Dr.

Katie Sauer Health Economics

Demand and Supply of Health Insurance Chapter 8 Overview: I. Risk and Insurance II. The Demand for Insurance III. The Supply of Insurance IV. Moral Hazard V. Deductibles, Coinsurance, and Secondary Insurance VI. Income Transfer Effects of Insurance ____________________________________________________________________ I. Risk and Insurance A. Desirable Characteristics of an insurance arrangement 1. large number of insured who are independently exposed to the potential loss 2. covered losses should be clearly defined in terms of time, place, and amount 3. probability of loss should be measurable 4. loss should be accidental from viewpoint of the insured B. Insurance vs Social Insurance Insurance is provided through markets in which buyers protect themselves against events with probabilities that can be estimated statistically. Social Insurance programs are insurance with the government as insurer and are distinguished by two features: Premiums are heavily and often completely (as in the case of Medicaid) subsidized. Participation is constrained according to government-set eligibility rules. C. Expected Value Expected value incorporates the probability of an occurrence of an event with its outcome. E = p1R1 + p2R2 + + pnRn pi is the probability of an event Ri is the outcome associated with an event The probabilities must always sum to 1. You are considering playing a game where the flip of a coin determines whether you earn a reward or not. heads: you win $1 tails: you win $0

How much would you pay to play this game? If you are risk neutral, you should be willing to pay up to the expected value of the game.

If the expected payouts from an insurance policy are exactly equal to the premiums taken in, then the policy is called actuarially fair. - use as a benchmark - in reality, other administrative costs What if the size of the bets are changed? heads: win $100 tails: win $0 Are you willing to pay $50 to play? - refuse an actuarially fair bet The disutility from losing money is larger than the utility of winning the same amount! - risk averse D. The Utility of Wealth

This utility of wealth function exhibits diminishing marginal utility. - 2x the wealth doesnt make you 2x as happy - describes an individual who is risk averse (will not accept an actuarially fair bet)

Suppose that Johns income is $20,000. He has a 10% chance of becoming sick. If he becomes sick, he will spend $10,000 as he pays medical expenses and misses work. Lets calculate his expected utility and expected wealth.

Expected Utility=

Expected Wealth=

In a world with risk, $19,000 of wealth would give John an expected utility of ____. In a world without risk, the same $19,000 would yield a higher utility. The horizontal distance between the expected utility line and the total utility line represents Johns risk aversion. At point A, he would be willing to pay up to $4,000 for insurance that protects against a reduction in wealth from illness. Insurance can be sold only in circumstances where the consumer is risk averse. Expected utility is an average measure. If insurance companies charge more than the actuarially fair premium, people will have less expected wealth from insuring than from not insuring. increased well-being comes from the elimination of risk The willingness to buy insurance is related to the distance between the total utility curve and the expected utility line.

II. The Demand for Insurance Suppose Johns wealth is $20,000. He has a 10% chance of becoming sick. If he does, his wealth will be reduced by $10,000. He is considering buying $500 worth of insurance at a premium of 20%. If John stays healthy, his wealth is

If John gets sick his wealth is

So, the insurance provides him with an additional _______ if he is ill. The additional cost is the ______ premium. Johns marginal benefits are greater than the marginal costs. How about purchasing an additional $500 of coverage? Healthy:

Sick:

Additional Benefit:

Additional Cost:

Additional benefits outweigh the additional costs.

However, recall that we are now starting from different income levels: $400 benefit to $10,000 is larger than a $400 benefit to $10,400. (diminishing marginal utility of wealth) $100 cost to $19,900 is smaller than $100 cost to $19,800.

Should John buy another $500 worth of insurance?

The optimal amount of insurance is Q*.

1. Change in Premiums Suppose the premium rises to 25% instead of 20%. Healthy: Sick:

The $500 of coverage now gives John a lower marginal benefit. An increase in premiums shifts the marginal benefit curve to the left. Similarly, the marginal cost of $500 of insurance has increased. An increase in premiums shifts the marginal cost curve to the left. The new optimal level of insurance is Q2. Higher premiums results in lower amounts of insurance being purchased.

2. Change in Expected Loss (Start from the original premium of 20%) Suppose the expected loss from illness increases from $10,000 to $15,000. Healthy: Sick:

Again, in the case of sickness, insurance provides $400 of benefit vs having no insurance. But, this $400 must be compared to the $5000 he would have if he didnt have insurance. $400 extra on $5000 is more than $400 extra on $10,000. The marginal benefits are higher. An increase in the expected loss will increase the marginal benefits from having insurance. The optimal level of insurance is now higher.

3. Changes in Wealth (Start from the original premium of 20% and original loss value) Suppose Johns wealth is $25,000 instead of $20,000. Healthy: Sick: At a higher level of wealth, the insurance policys benefits of $400 are a lower marginal benefit than at a lower level of wealth. At a higher level of wealth, the insurance policys cost of $100 is a lower marginal cost than at a lower level of wealth.

The marginal benefits are lower. The marginal costs are lower. The effect on the quantity of insurance is ambiguous.

III. The Supply of Insurance How are premiums determined? Insurance firms will maximize profits. profit = revenue - cost Let a be the premium rate. Let q be the insurance payout. Let t be the processing / administrative cost of writing a policy. Let p be the probability of a payout. Profit = aq - pq - t For firms in a competitive market, profits equal zero. 0 = aq - pq t a = p + (t/q) Suppose that premiums are 20% and policies are written in $500 increments. Suppose that the processing costs are $8 per policy. For those who do not get sick (90% of the policies), the only cost would be the cost of processing, $8. For those who do get sick (10% of the policies), the cost would be the $500 payment plus the $8 processing cost, or $508. Profit =

These are positive profits, and they imply that another similar firm might enter the market. Such entry into the market would continue until all excess profit was competed away. IV. Moral Hazard - any change in behavior in response to a contractual arrangement ex: failure to protect yourself from disease because you have health insurance So far we have assumed that the amount of a loss is fixed. But, buying insurance often lowers the out-of-pocket price of services. (buy more services!)

Suppose you pay all of your expenses out of pocket. If the price is p1, then you would consume Q1 units of health care. Your total expense would be (p1)(Q1). (assume p1 is cost of production)

Suppose the probability you will need to see a dermatologist is 0.50. You should be willing to pay the actuarially fair price of (0.50)(p1)(Q1) for insurance that would cover all of your losses. However, now additional medical care costs you nothing. At a price of zero, you would consume Q2 units of health care. Your care would cost (p1)(Q2) in terms of resources.

If your insurance charged (0.5)(p1)(Q1) they would be losing money. The expected payout is larger than the expected premium. (0.5)(p1)(Q2) > (0.5)(p1)(Q1) If the company charged (0.5)(p1)(Q2), then you may not buy the insurance. Any insurance premium has two components: - premium for protection from risk - resource cost due to moral hazard Moral hazard analysis helps us predict the types of insurance that are likely to be provided. 1.developed first for inelastic services 2. more coverage for inelastic services V. Deductibles, Coinsurance, and Secondary Insurance A. Deductibles With no insurance, if the price is p1, you consume Q1 units of care. With insurance, the price of care falls to zero so you consume Q3 units. If you must pay a deductible before care is free to you: then if the deductible is small you will consume an amount in between Q1 and Q3. then if the deductible is large, you may decide to self-insure and will consume Q1. A deductible has two potential impacts: 1. Small deductible: some effect on consumption 2. Large deductible: makes it more likely for people to self-insure and consume the amount of care they would have consumed with no insurance B. Coinsurance Coinsurance is the consumers out-of-pocket payment rate. (higher coinsurance means consumer pays more)

With marginal cost P1 and no insurance, the consumer will demand Q1 units of care. The consumers marginal benefit will be equal to the marginal cost. With 20% coinsurance, the price the consumer pays out of pocket falls to P2. Q2 units will be demanded A new demand curve is generated to reflect the 20% coinsurance. The additional resource cost is: The additional benefits to the consumer are: The additional costs exceed the additional benefits. Consumers are led by insurance to act as though they are not aware of the true resource cost of their consumption. Insurance subsidizes insured types of care at the expense of other types of care. Insurance subsidizes insured types of care relative to non-health goods.

C. Secondary Insurance Suppose your employer provides health insurance which pays 60% of all medical expenditure. You have secondary coverage through your spouse, which pays 60% of the medical expenditures not covered by your primary insurance. The market price of a doctors visit is $50.

With no insurance coverage, you decide to purchase 12 doctors visits per year. Your out-of-pocket expense will be:

The total cost of providing this care to you is:

With your employer sponsored insurance, the cost of a doctors visit is now: At this price you consume ______ visits. Your out-of-pocket expense is: The total cost of providing this care to you is: Of that amount, your employer pays: you pay:

Suppose you have supplemental insurance that pays 60% of what your primary insurance doesnt pay. The price of a doctors visit is now: At that lower price you consume _______ doctors visits. Your out of pocket cost: The total cost of providing these health care services to you: Of that amount, your employer pays: Your secondary insurance pays: You pay:

Claims paid by primary insurance with no secondary insurance: Claims paid by secondary insurance: Increase in claims paid by primary insurance due to the secondary plan:

D. The demand for insurance and the price of care Martin Feldstein (1973) was among the first to show that the demand for insurance and the moral hazard brought on by insurance may interact to increase health care prices even more than either one alone. More generous insurance and the induced demand in the market due to moral hazard lead consumers to purchase more health care. E. Welfare Loss of Excess Health Insurance Insurance policies lead to increased health services expenditures in several ways: - increased quantity of services purchased due to decreases in out-of-pocket costs for services that are already being purchased - increased prices for services that are already being purchased - increased quantities and prices for services that would not be purchased unless they were covered by insurance - increased quality in the services purchased including expensive, technologyintensive services that might not be purchased unless covered by insurance Empirical Estimates: Feldstein found that the welfare gains from raising coinsurance rates from .33 to .50 would be $27.8 billion per year in 1984 dollars. Feldman and Dowd (1991) estimate a lower bound for losses of approximately $33 billion per year (in 1984 dollars) and an upper bound as high as $109 billion. Manning and Marquis (1996) sought to calculate the coinsurance rate that balances the marginal gain from increased protection against risk against the marginal loss from increased moral hazard, and find a coinsurance rate of about 45 percent to be optimal. VI. The Income Transfer Effects of Insurance John Nyman (1999) argues that in contrast to the conventional insurance theory, we should view insurance payoffs as income transfers from those who remain healthy to those who become ill. These income transfers generate additional consumption of medical care and potential increases in economic well-being. Conventional logic: Suppose that Elizabeth is diagnosed with breast cancer at her annual screening. Without insurance, she would purchase a mastectomy for $20,000 to rid her body of the cancer.

With insurance, Elizabeth purchases (and insurance pays for) the $20,000 mastectomy, a $20,000 breast reconstruction procedure to correct the disfigurement caused by the mastectomy, and an extra two days in the hospital to recover, which costs $4,000. Total spending with insurance is $44,000 and total spending without insurance is $20,000. It appears that the price distortion has caused $24,000 in moral hazard spending. Nyman would ask: Is this spending truly inefficient? To answer we must determine what Elizabeth would have done if her insurer had instead paid off the contract with a check to Elizabeth for $44,000 upon diagnosis. With her original resources plus the additional $40,000, we can safely assume that Elizabeth would purchase the mastectomy and the breast reconstruction. She may or may not purchase the extra recovery days in the hospital. The $20,000 spent on the breast reconstruction is efficient and welfare increasing. The $4,000 spent on the two extra hospital days may be inefficient and welfaredecreasing. _____________________________________________________________________ Summary: We have characterized risk and have shown why individuals will pay to insure against it. The result, under most insurance arrangements, is the purchase of more or different services than might otherwise have been desired by consumers and/or their health care providers.