The Economics of Health Care
Topic 5. Health insurance
1. Risk and uncertainty
 Health care expenses are difficult for
consumers to predict. Many illnesses
occur rarely, seemingly at random, and
have large financial consequences.
 In health, as in other areas of economic
life where risk and uncertainty is present,
insurance markets develop.
Risk exists where the probabilities of the
possible outcomes are known.
Uncertainty exists where the probabilities of
possible outcomes are unknown.
Some important concepts in the analysis of
insurance
2. Expected values
The expected value of a gamble (a risky
activity) which has known risks is the average
return over repeated gambles.
It is calculated as the sum over all possible
outcomes of the probability of the outcome
multiplied by the value of the outcome.
For example, if a gamble X has two outcomes
a and b which have probabilities P(a) and P(b)
and values X(a) and X(b), the expected value
of X is:
E(X) = P(a)*X(a) + P(b)*X(b)
3. Fair gambles
A fair gamble is one in which the expected
value is zero.
For example, if rolling a six on a die wins £600
and any other number loses £120, the
expected value is (£600* 1/6) – (£120*5/6) = 0,
which is a fair gamble.
 If the win was £550, the gamble would be
unfavourable
 If the win was £650 the gamble would be
favourable.
 If the win was £1,200 (double £600) and
the loss was £240 (double £120) this
would still be a fair gamble, but it would be
‘riskier’
4. Attitudes to risk
Gambles are riskier if there is a greater variety
in the possible outcomes
 A risk neutral person looks only at the
gamble’s expected value, not at its degree
of risk. They accept fair or favourable
gambles.
 A risk averse person is willing to accept
only small degrees of risk. They refuse fair
or unfavourable gambles.
 A risk-lover is willing to accept higher
degrees of risk. They accept unfavourable
gambles.
5. Utility and risk
 Wealth in general is subject to diminishing
marginal utility. An increase in wealth from
£20,000 to £30,000 will give more
additional utility than an increase from
£30,000 to £40,000.
 This means that a fair gamble in money
terms may not be a fair gamble in utility
terms.
 People are therefore naturally risk averse
with respect to expected values calculated
in money terms.
 Risk averse people are willing to pay to
avoid risk and therefore buy insurance.
 Health insurance works by pooling risk:
the probabilities of risks are shared over a
large number of people. It converts
individual risky outcomes to certain losses
(premium payments).
Diminishing marginal utility of wealth
utility
.
wealth
 Implication: a ‘gain’ of a given
monetary amount will be worth less
than the ‘loss’ of that same amount.
6. Insurance markets
 An actuarially fair premium (AFP) is one
which involves the insurance holder and
insurance provider in a fair gamble.
Example, if there is a probability of 1 in 10,000
of a loss of £150,000, the AFP is
£150,000/10,000 = £15.
Risk pooling means that if 10,000 people pay
a premium of £15, the insurance company’s
income is £150,000 and its expected payout is
one sum of £150,000.
The risk to an insurance holder of losing
£150,000 is converted to a certain loss of £15.
 Transactions costs (‘loading charges’) and
profits mean that real world premiums are
greater than the AFP; therefore only riskaverse people will insure.
7. Market failure in health insurance: Moral
hazard
 Moral hazard arises when it is possible to
alter the probability or size of the
outcomes.
i.e. increased demand for medical care
because the price to the consumer of seeking
medical care has fallen.
 for a given medical condition, to demand
more treatment
 disincentives to minimise the probability of
a loss.
Demand
Demand
P1
P1
P0
P0
Inelastic demand:
Insurance has no impact
on the quantity demanded
Elastic demand:
insurance
decreases price to
P0 and quantity
demanded
increases.
Market solutions to moral hazard:
Cost sharing:
 Copayments: fixed £ contribution per
claim
 Coinsurance: fixed % contribution per
claim
 Deductibles: insurance does not apply
until consumer pays the deductible.
The effect of insurance on the demand for
health care with a 25% coinsurance.
price
D0 (no
insurance)
£100
MC
£25
quantity
 welfare loss
8. Adverse selection
 Adverse selection arises when it is
possible to conceal risks. The AFP differs
between individuals but all pay the same
premium, based on average AFP.
(‘community rating’)
 The result is that people with higher risks
will insure, as their AFP is higher than the
AFP charged – and those with lower risks
will not as their AFP is lower.
 The AFP rises, premiums rise, and fewer
people insure.
Solutions: experience rating, risk selection.
9. Preferred risk selection & equity.
 High-risk groups may not be able to afford
experience rated premiums. Not a market
failure as such, but arguably important
social concern?
10. Alternatives to traditional insurance
HMOs = health maintenance organisations.
 Vertical integration
 HMOs have an incentive to contain
costs because they are both insurers
and providers.
 staff model plans (HMO directly
employs physicians on salaries)
 group or network models: the MHO
contracts with a group(s), paid by
capitation.
 independent practice associations
(HMO contracts with independent
practices; payment on a discounted fee for
service basis)
 Each uses primary care physicians as
‘gatekeepers’
PPOs = preferred provider organisations
 enrollees may seek care either from
providers who are part of the network
(lower deductible and coinsurance) or
from other providers.
 physicians paid by negotiated
schedules of discounted fees.
 In both HMOs and PPOs, contracts
with hospitals promote price
competition.
See: Fairfield G et al (1997) Managed
care: origins, principles and evolution.
BMJ 314:1823.
Evidence on:
 Costs
 Outcomes
 Choice
How do HMOs make their savings?
 Selective contracting
 Physician profiling
 Utilization review
 Practice guidelines
 Formulary
Selection bias?
Undertreatment?