Advanced Health Economics Econ555/HPA543 Week 4: Health Insurance
Types of Insurance Coverage Fee-for-Service: Coinsurance Deductibles Catastrophic Maximum Indemnity Capitation Mixed
Coinsurance - Patient pays a fixed fraction (c) of the cost of medical care C = 1 Patient s Cost c 1 45º Total Cost
Coinsurance - Patient pays a fixed fraction (c) of the cost of medical care C 1 > C 2 C = 1 Patient s Cost c 1 c 2 45º Total Cost
Total Expenditures Coinsurance -Impact on expected distribution of family medical care expenses: %of families
Coinsurance -Impact on demand: P D 0 D 1 P m c 1 P m Q 0 Q 1 Q
Coinsurance -Impact on demand: P D 0 D 1 D 2 P m c 1 P m c 2 P m Q 0 Q 1 Q 2 Q
Coinsurance -Impact on demand: P D 0 D 1 D 2 P m c 1 P m c 2 P m Q 0 Q 1 Q 2 Q
Deductible -Patient pays a fixed amount out of pocket, then Insurance company pays all additional costs Patient s Cost No Deductible D 1 45º Total Cost
Deductible -Patient pays a fixed amount out of pocket, then Insurance company pays all additional costs Patient s Cost D 1 > D 2 No Deductible D 1 D 2 45º Total Cost
Total Expenditures Deductible -Impact on expected distribution of family medical care expenses: %of families
Deductible -Impact on demand: P D 0 P m Q* Q*** Q
Deductible -Impact on demand: P D 0 P m B A Q* Q** Q*** Q
Catastrophic -Patient pays full costs of medical care until reaching an upper limit at which point insurer pays any additional costs Patient s Cost SL 45º Total Cost
Total Expenditures Catastrophic -Impact on expected distribution of family medical care expenses: %of families
Maximum/Limit %of families -Insurer covers all costs until some upper limit is reached -Impact on expected distribution of family medical care expenses: Total Expenditures
Indemnity -Insurer pays fixed amount per unit of service (e.g. Physician office visit) and patient pays any additional costs Patient s Cost SL If provider charges > indemnity amount 45º If provider charges = indemnity amount Total Cost
Indemnity -Effect on demand: P P m D 0 Indemnity Q 0 Q 1 Q
Indemnity -Effect on demand: P Indemnity D 1 P m D 0 Q 0 Q 1 Q
Most plans include mix of cost sharing -Initial deductible (D*) followed by copayment up to Maximum out-of-pocket expenses (Max): C = 1 Patient s Cost Max D* c 45º Total Cost
Insurance and Demand for Medical Care Economic theory implies that more comprehensive health insurance (e.g. lower cost sharing) will: Increase the demand for health care services that are covered by insurance Reduce the price sensitivity of demand for services that are covered by insurance Increases importance of time costs in the demand for medical care Contributes to greater increases in medical care prices Empirical evidence strongly supports these predictions Best evidence come from RAND Health Insurance experiment
Empirical Studies of Demand for Medical Care - RAND Health Insurance Experiment - One of largest social science experiments ($80m in mid-1970s) - Study impact of insurance on use of medical care - 5,809 individuals under age 65 (~2,000 families); highest income excluded - Participate 3-5 years (70% 3 years) - Six locations: - 4 cities (Dayton OH, Seattle WA, Fitchburg MA, Charleston SC) - 2 rural sites (Georgetown County, SC and Franklin County MA) - 1974-1977 (1979)
Empirical Studies: RAND HIE - Randomly assigned to different insurance plans (had to give up existing coverage): - Variation in copayment rates: - Full coverage - 25 percent copayment for all services - 50 percent copayment for all services - 50 percent copayment for dental and mental health services; 25 percent for all other services - 95 percent copayment for all services - 95 percent copayment for outpatient services; limit of $150 per person/$450 per family; free inpatient care (deductible plan) - All plans had catastrophic coverage (maximum out-ofpocket expenses 5, 10 or 15 percent of income; maximum of $1,000 per year) - Additional HMO plan (no cost sharing) - Incentives to participants equivalent to maximum risk individual family faces (no one made worse off by participating)
Empirical Studies: RAND HIE - Multiple measures of health and medical care utilization - General health, physiological measures, dental/vision, mental health, health habits - Analytic Methods: - Comparison of means across plans (given randomized trial design) - Multivariate regression analyses to control for any differences in plan populations - Comparison of free care vs. other plans
RAND HIE: Mean Face-to-Face Visits 5 4.55 4.5 4 Face-to-Face Visits 3.5 3 2.5 2 1.5 3.33 3.03 2.73 3.02 1 0.5 0 Free 25% 50% 95% Ded. Source: Manning et al. (1987)
RAND HIE: Mean Outpatient Expenses 400 350 340 Outpatient Expenses (1984$) 300 250 200 150 100 50 260 224 203 235 0 Free 25% 50% 95% Ded. Source: Manning et al. (1987)
RAND HIE: Mean Hospital Admissions 0.14 0.128 0.12 0.1 0.105 0.092 0.099 0.115 Admissions 0.08 0.06 0.04 0.02 0 Free 25% 50% 95% Ded. Source: Manning et al. (1987)
RAND HIE: Mean Inpatient Expenses 500 450 Inpatient Expenses (1984$) 450 400 350 300 250 200 150 100 409 373 315 373 50 0 Free 25% 50% 95% Ded. Source: Manning et al. (1987)
RAND HIE: Mean Probability of Any Use 100 90 86.8 Probability of Any Use 80 70 60 50 40 30 20 78.8 77.2 67.7 72.3 10 0 Free 25% 50% 95% Ded. Source: Manning et al. (1987)
RAND HIE: Mean Probability of Admission 12 Probability of Admission 10 8 6 4 10.3 8.4 7.2 7.9 9.6 2 0 Free 25% 50% 95% Ded. Source: Manning et al. (1987)
RAND HIE: Mean Total Expenses 800 749 Inpatient Expenses (1984$) 700 600 500 400 300 200 634 674 518 608 100 0 Free 25% 50% 95% Ded. Source: Manning et al. (1987)
RAND HIE: Mean Total Expenses, Adjusted 800 750 Total Expenses (1984$) 700 600 500 400 300 200 617 573 540 630 100 0 Free 25% 50% 95% Ded. Source: Manning et al. (1987)
RAND HIE: Predicted Mean Probability of Any Use 100 Predicted Probability of Any Use 90 80 70 60 50 40 30 20 10 86.7 78.8 74.3 68 72.6 0 Free 25% 50% 95% Ded. Source: Manning et al. (1987)
RAND HIE: Predicted Mean Probability of Admission 12 Predicted Probability of Admission 10 8 6 4 2 10.37 8.83 8.31 7.75 9.52 0 Free 25% 50% 95% Ded. Source: Manning et al. (1987)
RAND HIE: Predicted Mean Total Expenses 900 800 777 Predicted Total Expenses 700 600 500 400 300 200 630 583 534 623 100 0 Free 25% 50% 95% Ded. Source: Manning et al. (1987)
RAND HIE: Predicted Prob(Any) by Income Probability of Any Use 100 90 80 70 60 50 40 30 20 82.8 87.4 90.1 71.8 80.1 84.8 64.7 76.2 82.3 61.7 68.9 73.8 65.3 73.9 79.1 10 0 Free 25% 50% 95% Ded. Source: Manning et al. (1987) Low Income Middle Income High Income
RAND HIE: Predicted Prob(Admit) by Income 12 Probability of Admission 10 8 6 4 2 10.63 10.14 10.35 10.03 8.44 9.08 7.97 8.06 7.77 8.77 7.38 7.07 9.26 9.44 9.88 0 Free 25% 50% 95% Ded. Source: Manning et al. (1987) Low Income Middle Income High Income
RAND HIE: Predicted Total Expenses by Income Total Expenses (1984$) 900 800 700 600 500 400 300 200 788 736 809 680 588 623 610 550 590 581 494 527 609 594 670 100 0 Free 25% 50% 95% Ded. Source: Manning et al. (1987) Low Income Middle Income High Income
RAND HIE: Predicted Prob(any) by Age Probability of Any Use 100 90 80 70 60 50 40 30 20 84 88.6 75.1 81.4 70.3 77.1 63.5 71.2 68.5 75.6 10 0 Free 25% 50% 95% Ded. Source: Manning et al. (1987) Children Adults
RAND HIE: Predicted Prob(admit) by Age 16 Probability of Admission 14 12 10 8 6 4 2 5.33 13.9 4.98 11.5 4.62 10.9 4.23 10.2 5.86 12.1 0 Free 25% 50% 95% Ded. Children Adults Source: Manning et al. (1987)
RAND HIE: Mean Prob(Any) for Dental Services 80 70 68.7 66.8 Probabiliyt of Any Use 60 50 40 30 20 53.6 52.6 54.1 53 47.1 48.3 48.9 48.1 10 0 Free 25% 50% 95% Ded. Source: Manning et al. (1987) Year 1 Year 2
RAND HIE: Mean Visits for Dental Services 3 2.5 2.5 Visits 2 1.5 1.93 1.73 1.8 1.51 1.5 1.39 1.44 1.7 1.33 1 0.5 0 Free 25% 50% 95% Ded. Year 1 Year 2 Source: Manning et al. (1987)
RAND HIE: Mean Expenses for Dental Services 400 380 Per Capita Expenses (1984$) 350 300 250 200 150 100 50 261 224 219 190 177 179 147 242 158 0 Free 25% 50% 95% Ded. Source: Manning et al. (1987) Year 1 Year 2
RAND HIE: HMO vs. Free Prob(Any) 92 91.1 91 Probability of Any Use 90 89 88 87 86 85 84 87 85.3 83 82 HMO Exp. HMO Ctrl. Free Source: Manning et al. (1987)
RAND HIE: HMO vs. Free Prob(Admission) 12 11.2 Probability of Admission 10 8 6 4 2 7.1 6.4 0 HMO Exp. HMO Ctrl. Free Source: Manning et al. (1987)
RAND HIE: HMO vs. Free Total Predicted Expenses 700 Total Estimated Expenses (1984$) 600 500 400 300 200 100 426 465 612 0 HMO Exp. HMO Ctrl. Free Source: Manning et al. (1987)
RAND HIE Estimated Elasticities Type of Care Co-Ins. Range Acute Outpatient Chronic Well All Hospital All 0-25% 0.16 0.20 0.14 0.17 0.17 0.17 25-95% 0.32 0.23 0.43 0.31 0.14 0.22 Source: Manning et al. (1987)
RAND HIE Summary/Conclusions Reductions in cost sharing lead to increases in health care utilization and spending Demand less elastic as cost-sharing falls No impact on quality of care Affects use of both essential and non-essential care Similar effects across income/age groups (although differences by income and age) Increases in utilization resulting from lower cost sharing had little or no impact on average health Some positive impact on detection/treatment of hypertension, vision, and oral health Better use of regular screening with free care Many poor health habits (smoking, exercise, diet) worse with free care Source: Keeler 1992
RAND HIE Impact 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
60% 55% 50% 45% 40% 35% 30% 25% 20% 15% 10% Inflation Adjusted Per Capita Personal Health Care Expenditures, by Source, 1960-2003 1963 1968 1973 1978 1983 1988 1993 1998 2003 Total Out of Pocket Private Insurance Other Private Federal State andlocal % Out of Pocket 5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0 2003 Dollars per Capita
Inflation Adjusted per Capita Hospital Care Expenditures, by Source, 1960-2003 25% 20% 15% 10% 5% 0% 1963 1968 1973 1978 1983 Total Out of Pocket Private Insurance Other Private Federal State andlocal % Out of Pocket 1988 1993 1998 2003 2,000 1,800 1,600 1,400 1,200 1,000 800 600 400 200 0 2003 Dollars per Capita
70% 60% 50% 40% 30% 20% 10% Inflation Adjusted per Capita Physician/Clinical Care Expenditures, by Source, 1960-2003 1963 1968 1973 1978 1983 1988 1993 1998 2003 Total Out of Pocket Private Insurance Other Private Federal State andlocal % Out of Pocket 1,400 1,200 1,000 800 600 400 200 0 2003 Dollars per Capita
Inflation Adjusted per Capita Dental Care Expenditures, by Source, 1960-2003 100.0% 90.0% 80.0% 70.0% 60.0% 50.0% 40.0% 1963 1968 1973 1978 1983 1988 1993 1998 2003 Total Out of Pocket Private Insurance Other Private Federal State andlocal % Out of Pocket 250 200 150 100 50 0 2003 Dollars per Capita
Inflation Adjusted per Capita Nursing Home Expenditures, by Source, 1960-2003 80% 70% 60% 50% 40% 30% 20% 1963 1968 1973 1978 1983 1988 1993 1998 2003 Total Out of Pocket Private Insurance Other Private Federal State andlocal % Out of Pocket 400 350 300 250 200 150 100 50 0 2003 Dollars per Capita
Inflation Adjusted per Capita Prescription Expenditures, by Source, 1960-2003 95% 85% 75% 65% 55% 45% 35% 25% 1963 1968 1973 1978 1983 Total Out of Pocket Private Insurance Other Private Federal State andlocal % Out of Pocket 1988 1993 1998 2003 600 500 400 300 200 100 0 2003 Dollars per Capita
Demand for Health Care Insurance Result of uncertainty Illness and medical expenditures unpredictable Can save for possible medical expenses Buy insurance to cover medical expenses Low probability/high cost illnesses Willing to pay to reduce risk Insurance company pools risks Spread risk among many consumers
Risk Aversion reflected by diminishing marginal utility of income/wealth Utility Income
Demand for Insurance Basic model: Individual earns income Y if healthy Income Y generates Utility U(H) If sick, individual faces health care costs of C Reduces income to Y-C Utility falls to U(S) Probability of illness occurring is p Expected Utility: E(U) = (1-p)U(H) + pu(s) E(Y) = (1-p)Y + p(y-c)
Demand for Insurance: Utility U(H) E(U) U(S) C Y-C E(Y) Y Income
Demand for Insurance Example: Income (Y) if healthy: $50,000 Generates Utility U(H): 100 If sick, health care costs (C) of $30,000 Reduces income to $20,000 Utility falls to U(S): 60 Probability of illness occurring is 0.25 Expected Utility: E(U) = (1-p)U(H) + pu(s) =.75(100) +.25(60) = 90 E(Y) = (1-p) Y + p(y-c) =.75($50,000)+.25($20,000)=$42,500 - Utility of Expected Income: U($42,500)=98
Demand for Insurance example: Utility 100 98 90 60 $30,000 $20,000 $42,500 $50,000 Income
Demand for Insurance Individual faces two options: Self insure: If healthy, enjoy full income ($50k); utility=100 If sick, pay $30k;income now $20k; utility=60 If P=0.25, the E(U)=90 Buy insurance at price I Guarantees income of $50k-I and utility U(Y-I) What should she/he do? Suppose price is the pure or actuarially fair premium (reflects only expected costs of medical care to treat illness): I = 0.25($30,000) = $7,500 If insure, then guarantee utility U(I)=98 Compare U(Y-I) and expected utility (E(U)
Demand for Insurance example: Utility 100 98 90 $7,500 60 $30,000 $20,000 $42,500 $50,000 Income
Demand for Insurance How much is individual willing to pay for insurance?
Demand for Insurance example: Utility 100 98 90 $7,500 60 $30,000 $20,000 $42,500 $50,000 Income
Demand for Insurance How much is individual willing to pay for insurance? Will be willing to pay until E(U)=U(Y-I)
Demand for Insurance example: Utility 100 98 90 $7,500 60 $30,000 $20,000 $42,500 $50,000 Income
Demand for Insurance How much is individual willing to pay for insurance? Willing to pay until E(U)=U(Y-I) (certainty equivalent) E(U) = U($32,500) - Individual willing to pay up to $17,500 for insurance - Pure Premium: $7,500 - Risk Premium (Loading Cost): $10,000 - Profits/taxes - Administrative expenses - Anything less expensive will guarantee that individual is better off than can expect to be by self-insuring - If more expensive, individual expects to be better off by self-insuring than if buy insurance
What factors affect demand for insurance?
What factors affect demand for insurance? Probability of Illness
Demand for Insurance p(illness) Utility U(H) I 1 p 1 C U(S) C Y-C Y-I 1 E(Y 1 ) Y Income
Demand for Insurance p(illness) Utility U(H) I 1 p 1 C p 2 C I 2 U(S) C Y-C E(Y 2 ) E(Y 1 ) Y Income
Demand for Insurance p(illness) Utility U(H) I 1 p 1 C p 2 C I 2 U(S) p 3 C I 3 C Y-C E(Y 3 ) E(Y 2 ) E(Y 1 ) Y Income
What factors affect demand for insurance? Probability of Illness For given cost of illness, individual will be willing to pay a higher price for insurance Pure premium (p*c) rises with increase in probability of illness Risk premium: Falls as probability of illness approaches zero (very unlikely event, little reason to pay more than pure premium) Falls as probability of illness approaches one (very likely event, again little reason to pay more than pure premium) Greatest when probability is 0.50 (greatest uncertainty)
What factors affect demand for insurance? Probability of Illness Cost of Illness
Demand for Insurance Cost = C 1 Utility U(H) pc 1 I 1 U(S) C 1 Y-C 1 E(Y 1 ) Y Income
Demand for Insurance Cost: C 1 > C 2 Utility U(H) I 2 pc 2 pc 1 I 1 U(S) C 2 C 1 Y-C 1 Y-C 2 E(Y 1 ) Y Income
What factors affect demand for insurance? Probability of Illness Cost of Illness Higher cost of illness: Raises pure premium (p*c) Raises risk premium Raises overall price individual will pay for insurance
What factors affect demand for insurance? Probability of Illness Cost of Illness Degree of Risk Aversion
Risk Aversion Ind. 2 more risk averse than Ind. 1 Utility U 2 pc U 1 Y-C 1 E(Y 1 ) Y Income
Risk Aversion Ind. 2 more risk averse than Ind. 1 Utility U 2 Risk Premium 2 pc Risk Premium 1 U 1 I 2 I 1 Y-C 1 E(Y 1 ) Y Income
What factors affect demand for insurance? Probability of Illness Cost of Illness Degree of Risk Aversion More risk averse individual willing to pay a higher risk premium for insurance More risk averse will pay higher total premium
What factors affect demand for insurance? Probability of Illness Cost of Illness Degree of Risk Aversion Income
Utility Demand for Insurance Income pc pc I M I M I H I H C C Y M -C Y M Y H -C Y H Income
What factors affect demand for insurance? Probability of Illness Cost of Illness Degree of Risk Aversion Income Risk premium individual is willing to pay will be smaller at relatively high or relatively low income Low income also have greater likelihood of eligibility for public health insurance
What factors affect demand for insurance? Probability of Illness Cost of Illness Degree of Risk Aversion Income Price higher price reduces likelihood that individual will insure against a given event
Demand for insurance empirical evidence Probability of Illness Increases with age affected by availability of public health insurance programs (SCHIP and Medicare) Differs by gender affected by availability of public health insurance programs targeting pregnant women Differs by type of care chronic vs. acute vs. preventive care Interacts with cost
Percentage of Population Without Health Insurance, by Age and Income, 2001 50 40 30 20 10 0 49.5 45.5 44.6 31.9 28.1 21.3 23.4 16.1 11.7 13.1 0.8 2.7 <18 18-24 25-34 35-44 45-64 65+ All Poor
20 15 10 16.1 Percentage of Population Without Health Insurance, by Gender, Jan-June 2003 13.7 19.5 17 11 8.5 5 0 At Interview Part of Past Year More than Past Year Male Female
Percentage of Population Without Insurance, by Region, 2003 25 20 20.8 21.6 18 17.7 15 13.3 9.9 15.1 11.2 12.2 12.2 10 5.7 6.7 5 0 Northeast Midwest South West In Past Year At Interview More than a Year
Demand for insurance empirical evidence Probability of Illness Cost of Illness Higher cost increases demand for insurance Interacts with probability of illness
Out-of-Pocket Spending as Percentage of Consumer Payments, 2003 80% 70% 70.3% 71.0% 60% 50% 40% 47.4% 38.0% 43.7% 39.1% 30% 28.5% 20% 15.3% 10% 7.6% 0% Personal Health Hospital Physician/Clinic Dental Other Home Health Prescription Durable Medical Nursing Home Care Professional Drug Equipment
Demand for insurance empirical evidence Probability of Illness Cost of Illness Degree of Risk Aversion Difficult to assess May be correlated with gender, age, race/ethnicity, education, marital status Correlated with other determinants of insurance demand
Percentage of Population Without Insurance, by Education, 2001 30 27.6 25 20 17.4 15 14.4 10.8 10 7.3 5 0 < HS Grad HS Grad Some College Assoc. Degree Bach. Degree+
Percentage of Population Without Insurance, by Education and Income 40 37.2 35.9 35.2 35.4 35 30 27.6 31.3 25 20 15 10 17.4 14.4 10.8 7.3 5 0 < HS Grad HS Grad Some College Assoc. Degree Bach. Degree+ All Poor
Percentage of Population Without Insurance, by Race/Ethnicity, 2001 50 45 40 35 30 25.5 26.2 38.3 33.2 43.7 25 20 19 18.2 15 10 10 5 0 White, Non-Hisp. Black Asian/Pacific Isl. Hispanic All Poor
Percentage of Population Without Insurance, by Nativity, 2001 70 62 60 50 42.9 40 30 26.1 31.8 20 10 12.2 17.2 0 Native Naturalized Citizen Not a Citizen All Poor
Percentage of Population Without Insurance, by Marital Status, 2003 35 30.9 30 26.7 25 20 22.4 15.5 22.1 18.9 15 12.1 10 5 8.1 5.6 4.2 0 Married Widowed Divorced/Sep. Living w. Partner Never Married At Interview More than a Year
Demand for insurance empirical evidence Probability of Illness Cost of Illness Degree of Risk Aversion Income Expect initially positive impact of income on demand for insurance Complicated by public health insurance programs targeting lowest income Expect greater likelihood of self-insurance among very high income Complicated by tax treatment of health insurance benefits
Percentage of Population Without Health Insurance, by Income, 2001 25 23.3 20 17.7 15 11.3 10 7.7 5 0 <$25,000 $25,000-$49,999 $50,000-$74,999 $75,000+
Demand for insurance empirical evidence Probability of Illness Cost of Illness Degree of Risk Aversion Income Wide range of estimates for income elasticity of demand for health insurance Most positive and less than one A few negative elasticity estimates Estimates based on aggregate data tend to be higher and greater than one
Demand for insurance empirical evidence Probability of Illness Cost of Illness Degree of Risk Aversion Income Price Wide range of estimates of price elasticity of demand for insurance (0 to -0.7) Most imply relatively inelastic demand (0 to -0.2) Studies looking at effects of price on choice of plan within a particular employer tend to produce relatively high elasticities
Tax Treatment of Insurance Estimating price, income elasticities of insurance demand complicated by tax exempt status of insurance benefits Discussion assumed individuals bear full cost of insurance Reality is that: Most insurance is purchased through group plans provided by employers Insurance benefits are tax exempt; example: Income(including benefits) $50,000; Price(Ins) $5,000; Income Tax Rate 20% If purchase insurance directly, after tax/insurance income is $35,000 If employer purchases, after tax/insurance income is $36,000 Cost of insurance to individual significantly higher
Tax Treatment of Insurance Consumption I 0 I 1 Insurance
Insurance Coverage Status, by Type 100 90 80 70 60 85.5 70.9 62.6 50 40 30 20 10 8.3 0 1987 1991 1995 1999 Year Employment-Based Total Private Self-financed Total Insured
Tax Treatment of Insurance Tax exempt status of health insurance benefits results in greater demand for insurance More services covered Reduced cost sharing
Out-of-Pocket as Percentage of Private Health Care Expenditures 1 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 1963 1967 1971 1975 1979 Personal Health Care Hospital Physician/Clinic Dental Nursing Home Prescription Drug Other Professional 1983 1987 1991 1995 1999 2003 0
Demand and Supply for Insurance Supply: Assume competitive market In equilibrium, total revenue (TR) equals total cost (TC); firm earns zero profit Total Revenue: TR=aq a is insurance premium q is coverage Total Cost: If healthy: t If sick: pq + t t is the loading cost or administrative cost for insurer p is the price of coverage
Demand and Supply for Insurance Supply: Total cost: TC= p (pq+t) + (1-p )t Since zero profit, TR=TC: aq = p (pq+t) + (1-p)t Equilibrium premium is: a = p p + t/q Premium is the pure premium plus the average administrative cost Actuarially fair premium is pure premium
Demand and Supply for Insurance Demand: If Insured, expected utility: E(U) = (1-p )U H (Y-aq) + p U S (Y-aq+pq-L) U H, U S are utility when healthy, sick Y is income L is cost of medical care to consumer Maximizing expected utility with respect to coverage: a(1-p )MU H = (p-a)p MU S If actuarially fair insurance (a=p p), then: MU H = MU S Assuming treatment restores person to full health, then only way for MU H = MU S is for income when healthy to be equal to income when sick (assuming marginal utility of income not affected by illness): Y-aq=Y-aq+pq-L or: L=pq Implies that optimal coverage is full coverage
Demand and Supply for Insurance Demand: If no loading cost, but MU H > MU S at any level of income, then for MU H = MU S, income when healthy must be greater than income when sick: Y-aq > Y-aq+pq-L or: L>pq Implies that optimal coverage is less than full coverage when premium includes administrative cost (loading cost) Similarly If some risk premium/loading cost (a=p p + t/q), then: MU H < MU S Implies that Income when healthy must be higher than income when sick Y-aq > Y-aq+pq-L or: L>pq Implies that optimal coverage is less than full coverage when premium includes administrative cost (loading cost)
Problems in Insurance Moral Hazard: Ex post: consumer uses more medical care than necessary Consumer faces probability of illness p If paying for full cost of care out-of-pocket, consumer would use care until MB=MC (Q 1 ) P P m Q 1 Q
Problems in Insurance Moral Hazard: If insurance company charges actuarially fair premium (pq 1 ) and individual buys insurance, he/she will use more (Q 2 ) than if paying for care out of pocket (since MC under insurance=0) Insurance company loses money P P m Q 1 Q 2 Q
Problems in Insurance Moral Hazard: If insurance company charges premium based on amount that will be used when insured (pq 2 ) Individual unlikely to buy insurance P P m Q 1 Q 2 Q
Problems in Insurance Moral Hazard: Ex Ante: Individual with insurance engages in behavior that affects need for medical care (e.g. more unhealthy behavior, less preventive/health behavior) - Greater use of care than would be the case without insurance P P m Q 1 Q 2 Q
Problems in Insurance Adverse Selection: Result of asymmetric information Two types of consumers: relatively healthy, with low risk of illness (p L ) relatively unhealthy, with high risk of illness (p H ) Insurance company observes overall risk in the market: p = f(p H )+ (1-f) (p L ) Sets premium based on observed risk: P = p C + t Who buys insurance?
Problems in Insurance: Adverse Selection Utility U(H) p L p U(S) p H C Y Income