CHAPTER 4 - INFORMATION FAILURE & HEALTH

INSURANCE
Wednesday, 2 October, 2019 6:58 PM

Learning objectives:
1) To understand the nature of the market failure in health insurance
2) To develop analytical tools to analyse choice under uncertainty
3) To understand the issue of adverse selection and potential solutions
4) To understand the issue of moral hazard and potential solutions

Insurance premium: Money paid to an insurance company in exchange for compensation if a specified adverse event occurs.

Actuarially fair insurance premium: An insurance premium for a given time period set equal to the expected payout for the same time period. It charges
just enough to cover the expected compensation for the expenses. In other words, an AFP charges the expected value of the loss so that on average the
insurance company neither loses nor gain any money.

In this example: Given that there is 90% chance of no loss in income and a 10% chance of a loss of $30000, the expected loss is $3000 = AFP which is just
enough for the insurer to cover their expected payouts for the year. When the risk of the adverse event increases, so does the premium that the company
has to charge in order to break even.

Option 2 gives Emily $47000 with certainty and option 1 gives Emily $47000 on average. In general, Emily prefers option 2, which provides the same
expected income but with certainty.

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Because people have diminishing marginal utility, they have a preference for risk smoothing. (taking action to obtain a certain level of consumption should
an adverse event occur)

If insurance company does not offer AFP & and includes loading fee, will Emily stop buying insurance? Not necessarily.
--> This depends on the shape of her utility function.

If utility function is like panel A, she would rather not purchase the insurance. She is indifferent between point C and E and both yields same expected
utility. Point E corresponds to her receiving $46500 with certainty, that is it is achieved if she fully insures against the risk at a premium of $3500.
Therefore, she is willing to pay up to $3500 for insurance rather than going without insurance. If the insurance company charges $4000, she won't buy
the plan.

If utility function = Panel B, she is willing to pay up to $10000 for the insurance plan because the insurance company only charges $4000, the she buys the
coverage and achieves higher expected utility than if she goes uninsured.

==> In general, the demand for insurance depends on the curvature of the utility, also known as the level of risk aversion.

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In short, because of information asymmetry, the insurer draws in customers who are, from its point of view, exactly the wrong people. This phenomenon
is known as adverse selection. More generally, adverse selection occurs when an insurance provider sets a premium based on the average risk of a
population, but the low-risk people tend not to purchase the insurance policy, leading the insurer to lose money.

Adverse selection: The phenomenon under which the uninformed side of a deal gets exactly the wrong people trading with it (that is, it gets an adverse
selection of informed parties)

In short, if an insurance company has less information on the health risks faced by its customers than do the customers, any premium set to cover the
average risk level may induce the lower-risk people to leave the market.

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Community rating: The practice of charging uniform insurance premiums for people in different risk categories within a community, thus resulting in low-
risk people subsidizing high-risk people.

Eg: Cost of illness will be fully compensated, the insured might be more likely to engage in risky behaviour, such as eating a lot of junk food, not exercising
much and smoking. The incentive to increase risky behaviour because the adverse outcomes of that behaviour are covered by insurance is known as moral
hazard.

Another related efficiency issue arises because the policy pays some or all of the incremental cost of health care. This increases the incentive for the
insured to seek out more health care services. Most insurance policies also require individuals to pay for some of their health expenses out of their own
pockets. The policy's deductible is the amount of health care costs the individual must pay each year before the insurance company sta rts paying
compensation.

Deductible: The fixed amount of expenditures that must be incurred within a year before the insured is eligible to receive insurance benefits.

Copayment: A fixed amount paid by the insured for a medical service.

Coinsurance: A percentage of the cost of a medical service that the insured must pay

DWL: abh

In this example, insurance coverage has led to M1 medical services being purchased each year, but at this point on the demand curve, the incremental
benefit of additional medical services is very small. The notion that additional medical services have very small (flat) impacts on health is sometimes

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benefit of additional medical services is very small. The notion that additional medical services have very small (flat) impacts on health is sometimes
referred to as flat-of-the-curve medicine. (marginal gain associated with additional health care is small)

The actual amount by which expenditures increase depends on the shape of the demand curve. How to estimate elasticity? One way is to compare the
amount of medical services purchased by people in generous insurance plans to those in less generous plans.

Does moral hazard justify government intervention?

The more generous the policy, the greater the protection from the financial risks of illness but the greater moral hazard as well. The efficiency problems
caused by moral hazard are not unique to private health insurance markets. They arise whenever a third party pays for a part or all of the marginal cost of
medical services.
The key point is that, both leads to same moral hazard problem because it too reduces the price of medical services faced by the patients.

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Definitions:-
1) Social insurance programs are government programs that provide insurance to protect against adverse events.
2) Insurance premium is the money paid to an insurance company in exchange for compensation if a specified adverse event occurs.
3) Expected value is the average value over all possible uncertain outcomes, with each outcome weighted by its probability of occurring.
4) Actuarially fair insurance premium is an insurance premium for a given time period set equal to the expected payout for the same time period. It
charges just enough to cover the expected compensation for the expenses.
5) Expected utility is the average utility over all possible uncertain outcomes, calculated by weighting the utility for each outcome by its probability of
occurring.

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 occurring.
6) Risk smoothing is taking action to obtain a certain level of consumption should an adverse event occur.
7) The demand for insurance depends on the curvature of the utility function, also known as the level of risk aversion. Risk aversion is a preference for
paying more than the actuarially fair premium in order to guarantee compensation if an adverse event occurs.
8) Risk premium is the amount above the actuarially fair premium that a risk-averse person is willing to pay to guarantee compensation if an adverse
event occurs.
9) Loading fee is the difference between the premium an insurance company charges and the actuarially fair premium level. One simple way to
measure the loading fee is the ratio of market insurance premiums divided by benefits paid out.
10) Asymmetric information is a situation in which one party engaged in an economic transaction has better information about the good or service
traded than the other party.
11) Adverse selection is the phenomenon under which the uninformed side of a deal gets exactly the wrong people trading with it (that is, it gets an
adverse selection of the informed parties).
12) Experience rating is the practice of charging different insurance premiums based on the existing risk of the insurance buyers.
13) Community rating is the practice of charging uniform insurance premiums for people in different risk categories within a community, thus resulting
in low-risk people subsidizing high-risk people.
14) Moral hazard occurs when obtaining insurance against an adverse outcome leads to changes in behavior that increase the likelihood of the outcome.
15) The more that an insurance plan smoothes risk by covering health care costs, the more it leads to inefficient overuse of health care through an
increase in risky behavior.
16) Deductible is the fixed amount of expenditures that must be incurred within a year before the insured is eligible to receive insurance benefits.
17) Copayment is a fixed amount paid by the insured for a medical service.
18) Coinsurance is a percentage of the cost of a medical service that the insured must pay.
19) Deadweight loss is the pure waste created when the marginal benefit of a commodity differs from its marginal cost.
20) Flat-of-the-curve medicine is the notion that at a certain point, the additional health gains of greater spending on health care are relatively limited.
21) Third-party payment is a payment for services by someone other than the consumer.
22) Paternalistic arguments would suggest that such people either have the 'wrong' tastes (they should be more risk averse) or they have 'wrong'
expectations (they should put a higher weight on the probability of a bad outcome).
23) Commodity egalitarianism is the idea that some commodities ought to be made available to everybody.

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