1. The role of insurance in health care, part 1
Today: Why health care is important to study; The advantages and disadvantages of private insurance

2. 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

3. 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

4. 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

5. 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

6. 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?

7. 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

8. 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

9. 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

10. 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

11. Insurance for your generation
Today’s 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

12. HMOs Little flexibility Lower in cost than other comparable options
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

13. 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

14. 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

15. 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

16. 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

17. 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)

18. Why buy insurance? Example
Insurance 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
$20,000
$47,000
Option 2: Full Insurance ($3,000 premium to cover $30,000 in losses
Actuarially Fair Insurance Policy
Expected values are equal

19. 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
20,000 X
Income
47,000
50,000

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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?

30. 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

31. Stay healthy