Lecture 7What is InsuranceSlide 3Concentration of Personal Health ExpendituresHistory of Private Health InsuranceSlide 6Actuarially Fair Gamble and Risk AversionDemand for Private Health InsuranceSlide 9Slide 10Moral HazardSlide 12Slide 13Slide 14Slide 15Slide 16Adverse SelectionSlide 18Slide 19Slide 20Slide 21Slide 22Slide 23Problems with Health Insurance Mkt (Cutler, 1994)Slide 25Slide 26Lecture 7Health InsuranceWhat is Insurance•Meant to insure us against random uncertainty.•Club of 100 members.•On average, each year one member gets sick, it costs $20,000. It is random who gets sick.•This is a lot of money for one person to pay.•Instead, they insure each other and each pay $200 a year. •Money put in bank to get interest, and pay out when someone gets sick.What is Insurance•Aim of insurance is to reduce the variability in one’s income by pooling risks with a large number of people.•Outlays for health may be variable for one person, they are fairly predictable for the group.•Health insurance would not be necessary if everyone had average needs. But we do not it is variable.•Insurance makes it possible to obtain health care without going Bankrupt (new cancer drug $100,000 a year).Concentration of Personal Health ExpendituresAll Top 1% Middle (75%)BottomPersons (000s)285,000 2,850 213,750 42,750Health $ millions1,545,900 4,36,400 455,700 7,730Per Person5,427 153,126 2,135 184Source: Getzen T. “Health Economics: Fundamentals and Flow of FundsHistory of Private Health Insurance•Modern private health insurance started in 1929.–Baylor University in Dallas began accepting premiums from local school teachers to cover any medical services provided at the University hopsital.•During great depression of 1930s other hospitals followed.•American Hospital Association created and organized several plans, Blue Cross, and gave subscribers free choice of hospitals within a city.–Premiums determined by community ratings.History of Private Health Insurance•Hospital insurance market expanded during WWII–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.–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.Actuarially Fair Gambleand Risk AversionConsider the gambling game:–Zan and Forest flip a coin.–If it comes up heads, Zan wins a dollar and Forest nothing.–If it comes up tails, Forest wills a dollar and Zan nothing.–How much should they each be will to pay to play this game?•Expected Return for Zan: P(head)*$1 + P(tails)*0=.50 (50 cents).Demand for PrivateHealth InsuranceExpected Value:E[income if heads]=PrbH*$1+PrbT*0=1Actuarially fair gamble: is one in which the amount you pay for the gamble is equal to the expected value of the gamble.•You paid a dollar to play, and you expected value of the game was a dollar.Demand for PrivateHealth Insurance•If price of gamble (amount pay to play game) is equal to the expected return, then the gamble is actuarially fair.•In health, if expected benefit payment is equal to premiums, the insurance policy is actuarially fair.•Now suppose the gamble was instead for $5,000, would you want to play the game?–If not you are defined as being risk averse, because you do not want to take the actuarially fair gamble.Demand for PrivateHealth InsuranceFactors affecting demand for health insurance:1. Loading fee2. Probability of illness3. Magnitude of loss relative to income4. Degree of risk aversionMoral Hazard•What are the effects of the new price system (with insurance) on demand for insurance.•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 insuranceMoral HazardMoral Hazard: refers to the increased usage of services when the pooling of risks lead to decreased marginal costs for services. (i.e the price is reduced).•It is also used to refer to how one changes behavior when they are insured.–We may take more risks, which could have health care implications when insured rather than not insured.–Learning snow boarding (lot of people break their arms). May not learn if don’t have health insurance.Moral HazardQuantityPricePoAmount paidby consumer With insuranceQoQ1“Moral Hazard” increase in consumption due to insuranceMoral HazardQuantityPricePoAmount paidby consumer With insuranceQoQ1D1D2Q2Moral Hazard:• Increase when the price elasticity of demand increases.Moral Hazard•For services that are not very price sensitive, insurance will not cause them to purchase more services.–E.g. purchase of insulin for diabetics.•For those that are price sensitive (cosmetic surgery – not from accidents), insurance will cause us to buy more or themMoral Hazard•Hypothesize about services covered by insurance: services for hospitals and surgery (not cosmetic) more likely to be insured than nursing home care, physical therapy, mental health care, dentistry.\•Exchange has to make both groups better off, moral hazard reduces the value of transacting.Adverse Selection•This theoretical idea comes from arrow 1963 article.•Risk pooling works b/c everyone in the group is at risk and therefore has an interest in making sure that solid insurance benefits are provided.•Suppose the risk was not random, you knew you had a higher chance of lung cancer because smoked all your life.–You would want to make sure you had health coverage and may be willing to pay more for it.Adverse Selection•Or suppose you never smoked, eat well, do exercise, so think there is a low chance of getting lung cancer.–You would not want to pay a lot for health insurance for lung cancer.•If the high risks are something the insurance company can observe in advance, they can adjust premiums up or down to account for varying risk.–e.g pricing by age is common $300 a month for <=35 and $650 for 51-60 year olds.Adverse Selection•Adverse selection occurs when some factors are known to the insured by not to the insurer.–i.e. there is asymmetric information•Example: suppose have n people all with the same demographic characteristics.–First person expected health expend. Is $0–The other expect to pay as