The role of insurance in health care, part 1

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 • 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 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 Income 20,000 X 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. 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 Moral hazard issues

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