Demand for Insurance
•Ref: Morrisey (2007) Health Insurance
Two-party health care market model
Direct out of pocket payment between
Health care providers
•Uncertainty in health care
•At the individual level, ill health is usually unpredictable. This means that the Demand for many types of health care is uncertain and that people who consume health care typically operate under conditions of uncertainty.
•Health care expenditures may be ‘catastrophic’ if they require people to spend a significant proportion of their income on health care as a result of unforeseen or unexpected illness.
•Problems arising from the existence of uncertainty may be addressed with the introduction of health insurance.
•Health Insurance involves the development of an insurance contract between an insurance provider and people who consider themselves to be at risk of ill health.
•When someone buys health insurance they enter into an agreement with the insurance provider to pay an agreed price, called an insurance premium, in exchange for a payout to be made to the contract holder by the insurance company should they become ill.
Third-party health care market model
Attitudes to risk
Households and Health care providers and Third-party payer
•People choose to buy health insurance because they are risk averse. This means that they will refuse a fair gamble - a gamble which, on average, will make exactly zero profit.
The amount of money someone is prepared to pay for insurance is equal to the fair premium, which is their expected loss if uninsured, plus a risk premium which reflects their degree of risk aversion.
One explanation for risk aversion is the diminishing marginal utility of income
Diminishing marginal utility of income
•Assume that we can assign a numerical “utility value” to each income level
•Also, assume that a healthy individual earns $40,000 per year, but only $20,000 when ill
•Individual doesn’t know whether she will be sick or healthy
•But she has a subjective probabilityof each event
–She has an expected value of her utility in the coming year
•Define: P0 = prob. of being healthy
P1 = prob. of being sick
P0 + P1 = 1
•An individual’s subjective probability of illness (P1) will depend on her health stock, age, lifestyle, etc.
•Then without insurance, the individual’s expected utility for next year is:
•E(U) = P0U($40,000) + P1U($20,000)
= P0•90 + P1•70
•For any given values of P0 and P1, E(U) will be a point on the chord between A and B
•Assume the consumer sets P1=.20
•Then if she does not purchase insurance:
E(U) = .80•90 + .20•70 = 86
E(Y) = .80•40,000 + .20•20,000 = $36,000
•Without insurance, the consumer has an expected lossof $4,000
•The consumer’s expected utility for next year without insurance = 86 “utils”
•Suppose that 86 “utils” also represents utility from a certain income of $35,000
–Then the consumer could pay an insurer $5,000 to insure against the probability of getting sick next year
–Paying $5,000 to insurer leaves consumer with 86 utils, which equals E(U) without insurance
•At most, the consumer is willing to pay $5,000 in insurance premiums to cover $4,000 in expected medical benefits
$1,000 ºloading feeº price of insurance
•Diminishing marginal utility of income
•Worked example of the demand for health insurance
•The majority of Americans have employer-provided health insurance
•Employer-paid health insurance is exempt from federal, state, and Social Security taxes
èEmployee will prefer to purchase insurance through work, rather than on his own
•Example: Insurance and take-home pay when income is $1,000 per week and income tax rate is 28%
•28% tax <280>
•after tax 720
•net pay 670
•28% tax <266>
•net pay 684
•Employer Health Insurance Coverage of U.S. Population (percent)
Determinants of Health Insurance Demand
1Price of insurance
–In the previous example, the consumer will forego health insurance if the premium is greater than $5,000
2Degree of Risk Aversion
–Greater risk aversion increases the demand for health insurance
–Larger income losses due to illness will increase the demand for health insurance•
4Probability of ILLNESS
–Consumers demand less insurance for events most likely to occur (e.g. dental visits)
–Consumers demand less insurance for events least likely to occur
–Consumers more likely to insure against random events
Four Insurance Hypotheses
•The greater the degree of risk aversion, the greater the demand for insurance
•The larger the size of the possible loss, the greater the demand for insurance
•The larger the probability of loss, the larger—then the smaller—the demand for insurance
•The greater the wealth, the smaller the demand for insurance
Theoretical Model of Health Insurance
•Consider an individual who will have an income of size W if he is lucky enough to avoid illness
•In the event an illness occurs, his income will be only W - d.
•The individual can insure himself against this illness by paying to an insurance company a premium α1, in return for which he will be paid ά2 if an illness occurs.
Without insurance his income in the two states, " illness," "no illness," was (W, W - d);
•With insurance his income is now (W - αi, W - d + α2),
where α2 = ά2 – α1.
•The vector α = (α1, α2) completely describes the insurance contract.
Demand for Health Insurance
Let W1 denote his income if there is no accident and
W2 his income if an accident occurs; the expected utility
(1)V(P, W1, W2) = (1 – p)U(W1) + pU(W2)
where U( } represents the utility of money income and p the probability of an accident. Individual demands may be derived from (1)
A contract α is worth V (p, α ) = V(p, W - αi, W - d + α2)
Individuals select from all possible insurance contracts the one
that maximizes V (p, α )
An individual will never purchase a contract that makes him worse off than without any insurance contract
•The supply of health insurance
•Insurance companies are able to supply health insurance because they can pool risks across a large number of insured people.
•The total premium charged by insurance providers is equal to the fair premium plus a loading factor, which covers the insurance provider’s administration costs and the profit it needs to earn from each insured person to remain in the market.
•Supply of health insurance
•The return from an insurance contract is a random variable. Assume that companies are risk-neutral, that they are concerned only with expected profits, so that contract a when sold to an individual who has a probability of incurring an accident of p, is worth
•(2) ∏(p, ) = (1 - p) α1 - p α2 = αi - p(α1 + α2).
•Even if firms are not expected profit maximizers, on a well-organized competitive market they are likely to behave as if they maximize (2).
•Insurance companies have financial resources such that they are willing and able to sell any number of contracts that they think will make an expected profit. The market is competitive in that there is free entry. Together these assumptions guarantee that any contract that is demanded and that is expected to be profitable will be supplied.
•Health insurance market failures
•Adverse selection arises because of the asymmetry of information between individuals who wish to buy insurance and the insurance provider.
•Because of this asymmetry the insurance provider may set a community rate for insurance which will be more attractive to high risk individuals. This will mean that people with low risks will choose not to buy insurance, and premiums can spiral until the insurance market collapses.
•Adverse selection may be addressed by experience rating and compulsory insurance.
•Moral hazard is a problem of excess use. It arises when it is possible to alter the probability of illness or the size of the payout required by the insurance provider.
•Moral hazard may be reduced by coinsurance, deductibles and no claims bonuses.
•Non-price competition arises when health care providers compete for patients not on the basis of price, but on other factors such as comfort, available facilities and the quality of food.
•This will cause health care costs to rise.
Incomplete health insurance coverage
•Incomplete health insurance coverage is likely to be a problem for low income groups and for high risk groups even if health insurance is charged at the fair premium rate.
A health care financing framework
•The type of third party payer
•The method by which health care providers are reimbursed
•The extent of integration between third party payers and health care providers
•The ways in which health care is financed
•Health care financing)
•Three broad types of third party payer in health care:
–private insurance providers
–social insurance funds
•Two main methods of reimbursement:
–Retrospective reimbursement, gives weak incentives for cost containment.
–Prospective reimbursement, which can take two forms: global budgeting and prospectively set costs per case
•Three levels of integration between third party payers and health care providers:
•As an example, managed care of three broad types:
–preferred provider organizations
–health maintenance organizations
–point of service plans
•Three main methods of financing health care:
–private health insurance
–social health insurance
Health care financing framework
•Extent and nature of coverage
The Extent of Coverage
•Current Population Survey (CPS)
–50,000 households surveyed in waves
–Employee Benefits Research Institute
•Roughly, 83 percent of the U.S. resident population in 2006 had some form of health insurance coverage
•Obtained as part of the compensation that workers receive
–Worker + 1 or Worker + 2
•Approximately half of those with this coverage have it through their own employer, the rest as dependents
•Typically offered to full-time workers
–Only 31 percent of firms offer coverage to part-time workers
•Approximately 78 percent of workers are eligible for coverage when offered
–However, of these, only about 82 percent take coverage
Choice of Health Plans
•The number of plans offered by employers varies significantly by firm size
–Of those with 5,000+ employees
•29 percent offer three or more plans
•42 percent offer two plans
–Of those with <200 employees
•Only 10 percent offer more than one plan
•Average 2006 monthly premium:
–$354 for single coverage
–$957 for family coverage
•Average 2006 employee premium contribution:
–$52 for single coverage
–$248 for family coverage
•Premium contributions have been a constant percentage of total premium for the last decade
•Virtually all employer-sponsored health insurance plans cover
–Hospitalization, physician visits, prescription drugs, ambulatory and inpatient mental health services
Extent of coverage differs substantially
Copays and deductibles are common
–57 percent of those with an HMO paid $15 or $20 copay
–Deductible for in-plan PPO usage averaged $473
–90 percent of plans use “multitiered” prescription drug copays
Plans differ with respect to utilization management
Consumer-Directed Health Plans
•Provide insurance coverage after a relatively large deductible is paid.
–HRET/Kaiser Survey said that 4 percent of employees were offered such plans in 2004
–Average single coverage deductible: $1,900
–Average contribution made to health savings account: $553
•Not purchased through a group
•Currently plays a minor role
Policy advocates see a major role
–Consumer-directed health plans
–Elimination of employer-sponsored coverage
–Individual tax credits
•Covers some 6.3 million under age 65
–Dependents of Medicare eligibles
•Covers virtually all residents over age 65
–Approximately 60 million people
–Hospital, skilled nursing, and home health coverage
–Paid for by payroll taxes
–Physician services and durable medical equipment
–Paid for by general taxes and monthly premium
–Medicare Advantage (Medicare managed care)
–Covers approximately 13 percent of beneficiaries
–Voluntary prescription drug coverage
–Paid for by an additional monthly premium
•Joint federal-state program
•The 13.5 percent is an underestimate of coverage
–Ignores those over age 65 who have nursing home coverage
–Suspicion that the CPS misses a number of Medicaid eligible—perhaps 5.8 million
–Military retirees and dependents of active duty, retired, and deceased service members
–Civilian Health and Medical Program of the VA
–Disabled dependents and certain survivors of veterans
Number and Percentage of Americans under Age 65 by Source of Insurance, 1994 and 2005
–Purchasers know more about their likely use services and use this knowledge to select a health plan that is designed for people with lower expected claims experience.
Compared to indemnity insurance, HMOs had:
o Admission rates: 26 – 37% lower
o Length of stay: 1 – 20% lower
o Hospital days: 18 – 29% lower
o Office visits: Higher or equal
o Expensive services: Used less
•HMO Effect vs. Favorable Selection
•How to keep people out of hospitals
•How to attract people who do not use hospitals
•Can a firm that has always offered a conventional insurance plan save money by adding an HMO option?
Effects of HMO Enrollment on Traditional Medicare Expenditures Revisited
•If Medicare HMOs attract lower utilizers, then when a larger share of Medicare enrollees are enrolled in traditional Medicare, the average claims expenditure should be lower, other things equal.
•Analysis of 1990–1994 nonrural Medicare county-level claims data
•Each 1 percent larger traditional share associated with:
–$1,033 lower average total claims
–$1,028 lower average Part A claims
–$ 18 lower average Part B claims (not statistically significant)
•Implies that Medicare HMO enrollees were 30 to 40 percent less costly
•Historically some firms have observed that when they began offering both traditional and HMO insurance offerings, their total insurance expense increased rather than decreasing or remaining unchanged.
–An HMO effect suggests lower total premiums as the managed care plan “does something” to keep people out of hospitals.
–A favorable selection effect suggests no change in premiums. The lower utilizing employees are disproportionately in the HMO and the higher utilizing employees are in the traditional plan.
Shadow-pricing” has been suggested as the explanation. The HMO is said to price its services “just a shadow below” the premium changed by the traditional insurer even though its utilization experience is lower due to either an HMO effect or favorable selection.
•Moral Hazard–Utilization Management
•In general, utilization management can be viewed as nonprice mechanisms to reduce moral hazard.
•The most common initial programs were inpatient based
–Preadmission certification and
•Effects of Inpatient Utilization Review (UR)
•Wickizer, Wheeler, and Feldstein (1989)
–Preadmission certification and concurrent review
–1984–1986 quarterly utilization data
•223 insured groups—41 percent with the UR program
–Utilization = f(UR, plan, market, and worker characteristics, seasonality, time trend)
•3.7 fewer admissions per 1,000
•20 fewer days per 1,000
•No effect on length of stay
•Wheeler and Wickizer (1990)
–Same 1984–1989 data
–Same model, but interacts UR with market characteristics
•To identify differential effects of UR
–Results: UR is more effective when
•Admissions per capita were higher
•Occupancy rate was lower
•Surgical specialists per capita was higher
•HMO penetration was lower
Blue Cross/Blue Shield (BCBS) UR
•Utilization management techniques examined:
–Denial of payment
–Mandatory second surgical opinion
Analysis of BCBS UM Data
Y = a + bT + cQ + dUM + eREG + fPLAN +gHCE +hDEM + u
Y = adm/1000, days/1000, length of stay, or inpatient $/1000
T = time trend
Q = seasonality (quarterly dummies)
UM = utilization management dummies
REG = % hospital days reimbursed under PPS
PLAN = %HMO, %PPO, Blue Cross market share, total membership
HCE = Docs, beds, occupancy rate, mandated benefits, region
DEM = age, race, gender
Data: 56 BCBS Plans, 1980–1988, quarterly (2,016 observations)
•Impact of Utilization Management on Readmissions
•Single UR company
–Preadmission certification and concurrent review
•Privately insured patients with cardiovascular disease
–2,813 requests for a medical admission
–1,513 requests for a procedural admission
•Number of requests denied:
–1 of 2,813 medical requests
–4 of 1,513 procedural requests
•Length-of-Stay Reductions among Utilization Review
Cases for Selected Diagnoses and Procedures
•Prevalence of Denials of Care
•Analysis of coverage requests from two medical groups in California
–MG1: 1/97–12/99—146,997 cases
–MG2: 1/98–12/00—329,382 cases
•Exclude inquiries about coverage under capitated rates and drug/vision/dental/behavioral services
•Effects of Gatekeepers
•Harvard Vanguard (formerly Harvard CHP)
•Eliminate prior approval of referrals to specialists as of April 1, 1998
•Previously in effect for 25 years
•Compare randomly selected cohorts of 10,000 members in each 6-month period for the 36 months prior and 18 months after elimination
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