2IntroductionThe field of health care has made great strides during the last century.This increase in quality has been accompanied by a much greater share of GDP devoted to the health sector.1950: 4% of GDP devoted to health care2003: 15% of GDP devoted to health care2075: 38% of GDP devoted to health care
3IntroductionIs growing health care spending a problem? There are certainly benefits. Treatment for many ailments has improved dramatically.Knee surgery that used to be very invasive and took months to recover is now a quick and easy procedure.The number dying from heart attacks has fallen by half.The infant mortality rate has fallen by 75%.Individuals can permanently improve their vision with LASIK surgery, that takes less than two hours, and be up and running within a day.
4IntroductionThere are some problems with the health care system however. Disparities in health outcomes exist by race and income.The white infant mortality rate is 6 per 1000, in line with countries like the United Kingdom and Australia.The black infant mortality rate is 14 per 1000, more than double. It is higher than some developing countries.
5Introduction Access to health care also varies. 15.6% of the U.S. population, or 45 million people were uninsured in 2003.The number of uninsured has remained high during both economic booms and busts.
6IntroductionAlthough the U.S. health care system is perceived to be “private,” the government accounts for almost one-half of all health spending.This spending takes up more than one-fifth of the budget of the federal, state, and local government.The spending will continue to grow as the U.S. population ages.
7AN OVERVIEW OF HEALTH CARE IN THE U.S. In 2003, the U.S. spent more than $1.6 trillion on health care, or 15% of GDP.This share of GDP is nearly twice as much as countries like Japan and the United Kingdom.It corresponds to more than $5,800 for each person in the U.S.See Figure 1.
8Figure 1Spending in the U.S. averages $5,800 per person, and nearly 15% of GDP.Countries like the United Kingdom and Japan spend a much smaller share on health care.
9AN OVERVIEW OF HEALTH CARE IN THE U.S. Table 1 shows health insurance coverage in the United States in 2002.These statistics come from the Current Population Survey (CPS).The questions of the CPS refer to insurance coverage over the entire previous year; thus being uninsured means no coverage at any point during the calendar year.
10Americans’ Source of Health Insurance Coverage, 2002 Table 1Americans’ Source of Health Insurance Coverage, 2002People(millions)Percentage of populationTotal population288.6100.0%Private177.861.6%• Employment-based161.055.8%• Individually purchased16.85.8%Public83.028.8%• Medicare40.514.0%• Medicaid42.814.8%• TRICARE/CHAMPVA6.92.4%Uninsured43.315.0%Roughly 44 million individuals were uninsured for the entire 2002 calendar year, or 15% of the population.
11How Health Insurance Works: The Basics To understand how health insurance works, there are some “basics” of its structure that must be understood.Firms or individuals pay “premiums” to insurance companies. In return, the insurance company pays health care providers when the individual has claims.
12How Health Insurance Works: The Basics Individuals often pay for part of the cost of their actual utilization, in one of three ways:Deductible: A person faces the full cost of care to some limit, and the insurance pays for costs after that.Copayment: A person pays a fixed payment when they get a medical good or service.Coinsurance: A person pays a percentage of each medical bill rather than a flat dollar amount.
13Private InsuranceThe private market provides nearly three-quarters 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.9 out of every 10 privately insured individuals gets their health insurance through their employer.
14Private InsuranceEmployers who offer health insurance often have requirements related to taking it up.Length of serviceEmployee premiumsSome employees choose not to take-up health insurance that they are offered.
15Private InsuranceA risk pool is a group of individuals to whom an insurance plan is offered.One motivation for employers to offer coverage 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 selectionLarge group sizesEmployers have a good chance of meeting these conditions.
16Private Insurance 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.
17Private InsuranceSome 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.
18Private InsuranceOverall, adverse selection, group size, and fixed costs lead to vast differences in the odds of being offered health insurance.98% of firms with 200 or more employees offer health insurance to at least some of their employees.Only 55% of firms with fewer than 10 employees offer health insurance.Even one costly health risk (such as a cancer or AIDS patient) can lead to losses for small groups.
19Private InsuranceThe tax subsidy to employer provided health insurance refers to the fact that workers are taxed on their wage compensation but not on their compensation in the form of health insurance, leading to a subsidy to health insurance provided through employers.This is a second motivation for employers to offer the coverage.
20Private InsuranceThe effective price of offering $1 of health insurance is only ($1-J), where J is the cumulative federal, state, and payroll 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.
21Illustrating the Tax Subsidy to Employer-Provided Insurance Table 2Illustrating the Tax Subsidy to Employer-Provided InsuranceMarginal product, wageEmployer health insurance spendingPre-tax wageAfter-tax wagePersonal health insurance spendingAfter-tax, after-health insurance incomeJim$30,000$25,500$4,500$21,000Peter$5,000$25,000$21,250Although Jim buys less expensive health insurance on his own, his net income is lower!
22Private InsuranceThe 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.
23Private InsuranceThe non-group market (e.g., privately-purchased plans) is relatively small.This is explained by the problems of adverse selection and administrative costs. These problems make the non-group market a poorly functioning market.Some individuals are denied coverage entirely.Often, policies have “preexisting conditions exclusions.”
24MedicareMedicare is the federal program that provides health insurance to all people over age 65 and disabled persons under age 65.35 million elderly were eligible in 2003, as well as 6 million disabled persons.Every citizen who has worked for 10 years in Medicare-covered employment (or their spouse) is eligible.Financed with an uncapped payroll tax totaling 2.9%.
25MedicaidMedicaid is the federal and state program that provides health care for the poor.It is financed with general revenues.It targets several groups:Those who qualify for cash welfareLow-income children and pregnant women (for expenses with pregnancy only)Low-income elderly and disabled (for non-Medicare costs and long-term care)
26MedicaidThe young, poor population, particularly mothers and children, make up nearly 70% of the programs recipients.On the other hand, over two-thirds of program expenditure is devoted to long-term care, which is largely spent on the elderly and disabled.
27TRICARE/CHAMPVATRICARE and CHAMPVA are health insurance programs targeted toward those currently or formerly in the military, and their dependents.Together they provide coverage for nearly 7 million Americans.
28The Uninsured44 million individuals in the U.S. are without any insurance coverage at all.They tend to have below-average incomes. Nearly two-thirds of the uninsured are in families with incomes below 200% of the poverty line.70% of the uninsured are in families with a head of household who is a full-time, full-year worker.Over one-fifth of the uninsured are children.
29The UninsuredWhy should we care about the uninsured?Physical externalities associated with communicable diseases.Financial externalities: Uncompensated care is the costs of delivering health care for which providers are not reimbursed.$35 billion delivered in uncompensated care, roughly 2% of total spending.Inappropriate delivery of care (e.g., through emergency rooms).Paternalism and equity–individuals may irrationally underinsure themselves by miscalculating the odds of getting sick.Finally, becoming uninsured is a concern for many.
30The UninsuredThis final concern, becoming uninsured, is an issue because of the great reliance on employer-provided health insurance.Job lock is the unwillingness to move to a better job for fear of losing health insurance.This can lead to a mismatch between workers and jobs, and can lower overall productivity.
31The Uninsured Example of job lock: Brigitte gains utility from two goods: consumption and health insurance. Her utility function is of the form U=U(C,HI), where HI equals 1 if insured, and 0 otherwise.In well-functioning labor market, she is paid her marginal product of labor in total compensation. She has a lower marginal product on job 1 than job 2, MP1< MP2, so it would be efficient for her to change jobs.If job 1 was at a large firm with relatively cheap health insurance ($P), then her utility on job 1 is U(MP1-P,1). If job 2 was a small firm which did not offer health insurance, her utility is U(MP2,0). If Brigitte values health insurance above its cost, she might stay at her old job.Thus, health insurance availability may inhibit productivity increasing job switches.
32Health insurance and mobility Empirical EvidenceThe most convincing evidence of job lock relies on “difference-in-difference” estimators.One strategy examines mobility rates for those who are covered/uncovered and those who value health insurance highly/or not (rather than simply making comparisons based on coverage alone).Another strategy uses state-law changes that loosened job lock with “COBRA continuation coverage.”Studies have found evidence of job lock and “retirement lock.”
33HOW GENEROUS SHOULD INSURANCE BE TO PATIENTS? As with other insurance, the optimal generosity will be determined by the trade off between consumption-smoothing and moral hazard.Generosity represents the share of medical spending that will be reimbursed by the health insurer.This generosity can be measured with respect to the patients and with respect to the providers.
34HOW GENEROUS SHOULD INSURANCE BE TO PATIENTS? Risk-averse individuals will value health insurance as a means of smoothing their consumption with respect to the cost of medical events.Some events, like a check-up, are minor and predictable, while others, like a heart attack, are more expensive and unpredictable.Expected utility theory suggests that insurance is much more valuable for expensive, unpredictable events.
35HOW GENEROUS SHOULD INSURANCE BE TO PATIENTS? The most generous insurance plans are ones that provide first-dollar coverage, reimbursing providers fully with little or no cost to the patient.Thus, first dollar coverage does not provide much more consumption smoothing than a plan that only pays for the higher costs of major medical events (catastrophic care).
36Consumption Smoothing Benefits of Health Insurance for Patients The consumption smoothing benefits of first dollar coverage for minor and predictable events is small because:Risk-averse individuals gain little utility from insuring small risks.And individuals are much more able to self-insure.
37Consumption Smoothing Benefits of Health Insurance for Patients Consider the following example. Sam faces an actuarially fair premium for a minor risk.He has $30,000 in income, and faces a 1% chance of a relatively minor $100 loss. His utility function is:
38Consumption Smoothing Benefits of Health Insurance for Patients Without any insurance, Sam’s utility is:With actuarially fair insurance, Sam’s utility is:
39Consumption Smoothing Benefits of Health Insurance for Patients Thus, Sam’s utility does not measurably increase if he buys insurance against a minor risk like this.Technically, the consumption-smoothing gains from insuring small risks is small because there is no diminishing marginal utility for small changes in consumption.The losses from reducing consumption by $1 are roughly equal to the gains from increasing consumption by $1.
40Moral Hazard Costs of Health Insurance for Patients Offsetting the consumption-smoothing benefits of health insurance to individuals is the risk of moral hazard.Feldstein (1973) analyzes the problem, as illustrated in Figure 2.
41The “right” amount of health care is where D=S. Deadweight Loss Figure 2Price ofeach visitThe “right” amount of health care is where D=S.Deadweight LossAB$100S=MCHealth insurance shifts the consumers’ demand, leading to more consumption.This over-consumption leads to deadweight loss.C$10DNumber of visitsto doctor’s officeQ1Q2
42Moral 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.
43Moral Hazard Costs of Health Insurance for Patients Moral hazard might then lead to “flat of the curve” medicine.Consider the relationship between an additional $1 of total spending on health care and the amount of marginal benefit from that spending.Initially, the marginal benefit is very high (e.g., influenza shots for the elderly, etc.), but it declines.Figure 3 illustrates such a curve.
44Further spending has diminishing returns. Figure 3Further spending has diminishing returns.Initially, dollars of spending lead to high benefits.$ of Marginal Health BenefitsA$5B$1C$0.10$1,000$2,000$5,000$ of Medical Spending
45Moral 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. Moral hazard means that the last $1 of private spending will equal $1 of marginal health benefit, potentially far greater than the socially efficient amount.If individuals 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.
46How Elastic Is the Demand for Medical Care How Elastic Is the Demand for Medical Care? The RAND Health Insurance ExperimentA 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.
47How Elastic Is the Demand for Medical Care How Elastic Is the Demand for Medical Care? The RAND Health Insurance ExperimentThe 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 coverage in the United States is in the range of $125 to $400 billion in current dollars.
48Optimal 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, andIndividuals are fully insured when costs become unaffordable.
49Health savings accounts ApplicationA recent attempt at this are Health savings accounts (HSA).HSAs are a type of insurance arrangement whereby patients face large deductibles, and they put money aside on a tax-free basis to pre-pay these deductibles.It is too soon to know whether HSAs will prove attractive to the insured, or whether they will decrease moral hazard.
50Optimal 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, andReceive full insurance thereafter.
51Why Is Insurance So Generous in the U.S.? In general, insurance in the U.S. is much more generous than Feldstein’s proposal.See Figure 4.
52Quality of Health Insurance Figure 4Quality of Health InsuranceExcept for the uninsured, most Americans have generous health coverage.Population44 million
53Why Is Insurance So Generous in the U.S.? Tax subsidy: Eliminating the tax subsidy may not be the most appropriate policy today, however. Rather capping the subsidy for a “basic” plan might be more sensible.Access motive: Offering health insurance has both income and substitution effects. Both result in increased expenditure, but only the increased expenditure from the substitution effect is a deadweight loss.Psychological motivations: There may be motivations for holding insurance beyond the expected utility model; health insurance may serve as a commitment device, for example.
54HOW GENEROUS SHOULD INSURANCE BE TO MEDICAL PROVIDERS? There is also moral hazard on the provider side.Even if an insurer could perfectly assess a patient’s true level of illness, the cost to treat that illness can vary considerably.Thus, insurers have often reimbursed medical providers according to their reported costs of treatment.
55HOW GENEROUS SHOULD INSURANCE BE TO MEDICAL PROVIDERS? Patient-side moral hazard refers to the extra care demanded for illness because insurers cover the cost of medical treatment.Provider-side moral hazard refers to the extra care provided for illness because insurers reimburse health care providers based on costs.
56HOW GENEROUS SHOULD INSURANCE BE TO MEDICAL PROVIDERS? Retrospective reimbursement is a payment arrangement reimbursing physicians for the costs they have already incurred.This system 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” medicine.In addition, if physicians are also concerned about income maximization, this sort of reimbursement only exacerbates the moral hazard.
57Managed Care and Prospective Reimbursement Patient cost-sharing did not slow the growth in health care spending, so the private market turned to managed care in the late 1980s and 1990s.Managed care is a private market approach to controlling costs using supply-side controls.Manage care comes in two forms: PPOs and HMOs.
58Managed Care and Prospective Reimbursement Preferred provider organizations (PPOs) are health care organizations that lower care costs by shopping for health care providers on behalf of the insured.PPOs form a restricted network of health care providers, and offer a discount if the employer restricts its employees to using that network.
59Managed Care and Prospective Reimbursement 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.
60Managed Care and Prospective Reimbursement More commonly, 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).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.
61Managed 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.
62The Impacts of Managed Care Has managed care improved the functioning of the insurance market?Existing research suggests managed care has controlled costs.Empirically, the selection of low-cost individuals into HMOs means that there is not a simple comparison between HMOs and traditional insurance plans.Even if HMOs didn’t change the delivery of medical care, their costs would be lower because they have the healthiest enrollees.The most convincing study accounting for this sort of selection is the RAND Health Insurance Experiment, where enrollees at one site were randomly assigned to HMOs or traditional plans.
63The Impacts of Managed Care There is no clear evidence that quality of care has suffered, even though prospective reimbursement might lead to the under provision of care in HMOs.There is not a consensus one way or another.Roughly equal numbers of studies find that HMOs deliver care that is better, worse, or the same as traditional health insurance.
64Recap of Health Insurance I: Health Economics and Private Health Insurance Overview of health care in U.S.How generous should insurance be to patients?How generous should insurance be to medical providers?