1. The role of insurance in health care 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 (most of today’s lecture) 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  Chapter 11 Social Security issues, including long-run problems  Chapters 12-13 Income redistribution issues

3. Today Chapter 9 (and a little bit of Chapter 10)  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  Private health insurance provides 35 percent of health care funds in the United States in 2004 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 one of many plans offered by the employer  More flexibility means higher premiums

12. 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

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. New directions for health insurance? As health care costs continue to increase, consumers must pay for it one way or another New methods to keep premiums down  Explicit reductions in benefits  More drug tiers See readings on class website for more on this  Restructuring of benefits

17. 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

18. 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)

19. Expected value example Draw cards from deck of cards Draw heart and receive $12 Draw spade, diamond or club and lose $4 Probability of drawing heart is 13/52 = ¼ Probability of drawing spade, diamond or club is 39/52 = ¾ EV = (1/4)($12) + (3/4)(-$4) = $0

20. Why buy insurance? Example Insurance Options IncomeProbability 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 $50,0009 in 101 in 10$30,000$50,000$20,000$47,000 Option 2: Full Insurance ($3,000 premium to cover $30,000 in losses $50,0009 in 101 in 10$30,000$47,000 Actuarially Fair Insurance Policy Expected values are equal

21. Why buy insurance? Income Utility 20,000 47,00050,000 UAUA UCUC UDUD UBUB D C B A Expected Utility Risk Smoothing Certainty Equivalent Note: Graph is not to scale X Willingness to pay (WTP) for insurance is 50,000 – X, which is more than $3,000

22. 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 See Figure 9.3, p. 185  Panel A uses a person that is relatively less risk averse  Panel B uses a person that is relatively more risk averse  WTP is higher for the person with more risk aversion

23. 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

24. Example 6 people at a firm Spending if 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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

31. Health care Suppose that Angela has been admitted to the hospital after being in a car accident She has a substantial MB for the first night in the hospital, due to the care that she needs

32. Health care As Angela’s condition improves, her MB declines When the demand hits the horizontal axis, she is completely better Think of demand like MB Think of supply like MC

33. 20 percent co-insurance Assume that Angela pays 20% of her costs  This is also known as coinsurance Angela will then decide to stay in the hospital as long as MB for each night exceeds its MC  She will want to stay in the hospital as long as her benefit is at least 20% of the hospital’s cost

34. What about a percentage co-payment? What if Angela had to pay 20% of her costs while in the hospital  Her PRIVATE MC is two-tenths of MC curve (See dashed line)  Equilibrium is at the yellow circle 0.2 MC

35. Only a co-payment Suppose that Angela’s insurance only mandates that she makes a co- payment Angela’s PRIVATE MC is zero after being admitted If hospital lets Angela stay in the hospital as long as she wants, equilibrium occurs at Q2  MB and private MC are both zero here

36. What is optimal? Angela’s optimal length of hospital stay occurs when the PUBLIC MC equals MB  This occurs at point A

37. Deadweight loss due to 20% coinsurance

38. Flat-of-the-curve medicine Flat-of-the-curve  Spending that occurs with low MB Is the US practicing this type of medicine?  Likely in some cases, due to insurance Analysis across countries is more complicated  Countries with nationalized medicine may not provide some services with MB > MC  Malpractice costs See Figure 9.5, p. 200, to see how rapidly health care costs have increased in the US since 1960

39. Some final issues Externalities Graying of the population  Longer life expectancy  Retiring baby boomers Improved technology Reimbursement policies

40. Externalities Externalities of health care exist in limited cases Examples  Vaccination (positive)  Overuse of antibiotics (negative)  Staying home when sick (positive)

41. Graying of the population The average age of the population is increasing for two reasons  Longer life expectancy  Retiring baby boomers Older people generally have higher health care costs per person  This can increase premiums for everyone working for the same firm More on this topic in later lectures  Government-provided health care  Social Security

42. Improved technology Old methods of health care are often not expensive  Aspirin first marketed over 100 years ago Modern drugs can have monthly price tags over $1,000  Should someone that is unable to afford a new drug be left out of using it? Commodity egalitarian arguments have led to price discrimination by pharmaceutical companies Prices slightly above MC are charged to poor people

43. Reimbursement policies Reimbursement policies for medical services to try to keep costs down  Review boards  Discharge criteria from hospitals

44. 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