Health Insurance Adverse Selection Moral Hazard

FGS 8,10,11, 12 Cutler 1994


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Uninsured in the US Demand for Insurance
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What is insurance – risk pooling What is risk aversion Demand for insurance Factors affecting demand for insurance Moral hazard Adverse selection

Problems with demand for insurance
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Problems with the health insurance market (Cutler) Health insurance features Insurance and demand for medical care Supply of insurance
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Fee-for-service Managed care Consumer-driven health plans and health savings accounts

US health insurance market a brief history


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Uninsured and Underinsured
47 million people uninsured in 2006 (15 % of population)
An increase of 8.6 million from 2000 Majority are employed in small firms (<100)

16 million non-elderly adults (20%) were underinsured
High out-of-pocket health costs to income ratio


Figure 1: 47 million uninsured in 2006; Increase of 8.6 million since 2000
Number of uninsured, in millions
60 40 38 40 42 43 43 45 47


0 2000 2001 2002 2003 2004 2005 2006

Source: U.S. Census Bureau, March Current Population Survey, 2001–2007.


Percentage of uninsured workers Ages 18-64, by Firm Size (1997)
40 35 30 25 20 15 10 5 0 34.7 29.7 18.2 20.9 15.8 12.7 12.3





100-499 500-999


Firm Size


Who are the uninsured?
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Mostly adults, not children – half are childless adults. The number of uninsured children increased from 8 million (10.9 percent) in 2005 to 8.7 million (11.7 percent) in 2006 Poor and near-poor – 60% have incomes above
federal poverty level

Workers and family members – 80% in families with
at least 1 worker

Unskilled laborers, service workers

3 of 5 of the uninsured who work, work in firms with <100 workers


Employer offers health plan.Uninsured: Why are they uninsured    Three primary reasons that workers don’t have insurance: The employer does not offer a health plan. but employee is not eligible for the plan because of part-time status or some other rule. Employee doesn’t buy plan because plan too expensive or does not perceive need for plan  7 .

700) 8 .  Why don’t they buy private health insurance  There is no risk pooling with private health insurance and it is expensive   Average annual cost of family policy in the private market (3. more    Change jobs Work part-time Work for small firms  Small-firms pay much higher premiums because their risk is perceived to be large.330) Average annual cost an employee pays out of pocket towards group insurance (2.Uninsured: Why are they uninsured likely to:  Uninsured.

9 . policy makers will have an increasingly difficult time ignoring health consequences of the uninsured.Uninsured: Impact on health outcomes  Empirical research gives mixed results  Empirically difficult to measure   Selection bias: Those who choose not to buy health insurance do so because they are healthier Endogeneity: does lack of insurance cause poor health. the argument that those without insurance experience poor health is powerful. (can’t determine direction of causality)   Despite inconclusive empirical evidence. or does poor health decrease the probability of being insured. As the number of uninsured grow.

Do the uninsured receive necessary health care? 10 .

.      Have higher rates of preventable and/or untreated illness Are less likely to receive care that they feel they need Have more preventable hospitalizations Have shorter hospital stays for the same conditions Are hospitalized sicker and have poorer health outcomes (including death)… 11 .Do the uninsured receive necessary health care?  Often No… compared to the insured population.. the uninsured.

”… “The care of the poor once was supported by the wealthy and the insured. but now the opposite is happening. (NYT.” 12 . 4/2/01)  “A New York gynecologist says he gets $25 for a routine exam for a woman insured by group health insurance and charges $175 for the same exam for a woman without insurance.Do the uninsured receive necessary health care?   Are not known to be a sicker or higher-cost population. Pay higher medical fees.

11% 13 .Effect on employers Rising health costs take bite out of small biz – USA Today 10/5/03 “Small-business profits are getting pinched because of price increases for employee health insurance. Among small companies that posted lower earnings in August vs. a year ago. says a survey of 544 firms by the National Federation of Independent Business trade group. 18% blamed higher insurance costs. In a similar survey a year ago.

While the average health insurance premium for workers jumped 13. the increase was bigger for small employers: Ouch! 3-9 workers 10-24 25-49 50-199 16.6% 15.2% 14.9% Source: Kaiser Family Foundation 14 .9% this year from 2002.3% 15.

Outline   Uninsured in the US Demand for Insurance     What is insurance – risk pooling What is risk aversion Demand for insurance Factors affecting demand for insurance Moral hazard Adverse selection  Problem with demand for insurance       Problems with the health insurance market (Cutler) Health insurance features Insurance and demand for medical care Supply of insurance    Fee-for-service Managed care Consumer-driven health plans and health savings accounts  US health insurance market a brief history 15 .

This is a lot of money for one person to pay. Club of 100 members. It is random who gets sick.What is insurance     Meant to insure us against random uncertainty. it costs $20. On average. 16 . each year one member gets sick.000.

Money put in bank to get interest. they insure each other and each pay $200 a year. 17    . They pay this to avoid the risk of uncertainty that they will have to pay 20.What is insurance  Instead. and pay out when someone gets sick. Aim of insurance is to reduce the variability in one’s income by pooling risks with a large number of people.000.

they are fairly predictable for the group. But we do not it is variable.What is insurance  Outlays for health may be variable for one person.   18 .000 a year). Insurance makes it possible to obtain health care without going Bankrupt (new cancer drug $100. Health insurance would not be necessary if everyone had average needs.

The chance of loss should be measurable 4. and amount 3.What is insurance Desirable characteristics for insurance: 1. and they should be independently exposed to potential risk 2. Losses covered should be definite in time. The loss should be accidental from view point of person who is insured 19 . place. The number of insured should be large.

000 Top 1% 2.730 1.36.Concentration of personal health expenditures.750 7. “Health Economics: Fundamentals and Flow of Funds”.850 Middle 75% Bottom 15% 213.135 184 Source: Getzen T.126 2. ($ millions) Per Person 285.700 5. in US in 2002 All Persons (000s) Health Exp.400 455.545.427 153.750 42. 20 .900 4.

such as sales. they typically pay a given premium for a given amount of coverage should the event occur. advertising. or profit. Premium: When people buy insurance policies.Terminology Loading Fee: general costs associated with the insurance company doing business. Should cover average medical care expenses 21 .

Demand for health insurance  Results of uncertainly     Illness and medical expenditures are unpredictable Hospitalizations. serious injury. and rehabilitation and other advanced modern treatments can be very expensive Can save for possible medical expenditures Most households are averse to risk Don’t take on risk. spread risk among many consumers  Insurance companies pool risk   What is risk aversion? 22 .

If it comes up heads. Forest wills a dollar and Zan nothing.Risk aversion Consider the gambling game:     Zan and Forest flip a coin. If it comes up tails. How much should they each be willing to pay to play this game?  Expected Return for Zan: P(head)*$2 + P(tails)*0=$1  Willing to pay $1 cents 23 . Zan wins a dollar and Forest nothing.

Risk aversion  Would you be willing to play this game for $5 get $10 if win.000 if win? The fact that you are less willing to play at larger amounts shows you are risk averse  24 .000 get $20. for $10.

Risk aversion: .Risk aversion   A simple test to see if you are “risk adverse. most of us are risk adverse and select the “certain” option.the degree to which a certain income is preferred to a risky alternative with the same expected income. OR Double your pay check for correctly picking one coin flip.” Which would you select?   Your pay check.   Equal expected values. 25 .

Risk aversion Expected Value: E [income if heads]=Prb(H)*$2+Prb(T)*0=1 Actuarially fair gamble: is one in which the amount you pay for the gamble is equal to the expected value of the gamble. and the expected value of the game was $1.  You paid a $1 to play. 26 .

if expected benefit payment is equal to premiums. the insurance policy is actuarially fair.000. then the gamble is actuarially fair. In health. 27 .Risk aversion    If price of gamble (amount pay to play game) is equal to the expected return. Now suppose the gamble was instead for $5. because you do not want to take the actuarially fair gamble. would you want to play the game?  If not you are defined as being risk averse.

A > B.Risk aversion Reflected by the diminishing marginal utility of income/wealth. Utility lost when lose a dollar is larger than utility gained by winning a dollar Utility B A 1 2 3 Income 28 .

Lesson from the theory of insurance: the losses that are insured are: large. infrequent. not in taking risks. and not associated with a large moral hazard. 29   .Risk aversion  Presence of aversion makes consumers willing to pay to spread risk with others. Insurance companies specialize in pricing risks. random.

3. 5. 4.Demand for insurance See notes from black board Factors affecting demand for health insurance: 1. 2. Probability of illness Loading fee Magnitude of loss relative to income (cost of illness) Degree of risk aversion Price: Higher price reduces likelihood that an individual will insure against a given event 30 .

Demand for insurance  Probability of Illness -. acute vs.evidence  Increases with age  Affected by availability of public health insurance programs (Medicare) Result of women responsible for child birth Affected by availability of public health insurance program targeting pregnant women Chronic vs. preventive   Differs by gender    Differs by type of care needed  Elasticity of demand will differ 31 .

2005 Source: ASPE tabulations of the 2005 Current Population Survey 32 .Uninsured by age.

Uninsured by income Source: ASPE tabulations of the 2005 Current Population Survey 33 .

5 Gender.Percentage of Population Without Health Insurance. Jan-June 2003 MALE FEMALE 34 . by 19.

Outline   Uninsured in the US Demand for insurance     What is insurance – risk pooling What is risk aversion Demand for insurance Factors affecting demand for insurance Moral hazard Adverse selection  Problems with demand for insurance       Problems with the health insurance market (Cutler) Health insurance features Insurance and demand for medical care Supply of insurance    Fee-for-service Managed care Consumer-driven health plans and health savings accounts  US health insurance market a brief history 35 .

Moral hazard: The disincentives created by insurance for individuals to take measures that would reduce the amount of care demanded. resulting from a decrease in the net price of health care attributable to insurance 36 .Problems in demand for insurance Two main problems with demand for insurance 1. additional quantity of health care demanded. OR.

Adverse selection: A situation often resulting from asymmetric information in which individuals are able to purchase insurance at rates that are below actuarially fair rates plus loading costs . who know more about their own health status than insurers do.Problems in demand for insurance 2.alternatively: occurs when high-risk consumers. subcribe to an insured group composed of lower-risk individuals to secure low premiums. 37 .

Moral hazard  What are the effects of the new price system (with insurance) on demand for insurance. 38 . Buying insurance lowers the price per unit of health care service at time it is bought. Person with health insurance is more likely to go to the doctor for a small problem than someone without health insurance    Likely to affect good with higher elasticity of demand such as preventive care.

39 . the price is reduced).  It is also used to refer to how one changes behavior when they are insured. (i.  Learning snow boarding (lot of people break their arms). May not learn if don’t have health insurance.Moral hazard Moral Hazard: refers to the increased usage of services when the pooling of risks lead to decreased marginal costs for services. which could have health care implications when insured rather than not insured.  We may take more risks.e.

Moral hazard  Five sources of Moral Hazard 1. Quantity demanded of medical care greater than 2. 5. amount consumer would purchase if he/she paid full cost Individual less likely to engage in preventive behavior and/or more likely to engage in unhealthy behavior Individual demands higher quality/more costly types of care than he/she would in the absence of insurance Individual’s incentives to monitor health care providers lower than in absence of insurance Individual’s incentive to search for lower prices lower in than in the absence of insurance 40 . 3. 4.

Moral hazard Price Price without insurance Price with insurance Po P1 Dead weight Lost (DWL) Qo Q1 Quantity “Moral Hazard” increase in consumption due to insurance 41 .

Moral hazard Price Price without insurance Price with insurance Po P1 Dead weight Lost (DWL) Qo Q1 Quantity “Moral Hazard” increase in consumption due to insurance 42 .

DWL Po P1 QoQ2 Q1 Quantity 43 .Moral hazard Price Price without insurance Price with insurance D1 D2 Moral Hazard: • decreases when the price becomes more elastic. (i. for those goods you want no matter the price.e.

 E.Moral hazard  For services that are not very price sensitive. insurance will not cause them to purchase more services. insurance may encourage one to buy more. purchase of insulin for diabetics. 44 .  For those that are price sensitive (cosmetic surgery – not from accidents).g.

Question: If you designed a health care plan…        Hospital Care Surgical & in-hosp medical Outpatient doctor Dental exams/cleaning Mental health Over the counter drugs Flu shots 45 .

Patterns of Insurance Type of Health Variance of Demand CoverageFinancial Elasticity Care Risk (RHIE) -0. random.3 -0. and not associated with a 46 .15 -0.4 Hospital Care Surgical & inhosp medical Outpatient doctor Dental Highest High Medium Low % of People Under 65 Insured 80 78 40-50 40 The losses that are insured are: large. infrequent.15 -0.

Typical solutions to the moral hazard cost sharing  Increase     Could do this through co-payments or deductibles Reduce the quantity demanded by increasing price consumer faces Increases preventive behavior/reduces unhealthy behavior since consumer faces part of “costs” from these behaviors Increases the likelihood of consumer choosing less expensive types of medical care 47 .

mental health coverage. preventive care) 48 .g.Typical solutions to the moral hazard   Raises the likelihood that consumer better monitors provider behavior Increases likelihood that consumer “shops around” for less expensive sources of care  Offer less generous insurance for specific services with more elastic demand (e..

Problems with solutions  Assumes you will decrease unnecessary care  People don’t know which care is unnecessary so may decrease necessary and unnecessary care  Some health services which are elastic have long-term health gains which may not be realized by consumer     Externalities argument Preventive care and chronic disease management will lead to better health in the future and can lead to lower health costs in the future These models don’t take the long-term effects of not receiving care into consideration. Increasing price may decrease demand in the short49 run but increase it in the long-run .

Other solution to moral hazard  Instead of rationing on price. ration on need  Don’t use price mechanism to say how much care you should or should not get  Managed Care or many universal care countries     Utilization review Gatekeepers Provider guidelines Provider networks 50 .

more of X is consumed Budget lines 0 PX $3 $2 $1 10 18 24 X=Quantity of Health care services Demand curve shows the willingness to pay (reflects marginal utility) of a particular purchase. 10 18 24 X (units) 51 .Quantity of all Other Goods Moral hazard revisited/criticisms U1 U2 U3 As price of X falls from 3 to 2 to 1 dollar.

so which is preferred to which. 52 . Preferences must exhibit transitivity If there are 3 bundles A.  Consumers must be able to rank any bundle. 1. Consumers must be rational.Moral hazard revisited Assumption on consumer preferences that must hold for demand to represent willingness to pay. C A preferred to B. B.      More of a good always makes them better off. and B preferred to C Then A must be preferred to C and not the other way round.

3.Moral hazard revisited 2. They must know what the result of their consumption decisions will be If these assumptions hold the demand curve shows the willingness to pay for an additional unit of health services 53 . They must have sufficient information to make good choices.

Do we really know all the differences?  Do people understand the difference between feefor-service and managed care and how the type of payment system might affect care? Are they just picking the least costs without recognizing the potential quality or service differences. 54 .   You can pay a lower price for a health plan but it is not the same product.Moral hazard revisited Do we meet these assumption? 1. Are consumers rational?  Consumers do not have information on prices and quality to be able to rank/choose different health bundles.

Moral hazard revisited  Infection or complication rates are not provided by hospitals  We have to choose health plans.  Is more health care better?  Or are you going to get more services because quality is poor and they can’t figure out the problem. this is very hard to do when you can’t get information on quality and pricing. 55 .  How much you are reimbursed if you have to seek healthcare outside the network when traveling.

young tend to think they are invincible   Who has done things where they think they were lucky? Who has friends that were not so lucky? Wearing helmet when riding bike. Would think differently about the decision if you had an accident and were hurt. Do consumers know what is best for them?  People can make the wrong tradeoffs.g.  E.Moral hazard revisited 2. 56 . Can be due to need to “show-off” or due to time preferences.

Moral hazard revisited 3. So after a month and a half of acupuncture you feel better. Do consumers know the result of their consumption decision?  Do we know what would have happened if we had not been treated? The counterfactual. Was it the acupuncture or was it time that healed you? 57 .  Would the result have been the same if I saw a different doctor?  We often do not know if we made the right decision. after head injury begin a series of acupuncture.g. It takes a number of session for acupuncture to work so takes time. Time also helps your head heal.  E.

prices of the drug for cancer going to go from $20.000 to $100.000 58 .Moral hazard revisited  Who said the prices reflect the cost of making the good  With monopolies that prices may be too high so we are under consuming care  E.g.

Moral hazard revisited Do costs outweigh benefits D2 D1 A C MC = P G 50 150 B If a person has health insurance and pays nothing. they will increase demand from point A to point B and their accrued benefits will be the triangle ABG since the demand curve 59 .

had annual expenditures that were 28% less Those who faced a 25% coinsurance spent 18% less than those who faced 0% Willard Manning used these results to show that total welfare loss from moral hazard is between $37 and 60 billion. (represents between 19 and 30 percent of total national health expenditure 60 .Moral hazard revisited Welfare loss from moral hazard     Used results from the RAND health insurance experiment (see handout) Found those who paid 95% coinsurance compared to those who paid 0%.

Moral hazard revisited The problem with welfare calculations These calculations are based on the assumption that the demand curves show the marginal utility a person derives from an additional service. Assumed that the services that were not consumed (when price rose) must have been those that gave them the lowest marginal utility (least effective). 61   . Hard to figure out marginal utility consumers receive from different services.

62 .Moral hazard revisited The problem with welfare calculations    RAND studied grouped services received into categories based on medical effectiveness. Cost sharing did not lead to rates of care seeking that were more “appropriate” from a clinic standpoint. Found that cost-sharing was just as likely to lower use of highly effective care as rarely effective care.

 e.Moral hazard revisited  When people try to measure moral hazard they are likely over estimating it.  Forget to take into account the utility you get from health insurance (that you are risk adverse)  You also have to ask if consuming more health care is a bad thing?  Comes back to a value judgment. Consuming more preventative care to avoid later large costs would be good thing for society. 63 .g. article on providing preventative care for diabetes patients in NY times. Yet preventative care is often something an insurance company doesn’t cover (elastic demand – more moral hazard).   Much of health care are private goods.

Impact of RAND health experiment  Increased cost-sharing in private insurance plans  % of plans requiring deductible for hospital costs rose from 30% in 1982 to 63% in 1984  Significant drop in admissions – down 34% ages 1-44. down 28% ages 45-64   % of plans with annual deductible of $200 rose from 4% in 1982 to 21% in 1984 % of plans with cap on out-of-pocket expenses rose from 78% in 1980 to 98% in 1984  Contributes to increase in cost per admission  Increased interest in/adoption of managed care plans 64 .

Suppose the risk was not random. eat well. so think there is a low chance of getting sick – would not want to pay a lot for health insurance. Risk pooling works because everyone in the group is at risk and therefore has an interest in making sure that solid insurance benefits are provided.Adverse selection   This theoretical idea comes from Arrow’s 1963 article. you knew:    You had a higher chance of lung cancer because smoked all your life – insure You never smoked. 65 . do exercise.

Those who are healthier or less risk adverse are more likely to under insure or not insure and those who are sicker and risk adverse will insure 66 . you decide to take up health care or not based on your actual risk. with high risk of illness (p H)  Insurance company observes overall risk in the market not the actual risk for each individual:  p = f(p H)+ (1-f) (p L). you) by not to the insurer.Adverse selection  Adverse selection occurs when some factors are known to the insured (i. there is asymmetric information Two types of consumers:    Result of asymmetric information  relatively healthy. p is probability of illness  Sets premium based on observed average risk. with low risk of illness (p L) relatively unhealthy.  i.e.e.

   Insurance company knows distribution of health expenditures by person but not which person pays what. How much should insurance company charge? 67 . People know exactly what they will have to pay.  Each person knows what they will probably have to pay  So know where they are on the horizontal axis of the next graph.Adverse selection  Example: suppose have n people all with the same demographic characteristics.

Adverse selection Probability 1/n 0 1/4M 1/2M 3/4M 1M Health Expenditures ($) 68 People know how much they have to pay .

69 . Insurance company expects to pay out $1/2M so would be losing money.Adverse selection  Suppose set price of insurance at $0   Everyone will sign up.

there may be no health insurance offered! 70 . the expected amount insurance company will have to pay is $3/4M. so premium will need to be this much. But then others will drop out of the market.Adverse selection  So suppose try to set the price of insurance at $1/2M     Those who know their expenditures are less than 1/2M will choose to self-insure and will not sign up for the program. In fact. if adverse selection is very bad. Once they leave the market.

Adverse selection  People select into insurance based on their own risk of sickness Adverse selection into the health insurance market will be a problem if insurance companies only know the average risk of the population . To try to mitigate the problem of adverse selection insurance companies need to figure out each person’s actual probability of illness 71   .

gender. they can adjust premiums up or down to account for varying risk.  Adjust insurance based on age. BMI.Possible solutions to adverse selection  Waiting periods   Pre-existing condition exclusions Risk rating (underwriting)  If the high risks are something the insurance company can observe in advance. blood pressure 72 . your cholesterol. behaviors (how much you smoke or drink).

Possible solutions to adverse selection  Insurance that precludes individual selection according to subscribers’ perceptions of their own risk   Mandate that everyone must purchase health insurance Universal health insurance 73 .

  Old and young in a group pay the same amount. there are:  Group or Community Ratings: Premiums are based on the average characteristics of a group or community rather than your individual characteristics. Those with and without chronic conditions pay the same amount 74 .Adverse selection Alternatively.

 Still can be adverse selection. Ford has older workers – so their insurance premiums and what the company might pay will be quite high. Health care unaffordable for some companies 75 . young workers may not want to buy insurance  Google is probably happier than Ford with group ratings used by private health care.Adverse selection  Problems for companies in US: Compare Google to Ford   Google is full of young workers – so insurance premiums and what the company has to pay might be quite low.

000 $3.30.000 $6. “Individual Health Insurance: A Comprehensive Survey of Affordability.45.6024 29 34 39 44 49 54 59 64 Single Family Source: America’s Health Insurance Plans.000 $0 < 18 18. 2004 $8.35.000 $5.25.000 $2.000 $7.55.50. and Benefits” 76 .Health insurance premiums by age.000 $1. Access.000 $4.40. 2008.

Harvard University was facing a substantial deficit in the employee benefits budget. “high-option” PPO plans for employees. Needed to determine how to reduce employee benefits 77 .Adverse selection: Harvard University Problem:     1994. Harvard generously subsidized the more expensive. Offered both HMO plans and a more expensive PPO health insurance plan.

 78 .Adverse selection: Harvard University Strategy:  1995. Harvard decide to contribute the same amount to employee plans regardless of which type they chose Employee contributions increased for both the HMO and PPO plans. but more severely in the more expensive PPO plans.

191 79 Individual PPO Flex Individual HMO Family PPO Flex Family HMO $5.248 $776 $1.980 $6.208 $1.152 $421 $2.733 $1.395 .Adverse selection: Harvard University Premium $2.238 Employee Pays: Old New $555 $277 $1.

 What would you predict about the characteristics of those employees who switched?  Those employees who switched tended to be younger and had spent less on medical care the previous year. more  Enrollment in expensive PPO plans decreased. 80 .Adverse selection: Harvard Universitythe more generous.

completing the adverse selection “death spiral” in just three years. making the PPO option even more expensive => More employees were (voluntarily) “pushed out” of the expensive PPO plans => By 1997. the PPO plan was discontinued. premiums for the high option PPO plans increased.   81 .Adverse selection: Harvard University  Due to decreased enrollment.

Adverse selection: Harvard University PLAN ENROLLMENT 1995 13% 87% 18% 82% 1996 8% 92% 11% 89% 1994 Individual PPO Flex Individual HMO Family PPO Flex 1997 discontinued 16% 84% 22% 100 % discontinued Family HMO 78% 100 % 82 .

Outline   Uninsured in the US Demand for Insurance     What is insurance – risk pooling What is risk aversion Demand for insurance Factors affecting demand for insurance Moral hazard Adverse selection  Problem with demand for insurance       Problems with the health insurance market (Cutler) Health insurance features Insurance and demand for medical care Supply of insurance    Fee-for-service Managed care Consumer-driven health plans and health savings accounts  US health insurance market a brief history 83 .

  He suggests that individual costs should be experience rated to ensure people face the true cost of their habits 84 .Problems with the health insurance market (Cutler. Costs which are truly random factors (for unforeseen diseases or accidents). 1994)  Insurance is over “experience rated”    3 types of health care costs. Those individuals can control (smoking) Costs that are not controllable but predictably related to characteristics of the group (age).

charge everyone the same rate based on age or location. it is natural to pool costs.Problems with the health insurance market (Cutler.  He argues for community ratings. 1994)   For predictable but uncontrollable costs it is essentially a distributional issue (should the young subsidize the old) For random costs. so why stop at community? 85 .  For individual or employees of small firms their premiums are large and variable often making them unsustainable.  But the bigger the pool of people the better.

and if a sick person less people to spread the costs Adverse selection 86 .Question: why is small group health insurance so expensive?  Loading cost: administrative and other costs associated with underwriting insurance policies  Per capita loading costs decrease as firm group size increases    Loading costs = (risk premium + administrative costs + marketing costs + profits) Small group purchasers have less bargaining power Risk pool is smaller.

5 87 .Typical loading fees by group size 80 70 As a percent of benefits 70 60 (Phelps.5 6. 343) Percentage 50 40 30 20 10 0 Individual 1-10 11-100 100-200 201-1000 1000+ 35 25 17.5 11. p.

Outline   Uninsured in the US Demand for Insurance     What is insurance – risk pooling What is risk aversion Demand for insurance Factors affecting demand for insurance Moral hazard Adverse selection  Problem with demand for insurance       Problems with the health insurance market (Cutler) Health insurance features Insurance and demand for medical care Supply of insurance    Fee-for-service Managed care Consumer-driven health plans and health savings accounts  US health insurance market a brief history 88 .

then insurance company pays all additional costs Insurer covers all costs until some upper limit is reached Insurer pays fixed amount per unit of service (e.g. Physician office visit) and patient pays any additional costs 89  Deductibles   Maxiumum/limit   Indemnity (Co-pays)   Mixed .Health insurance features  Co-insurance  Consumer pays a fixed percent of the cost (say 20%) and the insurance company picks up the rest Patient pays a fixed amount out of pocket.

Outline   Uninsured in the US Demand for Insurance     What is insurance – risk pooling What is risk aversion Demand for insurance Factors affecting demand for insurance Moral hazard Adverse selection  Problem with demand for insurance       Problems with the health insurance market (Cutler) Health insurance features Insurance and demand for medical care Supply of insurance    Fee-for-service Managed care Consumer-driven health plans and health savings accounts  US health insurance market a brief history 90 .

We’ll investigate:  Co-insurance  Indemnity Insurance  Deductibles 91 .Demand for health care Effect of health insurance How much you demand may depends on type of insurance.

5*50 Consumer Pays with insurance Dwo 5 6 Quantity of Physician Services 92 .Demand for health care Health insurance: co-insurance Price of Physician Services Dwo: Demand without insurance Effective Price: Amount paid out of pocket Model using DWO curve Consumer pays without insurance Assume: .5 co-insurance Demand increased by one unit 50 .

50 . Quantity of Physician Services 93 .5*50 Dwo 5 6 A -Makes demand less elastic: for the same increase in price will reduce demand less with insurance.Demand for health care Health insurance: co-insurance Price of Physician Services Dwi Dwo: Demand without insurance Dwi: Demand with insurance Model by using market price -Insurance makes her demand more health care.

-demand more health care .Elasticity does not change Dwo $30 Dwi P=60 5 6 Quantity of Physician Services 94 .Demand for health care Health insurance: indemnity Price of Physician Services Pay $30 instead of 60 for a doctors visit.

95 . May lower demand for medical care   Depends on cost of the medical episode Small costs small problem may not demand health care. big costs you are more likely to get the health care. Reduce administrative costs because lower number of small claims.Demand for health care Health insurance: deductible Purpose of deductible is to lower cost for insurance company 1. 2.

Demand for health care Health insurance: deductible  Time cont. won’t wait to go to doctor.  If know definitely will meet deductible.   96 . may wait for care  If just after deductible has started more likely to have care Probability of needing additional medical care in the remainder of the deductible period. when medical care is demanded If close to time when deductible is reset.

Outline   Uninsured in the US Demand for Insurance     What is insurance – risk pooling What is risk aversion Demand for insurance Factors affecting demand for insurance Moral hazard Adverse selection  Problem with demand for insurance       Problems with the health insurance market (Cutler) Health insurance features Insurance and demand for medical care Supply of insurance    Fee-for-service Managed care Consumer-driven health plans and health savings accounts  US health insurance market a brief history 97 .

Consumer-driven health plans and health savings accounts 98 . Managed care (associated with capitation) 3.Three important insurance markets Three important insurance types in the US are 1. Fee-for-service 2.

Popular system before the 1990s

Patients choose medical provider

No gatekeeper: can go to any doctor and ask for any services

Doctors are reimbursed for each service they provide by the insurance company

Physicians have a schedule of fees, and so did insurance companies and the lower of the two would be paid

  

Providers (doctors) had autonomy over what care to prescribe and how to practice medicine Doctors tended to have independent practices Insurer manages the financial risk and pays usual, customary, or reasonable charges

Problems with fee-for-service:  No restraint on supply-side

With asymmetric information, problem of supplier induced demand. (over prescribing)

Doctors know more than patients so prescribe things that patient doesn’t really need

No incentives to find most cost-effective way to deliver care. Saw excess supply of hospital beds, nursing staff etc

Could be so doctors had room to maximize income


No demand constraint
 

Often no co-payments Could choose what doctor, hospital, and specialists

 

These two problems lead to over-utilization and high health care costs Policy options
 

 

Gate keepers, must go to primary care physician before go onto specialist Second or third opinions, must seek second opinions before expensive care given (another doctor who would not have the profit motive) Co-payments Managed-care a major response in US


  Patient must use the preferred providers or will pay more Organization is held clinically and fiscally responsible go the outcomes and health status of the population served 102 . physician.Managed care Key features: 1. Patient care is provided through a network or organization of providers (hospitals. clinics etc).

doctor told if they are over prescribing or not using the most cost-effective care by administration)   Doctors don’t like this because they can’t practice how they want to integrate financing and delivery of health care Goal is to provide cost-effective and comprehensive health care 103 .Managed care 2. Utilization review: centralized reviews of the appropriateness of provider practices (i.e.

Managed care 3. Selective contracting: payers negotiate prices and contract selectively with local providers (physicians and hospitals   Distinguishing characteristic from fee-for-service Patient must use the preferred providers or will pay more 4. Gatekeeper: must see a primary physician who needs to prescribe any specialty services 104 .

Doctors payment:   Capitated rate per member per month i. doctor paid a set amount per patient. if don’t use it all keep the rest. if use more have to finance themselves Stop loss provision in contract.e.Managed care 5. Specifies the total over the capitation rate per member before must be paid more. Reinsurance again large losses     Yearly salary: may be adjusted for patient load Negotiated fee-for services (for some kinds) 105 .

Managed care These features could lead to lower cost and better quality care Capitation:  Introduce a budget constraint onto the supply side  More volume means less profit  Creates an incentive to keep people healthy. prevention emphasized Incentive to choose most cost-effective way to provide care 106  .

Managed care Utilization review:   Incentive to choose most cost-effective way to provide care Incentive to provide only needed care Introduces a demand constraint May provide better quality care since better communication between different doctors looking after case Gatekeeper:  Networks:  107 .

approx. 41% of hospitals reported having revenue from capitated contracts Managed care organizations often only contract with one hospital in the area   Hospitals compete on price to get these contracts  Note the competition for fee-for-service payment to hospitals increased price as they competed on quality and number of services 108 .Managed care Competition among hospitals:  2004.

Health Maintenance Organizations (HMOs):     Example Kaiser Provide comprehensive health care. Must use services provided by the HMO doctors or network  Tend to hire all personal and have them as salaried staff.Managed care Types of Managed Care Organizations (MCOs): 1. Usually entail few out-of-pocket expenditures. Must see primary care physician and have them authorize any care you get Choose a primary care physician and can’t see others 109  Primary care physician is the gatekeeper    Unauthorized care is not reimbursed .

 Use in-network providers and have a lower deductible and co-payment Use out of network providers but pay a higher out-of-pocket costs.Managed care 2. So financial incentives provided to encourage use of network providers.  Usually no gatekeeper system 110 . 2. Preferred Provider Organization (PPO)  Consumer given two choices of plans 1.

negotiates prices for services).e.Managed care  Organization contracts with physicians and hospitals to provide services at below average cost (i. 111 . Some kind of utilization review is usually done.    These are the people that become in-network providers Usually does not use capitation   No guarantee provider will see patients under the plan About half require a mandatory second opinion for recommended surgery.

 Like HMO. two tier coverage  In network much cheaper than out-of-network. 112 .Managed care 3. who must authorize innetwork care in order for the care to be covered on the in-network terms. Point-of-service (POS)   Hybrid of HMO and PPO Like PPO. each member is assigned to a physician gate-keeper.

Growth in managed care  Growth of managed care was slow  Historic opposition by organized medicine groups to managed care   Took away patient choice of doctor Threatened ability of doctors to earn excess profits  Under fee-for-service can price discriminate  Charge different fee for the same services  Not possible to price discriminate due to capitated or negotiated fees 113 .

Growth in managed care  HMO Act 1973:    Enabled HMOs to become federally qualified if they provided comprehensive benefits and some other requirement Loan guarantees and grants for startup costs provided Qualified HMOs could require firms in the area with 25 or more employees to offer the HMO as an option Medicare and Medicaid switching to HMOs Number of HMOs grew from 235 in 1980 to 623 in 1986 114  Still no real expansion until the 1980s   .

Growth in managed care  Really expanded in the 1990s  First HMOs expanded  HMOs consolidated  Enrollment in HMOs increased from 33 million in 1990 to 81 million in 2000 HMO enrollments decreased but PPOs are expanding rapidly  Provider greater choice of doctors (more expensive than HMO)  2000s   See Figure 12-1 FGS 115 .

dark grey Quantity 116 .Economics of managed care Figure 12-2 FSG: Changing expenditures D = Demand (fee-for-service) Price f Df Dm Pf Pm Dm = Demand (managed care) Total expenditure FFS – light grey Total expenditure MC .

Economics of managed care
Predictions using economic theory:
1. Factors leading to a decrease in price

Exerts market power to lower prices from Pf to Pm

Only possible when had been earning economic profits 1. Factors leading to the decrease in demand
   

Reduce inpatient care by keeping patients healthier, using alternatives which are more cost-effective Limiting length of stays Minimizing supplier induced demand Encouraging more cost-effective care though information technology and financial incentives to providers

Constraint on consumer choice of doctors

Economics of managed care
3. Amount of care provided by managed care organization may provide less care than is optimal
 

We want good health over our life-time HMO wants to minimize costs since receives a constant revenue per patient each year

If they believe their patients will not stay in the HMO for a long period of time

Provide cheaper care in the short-term to minimize costs, even if it mean higher long term costs May mean the other HMOs have higher long-term costs if the patient moves to a different HMO This is called a negative externality


Economics of managed care Figure 12-3 FSG: Health Marginal cost externalities Marginal social cost HMO

(including external health effect on HMO2)

Marginal Revenue (price) Quantity of services

leading to low costs in both periods. and zero Period 2 costs.  It is not certain if we will be with the same HMO in the second period.Economics of managed care 4. possibly capital-intensive procedures leading to high period 1 costs. they will choose the less capital intensive 120 option in period 1 to minimize costs.  Low-tech. May use less high tech care Assume:  We split our life into two periods (period 1.  You are sick and HMO has two options which across the two period cost the same:  High-tech.  Given HMO does not know if you will stay with them. and period 2). les capital-intensive procedures. .

Managed care Potential Problems with MCOs: 1. FFS won’t do this because charge for all services given. Dumping: refusing to treat less healthy  patients who might use services in excess of their premiums. Say the organization is not equipped to treat certain patients.  1. Creaming: Seeking to attract more healthy patients who will use services costing less than their premiums  FFS may do this if reimbursement rates are not high enough 121 .

Skimping: Providing less than optimal quantity of services for any given condition  FFS won’t do this because can charge for each service given pay MCO to provide preventative or quality care. Poor Quality: If patients don’t stay in MCO long.Managed care 3. since they will not reap the lower future health care costs from these efforts 3. may not  FFS may do this if reimbursement rates are not high enough On the flip side MCO may promote more preventive care than under FFS – depends on how fast the rewards are reaped. 122  . FFS don’t like to do it because reimbursement rates often low for preventive care.

Impact of managed care Recap: Predictions  Theory predicts that MC compared to FFS:    Increase utilization of preventive services Reduce utilization or more costly service (partly by more preventive care) – hospital care Lower health care costs Reduced quality/quantity of care:     Capitation raises some concerns  Skimming – provide less than optimal care Use lower technology solutions Could result in poor health outcomes 123 .

Impact of managed care Recap: Predictions  Adverse selection    Healthier patients select into MC given lower costs Riskier select MC due to more comprehensive benefits and community rating Healthier patients due to cream skimming and dumping by plans. What happens in reality? 124 .

and quality for all those who are under FFS and all those under managed care.Impact of managed care Methodological issues  Methodologically difficult to find empirical evidence  Could compare health care costs. 125 .

Impact of managed care Methodological issues  Problem 1:   If utilization decreases is this because the managed care organization is reducing necessary care. Need to look at outcomes that will separate out these effects. or because the population is healthier due to more preventive care therefore not needing as much care altogether. 126 .

sicker people more likely to choose FFS so health care costs for those people will be higher     Expenditure may be higher not because FFS more expensive. Very hard to control for how sick someone is.Impact of managed care Methodological issues  Problem 2: SELECTION BIAS  Do the same types of people choose FFS and managed care?  No. Not because of incentives but because they have a sicker population and more high tech care is more likely to be needed. but because they have a sicker population May also find FFS uses more technology. 127 . Comparing two very different populations so may not have people with the exact same types of sickness in both groups.

Impact of managed care Methodological issues  To do analysis well really need to randomize people into FFS or managed care – or to find a policy experiment where people are forced to move from one to the other due to a mandate 128 .

Impact of managed care Empirical evidence  Selection  Evidence that the healthier select into managed care plans   10-30% lower utilization prior to switch for non-elderly population Greater differences among Medicare population  Riley et al (1994) – Medicare patients entering HMO had 37 % lower than average costs while those exiting had 60% higher than average costs  Need to worry about selection bias when examining impact on costs. utilization and quality 129 .

1981)      130 .Managed care Empirical evidence  Utilization  Confounded by selection issues  Evidence on selection means there would be lower utilization due to healthier population in managed care Studies are confounded Lower inpatient admission rates Mixed effects on length of stay Overall lower average number of inpatient days Great likelihood of number of outpatient visits  Early studies of HMOs (reviewed by Luft.

353 individuals randomly assigned to either:    FFS physician of their choice (431 people) HMO (1.149) Control group: HMO people who had been in the HMO the year before. up to a max of $150 per person or $450 per family 131 .000 out of pocket 95% co-insurance on outpatient services. 1984) Randomized experiment  2.  The FFS people where then randomized into one of four groups.000 out of pocket Pay 95% of expenses up to max of $1.     Free care Pay 25% of expenses up to max of $1.Managed care Empirical evidence  Rand Health Experiment (Manning et al.

Managed care Empirical evidence     See Table 12-3 FSG for results HMO findings consistent with non-experimental findings Less inpatient hospital use More outpatient use  Costs:  Rand Health Experiment    Lower inpatient costs Higher. but not significantly. outpatient costs Overall costs 28% lower than under “free care” plan 132 .

including monopoly power of hospitals. excess or non-excess capacity of provider in the market  Other find higher prices  133 .Managed care Empirical evidence  Prices  Mixed evidence  Some evidence that managed care plans effective in obtaining lower prices for care  Tied to monopsony power Depends on the market.

2002 – Table 12-4 FSG 134 .Managed care Empirical evidence  Innovation/Adoption of new technology  Mixed evidence    Early studies found positive association between managed care penetration and use of new technology More recent studies find slower diffusion of new technology where managed care penetration in higher Some find no differences  Recent literature on a number of issues  Miller and Luft.

Managed care Empirical evidence Costs: 2 questions a) Do they reduce the level of costs?    Use more cost-effective practices so as more people move to managed care the overall health care costs will go down. This is a one time cost decrease Evidence that the overall costs are reduce (Rand health experiment) 135 .

 Earlier studies found that growth in costs about the same between FFS and managed care. More recent studies find slower rates of growth under managed care plans (up to 1 percentage point a year) 136 .Managed care Empirical evidence b) Do they reduce the growth in costs (trends)   Reduce the percent increase in costs each year.

but to also pay for the differences in the costs of the providers 137  Emphasizes    .Consumer-driven health plans and New approach to health insurance health savings accounts Response to:       Renewed growth in health care costs  Move in 2000s from HMOs to PPOs may be partly responsible for this Continued growth in health insurance premiums Backlash against restricted choice in managed care Growth in information technology Greater consumer control over health care spending Making consumer sensitive to cost of care Allowing consumer to choose provider.

000 out-of-pocket don’t need to pay anymore.000 after that the insurance company will pay.000 max One pay 5. still have to pay co-insurance For individual may have a $5. more for families  Must pay for all care up to $3.000.Consumer-driven health plans and Consumer savings accounts healthDrive Health Care: Typical package  High deductible/catastrophic health insurance plan (typically PPO type)  Individual deductible may be $3.  Co-insurance: in-network co-insurance much cheaper than out of network.  Out-of-pocket maximum   138 .  Even if reach deductible.

Consumer-driven health plans and  Health savings account (HSA). Personal health savings accounts savings
account used to pay for care
 

Only eligible for HSA if have a high deductible. Account is tax exempt. Don’t pay taxed on the money you contribute and don’t pay taxes when you take the money out Individual or employer may contribute up a fixed amount (e.g. 100 percent of deductible or $2,700 per individual or $5,450 per family in 2006). Can’t contribute more.


Consumer-driven health plans and Can only take out money to pay for qualified health health savings accounts else expenditures. Will pay a penalty if use it for anything
  

If you don’t spend the money one year it stays in your account and you can grow it through money market funds, mutual funds, CDs etc. Once reach 65, individuals can make nonqualified health withdrawals and only play the appropriate tax rate without any penalties.
 

Problem with this is it is being used for tax evasion Used to save money tax free while pay a high tax rate. Then take money out when retired so are paying a low tax rate. Rich benefit more than poor.


Consumer-driven health plans and Advocate argue: health more likely: savings accounts Consumers

   

Only get care they need since they have to pay much of the cost out-ofpocket Will choose cheaper or more cost-effective care since pay out-of-pocket Will be more likely to use cheaper drugs This will all lead to decrease in growth in health care costs. Still have incentive to managed costs once high deductible has been reached


Benefit people of all risk levels by imposing caps on out-of-pocket spending. More people will insure because the costs of the plans are cheaper


Consumer-driven health plans and health savings accounts Opponents argue:  May decrease costs now but lead to higher costs later  People won’t pay for necessary care that keeps them healthy in the future   May not get necessary preventive care or manage ongoing chronic conditions Leads to higher costs in the future   If can switch plan with lower out-of-pocket costs will do so. will be left pay high health care costs  Detracts from risk pooling (purpose of insurance)   Plan likely to attract the healthy Pay: low costs when healthy. high costs when unhealthy 142 . Otherwise.

Consumer-driven health plans and health savings accounts  Difficult for individual to measure quality of care due to asymmetric information – not clear how easy it is for them to make the right choices  Will not decrease the number of uninsured because they don’t have enough money to pay the high deductibles so no point getting the insurance 143 .

Consumer-driven health plans and health savings accounts  Choice of provider not really different if not rich  To keep prices down need to use in network provider  Choice of provider has not changed  Costs may go up with choice of provider  Can use out of network provided (choice) but will pay more   No negotiated prices with out of network providers so they can charge much more If insurance covering costs once the max is hit this choice of providers will cost a lot more to the health care system 144 .

Consumer-driven health plans and health savings accounts  Early Evidence    Little use to date. but growing interest Some evidence that lower risk population more likely to choose this type of health care.000 or more out-of-pocket  Means there is may be little impact on reaching the 145 uninsured .  This is called favorable selection (healthier choosing to insure this way) Others suggest greater appeal to high income populations  Tax evasion  Can choose high cost providers and still have insurance pay for it when have expensive years  No trouble paying the 5.

Outline   Uninsured in the US Demand for Insurance     What is insurance – risk pooling What is risk aversion Demand for insurance Factors affecting demand for insurance Moral hazard Adverse selection  Problem with demand for insurance       Problems with the health insurance market (Cutler) Health insurance features Insurance and demand for medical care Supply of insurance    Fee-for-service Managed care Consumer-driven health plans and health savings accounts 146  US health insurance market a brief history .

US health insurance market Brief history  Earliest health insurance dates to 1840s  Sickness insurance  Provided income during illness  Limited supply of private insurance  Some interest in public health insurance in the early 1900s   Teddy Roosevelt: Progressive party Opposed by American Medical Association and others “socialized medicine”  1920s/1930s see increasing demand for and supply of health insurance  Rising health care costs 147 .

US health insurance market Brief history 1929: Modern private health insurance  Dallas teachers contracted with Baylor University Hospital   $6 annual payment paid in monthly installments 21 days of hospitalization 148 .

g.US health insurance market Brief history 1930s & depression  Growth in similar prepaid health care plans with hospitals   Protect individuals from risk during period of low and falling incomes Guaranteed hospitals a steady income  American Hospital Association created and organized several plans. Blue Cross     Subscribers free choice of hospitals within a city Pre-paid policies covering fixed amount of hospital care with no deductible/copayments Premiums determined by community ratings Grow from 1. e.300 to over 3 million covered from 1929-1939 149 .

1939: California physicians’ service plan  Covered all physician services  Physicians could charge patient above the amount they received from BS plan (cost-sharing) 150 .US health insurance market Brief history  Blue Shield plans  Success of Blue Cross plans for hospital care led to the development of Blue Shield plans for physicians care.

These fringe benefits were not reported to IRS (tax-exempt) IRS eventually asked them to be included in wage bill Workers expressed alarm and congress passed the health insurance could remain tax exempt 151  Use experience rating not community rating so could set lower premiums for some .US health insurance market Brief history 1940s/1950s  Growth in for-profit insurance companies    Success of BC/BS Health care costs increasing Employers offering health insurance as a benefit      Gov’t imposed price and wage controls to curb inflation Only way employers could attract new workers was with fringe benefits. So offered private health insurance.

US health insurance market Brief history 1960s/1970s  Increase in population covered by private health insurance  Most through employers   Continued increase in comprehensiveness of policies Fueled by:   Growth in incomes Tax treatment of insurance benefits  Don’t pay tax on money going to health insurance  Medicare/Medicaid introduced in mid-1960s  See rise in health care expenditures 152 .

US health insurance market Brief history 1980/90s   Increase in managed care (HMOs) Medicare/Medicaid switching to managed care Increase in PPOs and introduction of consumer driven care and HSA 2000s  153 .

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