The role of insurance in health care, part 1 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 (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

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

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 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 different plans offered by the employer HMO plans PPO plans POS plans

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

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

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)

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

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

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

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 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

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

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?

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

Stay healthy