predictability of medical risk distributions:
 The absence of adverse selection

 Large group sizes

 Workers at large firms have a good chance of meeting these

conditions.

Why is private insurance often offered via

the employer?
 Individuals are not likely to meet these conditions.
 Although large groups of individuals could be
formed, the concern about adverse selection remains.
 That is, is the group looking for health coverage
simply because they are sick.

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Why is private insurance often offered via

the employer?
 Some administrative costs of running a health
insurance plan are fixed; thus, the larger the pool,
the smaller the per-enrollee costs.
 This also reinforces the preference for providing
insurance through large firms.

Why is private insurance often offered via

the employer?
 Often governments use tax incentives for firms to
offer health insurance
 The tax subsidy to employer provided health
insurance refers to the fact that workers are taxed
on their wages but not on the value of the insurance
that their company buys for them.

Why is private insurance often offered via

the employer?
 The effective price of offering €1 of health
insurance is only €(1-t), where t is the marginal
income tax rate.
 Table 2 illustrates this incentive. In this example,
even though it is cheaper to purchase health care
outside of the employer, the tax subsidy more than
offsets these savings.

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Table 2
Illustrating the Tax Subsidy to Employer-Provided Insurance
Marginal Employer
Although Jim buys Pre-tax After-tax
less expensive Personal After-tax,
product, health wage
health insurance
wage insurance
on his own, hiswage
net health
insurance
after-health
insurance
income is lower!
spending spending income

Jim €30,000 0 €30,000 €25,500 €4,500 €21,000

Peter €30,000 €5,000 €25,000 €21,250 0 €21,250

Why is private insurance often offered via

the employer?
 The subsidy in this case is to employees purchasing
health insurance in the employment setting.
 From the employer’s perspective, the way in which
it pays the employee is irrelevant; €5000 of health
insurance is as costly as €5000 in wages.
 Any type of employee compensation is deductible
from corporate taxes (impuesto de sociedades).

Private Insurance. The non-group market

 The non-group market (e.g., privately-purchased plans).
In Spain

 Private insurance purchased individually (about 15% of the

population)
 In the US it represents about 1 out of every ten insurees
 In the case of the US, where PI is the only form available to a large
section of the population, this is explained by problems of adverse
selection and administrative costs.
 Some individuals are denied coverage entirely (remember the
film Sicko).
 Often, policies have “preexisting conditions exclusions.”

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Moral hazard in the supply side

 Patient-side (demand-side) moral hazard refers to the extra

care demanded for illness because insurers cover the cost of
medical treatment.
 Provider-side (supply-side) moral hazard refers to the extra
care provided for illness because insurers reimburse health
care providers based on costs.
 Even if an insurer could perfectly assess a patient’s true
level of illness, the cost to treat that illness can vary
considerably.
 Insurers have often reimbursed medical providers
according to their reported costs of treatment. This is
called retrospective reimbursement

Moral hazard in the supply side: The problem

with retrospective reimbursements
 Retrospective reimbursement can create moral
hazard in the supply side
 Because it removes any incentive for providers to
treat their patients cost-effectively.
 If a physician’s objective is to maximize health of the
patients, then this system will likely yield “flat of the
curve” (ineffective) medicine.
 In addition, if physicians are also concerned about
income maximization, this sort of reimbursement
only exacerbates the moral hazard.

Managed Care

 Health insurance, be it private or social/public

provides health services under some form of
managed care
 Managed care is an approach to controlling costs
using supply-side controls.
 Manage care comes in two basic forms: PPOs and
HMOs.

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Managed Care: PPOs

 Preferred provider organizations (PPOs) are health care

organizations that lower care costs by shopping for health
care providers on behalf of the insured.
 The insuree is then restricted (or encouraged) to use health
care within the network
 This is the case of most of the services offered by private
health insurance companies in Spain
 If you contract a policy with ASISA, DKV, ADESLAS
etc. you can only use the doctors and hospital of its
“cuadro médico”
 The payment system is frequently retrospective but at a
discounted fee for service

Managed Care: HMOs

 Health maintenance organizations (HMOs) are

health care organizations that integrate insurance
and delivery of care.
 For example, HMOs may pay its own doctors and
hospitals a salary independent of the amount of care
they deliver.
 In the classic staff model, HMOs hire their own
physicians and may have their own hospitals.
 This is the case of the Servicios Regionales de Sauld
in Spain

Managed Care: HMOs

 Frequently, the HMO contracts with independent providers

within a restricted network to deliver care to its enrollees.
 This model is known as the Independent Practice
Association (IPA).
 This model of managed care is gradually being
experimented in Spain, where the HMO is the
corresponding Servicio Regional de Salud and the IPA is
some private hospital
 Prospective reimbursement is the practice of paying
providers based on what treating patients should cost, not
on what the provider actually spends.
 HMOs with the IPA model uses prospective
reimbursement to counteract provider moral hazard.

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Managed Care and Prospective Reimbursement

 Prospective reimbursement completely reverses the financial

incentives of physicians.
 Now when physicians deliver less care, profitability goes
up.
 This could create financial incentives to give insufficient
care.
 The HMO often gives incentives for a physician to limit
the care he delivers, and to restrict the use of specialists as
well.
 Some critics of subcontracting public care to private
hospitals and network in Spain are concerned about these
potential incentives

Summary of part 2
 Private and public insurance
 Private insurance via employment
 The non group market
 The problem of the uninsured

 Retrospective reimbursement and provider

side moral hazard
 Managed care
 PPOs and discounted fee for service
 HMOs and prospective reimbursement

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