Economics of Health Insurance
So, niere_oferessea, ask and yeah shall receive...
A very simplistic lecture on the common issues in health insurance market. Warning: may be boring, some trivialization of issues, beginner probability theory, author being the insufferable know-it-all. Proceed at your own risk.
niere_oferessea will be given a quiz. :D
Disclaimer: I am not a Health Economist, you should not take me very seriously.
Introduction
It is better to have health insurance than not to have health insurance. Why. Several arguments:
1) Avoidance of risk - as with any kind of insurance.
Suppose a person has 10% chance of falling sick, in this case the doctor bill would be $1000. The Expectation of future health payments is $1000*0.1=$100.
People in general are risk-averse. A majority of us would choose to pay $100 (or even a bit more: $110, $120) upfront in order to avoid a possibility of $1000 bill.
2) Preventive medicine.
Some medical procedures benefit not only the recipient, but also other members of society. Vaccination is a typical example. Not only the vaccinated person has a much lower chance of falling ill, but also he will not spread the disease onto others. Economists call this positive externality. Therefore, it is in general interest of society that everyone receives the treatments that carry positive externalities. Most preventive medicine does. In case of purely private health market preventive medicine is underutilized: people rarely go see the doctor unless they are seriously ill.
3) Costs cannot be avoided.
There is one argument that is not straightforward to the majority of people, but obvious to the Economists: the fact that you are not billed or taxed for something directly does not mean that you are not paying for it. For example, if a poor person is treated at the hospital and he is unable to pay, who is paying for all the services? The answer: everybody else does. Either government covers the bill, or Hospital takes the loss. In order to operate Hospital has to charge enough to its patients so that losses are covered. So, either Hospital raises all the prices, and Insurance Company raises the policy rates; or Government raises taxes. Ultimately all society pays for it, the same amount, either through taxes or through higher prices. There is only one way to avoid the cost: deny medical services to those who cannot pay.
So, assuming the denial of service is not an option, why is it good for everybody if poor people have insurance? Because if they receive better preventive care there will be less serious illnesses and less huge Hospital bills that get dumped back on the society as a whole. Medical professionals usually agree that it is cheaper to prevent illness than to treat it.
Note: In current system in US employer provides health insurance, but this means that the cost of insurance is reflected in the price of products, and tax incentives the company receives are reflected in Government budget. So, in fact, if you are insured by your employer, your policy is paid partially by Government and partially by customers.
Problem
Now, why health insurance cannot be a perfectly competitive market?
Adverse selection.
Assume there are two different people: Mr. Sick and Mr. Healthy. Mr. Healthy will get ill with 10% probability, his bill would be $1000. Mr. Sick will get the bill of $10,000 with 10% probability.
Expected health payments: Healthy = $100, Sick = $1000.
Now, assume there are 100 million of Mssrs. Healthy and 100 million of Mssrs. Sick.. If Insurance Company has to insure all 200 million people, what is the policy price to charge to break even (ignoring overhead costs)?
That would be 0.5*$100+0.5*$1000= $550. - average expected health expenditure of a person.
Now the trick is, Insurance Company does not know if you are Sick or Healthy, but you do. If you are Healthy, would you buy $550 policy just to avoid 10% risk of $1000 bill? I wouldn't.
If you are Sick, then $550 per policy is a very good deal, in fact anything below $1000 is a good deal.
So, the outcome of competitive market is: only Sick people will buy insurance. But if this is true, than the Insurance Company has to charge $1000 just to break even. In this case, he Healthy part of the population does not buy any insurance. Why is it bad? Because with the lack of preventive care they will not be Healthy for long. (see (2) )
How to solve the problem of adverse selection? Make sure people cannot sort themselves: make pooling mandatory, make sure all Healthy people buy insurance. This would require Healthy people to subsidize Sick, of course. Such is the nature of any insurance: careful drivers subsidize those who have accidents, lucky homeowners subsidize those who have some house damage. Is it fair? Quite fair if you think of it ex-ante: you could have been born Sick, your family members could have been born Sick.
Incentives of the Insurance Company:
Now, suppose Insurance Company is obligated to charge everyone the same price, say $550. What if Insurance Co. knew who is Healthy, and who is Sick? Then, it would make good business sense to sell policies to Healthy only, and deny coverage to Sick. No matter what you do, Insurance Co will always try to sort people and deny coverage to those who are the sickiest ones. What is the solution? Again, make insurance universal and mandatory.
Note: Currently in US insurance market is not individual, of course. Some pooling occurs when people are insured under group policies: through employer, state programs, etc. That is why group policies are always cheaper: because of the pooling they partially solve the problem of Adverse Selection.
Moral Hazard.
Health insurance costs a lot. People are generally healthy when they are young, sicker when they are old. Why not go without insurance while you are young and healthy, save money? Then, when you feel like you need a doctor you can join some group policy where you are pooled with young and healthy that subsidize you. Perfectly rational thinking: why not free-ride? If everyone does this, however, it would lead to the same kind of market failure as Adverse Selection: people sorting themselves. Solution: again, mandatory and universal insurance.
Conclusions
Hardy anyone disputes that one of the cases when Government intervention in economy is beneficial is when we are faced with market failure. In cases of externalities, asymmetric information (that would apply to Moral Hazard and Adverse Selection cases) it is possible that Government intervention could improve economic outcome. The argument against Government intervention is typical inefficiency of public sector: will benefits of intervention outweight the losses due to bureaucratic inefficiency? Well, IMHO this is an argument in favor of better management of state services, not an argument against their existence.
Further reading:
An article by a famous Health Economist analyzing Bush's and Kerry's health reform plans from a perfectly neutral non-partisan point of view, aimed at journalists is here: by Uwe E. Reinheart, Princeton University.
A very simplistic lecture on the common issues in health insurance market. Warning: may be boring, some trivialization of issues, beginner probability theory, author being the insufferable know-it-all. Proceed at your own risk.
niere_oferessea will be given a quiz. :D
Disclaimer: I am not a Health Economist, you should not take me very seriously.
Introduction
It is better to have health insurance than not to have health insurance. Why. Several arguments:
1) Avoidance of risk - as with any kind of insurance.
Suppose a person has 10% chance of falling sick, in this case the doctor bill would be $1000. The Expectation of future health payments is $1000*0.1=$100.
People in general are risk-averse. A majority of us would choose to pay $100 (or even a bit more: $110, $120) upfront in order to avoid a possibility of $1000 bill.
2) Preventive medicine.
Some medical procedures benefit not only the recipient, but also other members of society. Vaccination is a typical example. Not only the vaccinated person has a much lower chance of falling ill, but also he will not spread the disease onto others. Economists call this positive externality. Therefore, it is in general interest of society that everyone receives the treatments that carry positive externalities. Most preventive medicine does. In case of purely private health market preventive medicine is underutilized: people rarely go see the doctor unless they are seriously ill.
3) Costs cannot be avoided.
There is one argument that is not straightforward to the majority of people, but obvious to the Economists: the fact that you are not billed or taxed for something directly does not mean that you are not paying for it. For example, if a poor person is treated at the hospital and he is unable to pay, who is paying for all the services? The answer: everybody else does. Either government covers the bill, or Hospital takes the loss. In order to operate Hospital has to charge enough to its patients so that losses are covered. So, either Hospital raises all the prices, and Insurance Company raises the policy rates; or Government raises taxes. Ultimately all society pays for it, the same amount, either through taxes or through higher prices. There is only one way to avoid the cost: deny medical services to those who cannot pay.
So, assuming the denial of service is not an option, why is it good for everybody if poor people have insurance? Because if they receive better preventive care there will be less serious illnesses and less huge Hospital bills that get dumped back on the society as a whole. Medical professionals usually agree that it is cheaper to prevent illness than to treat it.
Note: In current system in US employer provides health insurance, but this means that the cost of insurance is reflected in the price of products, and tax incentives the company receives are reflected in Government budget. So, in fact, if you are insured by your employer, your policy is paid partially by Government and partially by customers.
Problem
Now, why health insurance cannot be a perfectly competitive market?
Adverse selection.
Assume there are two different people: Mr. Sick and Mr. Healthy. Mr. Healthy will get ill with 10% probability, his bill would be $1000. Mr. Sick will get the bill of $10,000 with 10% probability.
Expected health payments: Healthy = $100, Sick = $1000.
Now, assume there are 100 million of Mssrs. Healthy and 100 million of Mssrs. Sick.. If Insurance Company has to insure all 200 million people, what is the policy price to charge to break even (ignoring overhead costs)?
That would be 0.5*$100+0.5*$1000= $550. - average expected health expenditure of a person.
Now the trick is, Insurance Company does not know if you are Sick or Healthy, but you do. If you are Healthy, would you buy $550 policy just to avoid 10% risk of $1000 bill? I wouldn't.
If you are Sick, then $550 per policy is a very good deal, in fact anything below $1000 is a good deal.
So, the outcome of competitive market is: only Sick people will buy insurance. But if this is true, than the Insurance Company has to charge $1000 just to break even. In this case, he Healthy part of the population does not buy any insurance. Why is it bad? Because with the lack of preventive care they will not be Healthy for long. (see (2) )
How to solve the problem of adverse selection? Make sure people cannot sort themselves: make pooling mandatory, make sure all Healthy people buy insurance. This would require Healthy people to subsidize Sick, of course. Such is the nature of any insurance: careful drivers subsidize those who have accidents, lucky homeowners subsidize those who have some house damage. Is it fair? Quite fair if you think of it ex-ante: you could have been born Sick, your family members could have been born Sick.
Incentives of the Insurance Company:
Now, suppose Insurance Company is obligated to charge everyone the same price, say $550. What if Insurance Co. knew who is Healthy, and who is Sick? Then, it would make good business sense to sell policies to Healthy only, and deny coverage to Sick. No matter what you do, Insurance Co will always try to sort people and deny coverage to those who are the sickiest ones. What is the solution? Again, make insurance universal and mandatory.
Note: Currently in US insurance market is not individual, of course. Some pooling occurs when people are insured under group policies: through employer, state programs, etc. That is why group policies are always cheaper: because of the pooling they partially solve the problem of Adverse Selection.
Moral Hazard.
Health insurance costs a lot. People are generally healthy when they are young, sicker when they are old. Why not go without insurance while you are young and healthy, save money? Then, when you feel like you need a doctor you can join some group policy where you are pooled with young and healthy that subsidize you. Perfectly rational thinking: why not free-ride? If everyone does this, however, it would lead to the same kind of market failure as Adverse Selection: people sorting themselves. Solution: again, mandatory and universal insurance.
Conclusions
Hardy anyone disputes that one of the cases when Government intervention in economy is beneficial is when we are faced with market failure. In cases of externalities, asymmetric information (that would apply to Moral Hazard and Adverse Selection cases) it is possible that Government intervention could improve economic outcome. The argument against Government intervention is typical inefficiency of public sector: will benefits of intervention outweight the losses due to bureaucratic inefficiency? Well, IMHO this is an argument in favor of better management of state services, not an argument against their existence.
Further reading:
An article by a famous Health Economist analyzing Bush's and Kerry's health reform plans from a perfectly neutral non-partisan point of view, aimed at journalists is here: by Uwe E. Reinheart, Princeton University.