Financing Systems Part 1
Introduction to Health Insurance
Unit 6
Outline
• 1) Introduction. Define premiums, indemnities,
co-pays
• 2) Describe the role of size in risk pools
• 3) Describe the incentive effects behind
selective enrollment in insurance and methods
used to control these adverse incentives
• 4) Describe the incentive effects that makes
insured people overutilize services and ways to
control these harmful incentives
Earliest Health Insurance
Beneficiary
• Earliest evidence:
30,000 BC
– Healed fractures in
human remains of
elderly man in AbriCro Magnon, France
(“Grandpa C”)
Evolution of Health Insurance
• Health shocks and weather shocks since
Pre-Cambrian
• Variance in income (calorie intake) is bad
• Multiple biological adaptations
– Bears hibernate
– Worms dessicate
– Bacteria sporulate
– Social groups pool risk
Part 1: Defining Insurance Terms
What Insurance Companies Do
• How insurance companies create value
– Gather large groups of people at risk
– Collect their money
– Pay indemnities when events occur
• Premium=Expected Payouts + “Load”
Defining Insurance
• Insurance is a contract, a piece
of paper that offers the
following promise:
– “The insurance company will
pay (1-C)% of qualified
medical expenses (X) incurred
during a time period”
• Definition of Premium--The
price, P, paid by the customer
to the insurance company to
purchase the contract is called
the premium
• Definition of Indemnity—The
total amount that the insurance
company has to pay out on
behalf of a patient
– (1-C)X
• Definition of Co-Pay—When
there is a claim, the proportion
of the claim paid by the patient
is the co-payment
– (“C”)
Fundamental law of insurance
• Revenue ³ Expenses
SP ³ S(1-C)X
Bankrupt if expenses
greater than revenue
– Revenue =
Sp
– Sum of all premiums
– Expenses=
S(1-C)X
– Sum of all indemnities
Actuarial Fairness
• Definition: actuarially fair premium is the
average value of indemnity payments
• For a population of “N” insured people,
Actuarially Fair Premium=
S(1-C)X
N
• Insurance that charges actuarially fair
premium pays all its revenue out and has
no money to pay its own staff
Another version
• Actuarially fair premium is the same as the
expected expenditure
– ps = probability of illness
– C = cost of illness
– Actuarially Fair Premium = psC
– An insurer needs to insure a population and
not just an individual for an actuarially fair
premium to cover the expected health
expenditures
Insurance Load
• Definition: Insurance Load (L) is the
insurance companies operating expenses
to sell premiums and process claims
• Actual Premium=
Actuarially Fair Premium+Load
• Insurance companies must charge more
than the actuarially fair premium
– If they charge less they will go bankrupt
Insurance Load
• Skyscrapers full of
– Claims analysts
pushing paper
back and forth in
billing arms race
– Marketing reps
– Financial investors
who park unspent
funds in stock
market
Hartford Connecticut Skyline 2005
Part 2: The role of size in insurance
Returns to Scale in Insurance
• Health insurance is possible with no fewer
than 10,000 insureds
• Relevance for capitation
– Church congregations have 100-500
– Villages have 100-500 people
– Urban Physician practices have about 5001000 patients
Example
• All insurance based on the law of large
numbers
– Let PS=0.1
– Let C=$10
• Actuarially fair premium is?______
• Let A be 10%
– Charge customers $1.10
The Law of Large Numbers
• The variance in expected payouts is lower the
larger the risk pool is
• With 10 customers in an average year
– Revenue is $11 Costs are $10 Profit is $1
– But what if there is bad luck?
– Bankrupt if more than 11% of customers get sick
• Binomial theorem says
–
–
–
–
With 10 customers Prob of Bankrupty is 0.26
With 100 customers Prob of Bankruptcy is 0.297
With 1000 customers Prob of Bankrupty is 0.138
With 10,000 customers Prob of Bankruptcy is 0.0005
Part 3: Incentives for Insurers
Private Insurance Incentives
• Private Insurers in competition want
revenue to be bigger than expenses
• Ways to make revenue bigger
– Strategy 1) Charge higher premiums
• The more they charge, the fewer customers
Controlling Expenses
• Ways to make expenses smaller
– Strategy 2) Charge higher co-payments
• The higher the co-pays the fewer customers
– Strategy 3) Only cover low cost health
services and don’t cover the expensive ones
• This is backwards from what will protect patients
the most
– Strategy 4) Cherry picking
Cherry Picking
• Find healthier patients and sell
insurance to them
• This is called “cherry picking”
– Healthy patients will have lower
expenses
– Leaves sicker patients for competitors
and competitors will be driven out of
business
How to Cherry Pick
• Find healthy people by going to where
they are:
– Formal sector laborers tend to be healthier
– Educated people tend to be healthier
– People who are attracted to free health club
memberships tend to be healthier
• Set prices and benefits to attract the
healthy
Pricing to Cherry Pick
• Healthy people don’t expect high
expenses
– They are drawn to low premiums
– They don’t mind high co-pays because they
don’t expect to need to pay anything to
doctors
• To cherry pick use a lower premium and a
higher co-pay
Experience rating to cherry pick
• If insurance companies can use health history to
set premiums this is called “Experience rating”
– With experience rating, sicker patients pay higher
premiums or have no coverage for pre-existing
conditions
– If insurance systems are allowed to experience rate
they will
• A government has to outlaw experience rating to
prevent it
– Governments can insist on “Community rating” where
past health events have no effect on coverage
Diagnosis 1: Adverse selection
• When companies cherry pick bad things happen
• A well functioning risk pool needs to have a
balance of sick people and healthy people
– The premiums paid by healthy people help to pay the
bills of the sick
– If all of the healthy people are attracted to one pool
that leaves behind a group of expensive sick people
• This process is called “adverse selection”
More on adverse selection
• Allowing companies to set different rates for
different customers is going to lead to adverse
selection
• Adverse selection leads insurance companies to
compete with each other for healthy patients to
insure
– The more insurance plans compete, the fewer healthy
patients remain uninsured
– Those without insurance tend to be sick and have an
actuarially fair premium that is unaffordable
Death Spiral
• When insurance companies attempts to
cherry pick exhaust the pool of healthy
patients the sick patients have nobody to
share risks with
• The insurance market is said to have
undergone a “death spiral”
– The sick can’t get insurance they can afford
– The healthy have insurance that they have
little use for
Part 4: Incentives to overutilize
How Does Insurance Affect the
Demand for Medical Care?
• Demand for health care is price
responsive
• The cheaper it is, the more medical care
people buy
• What does a demand for more health care
imply?
• Care that produces more “health”
• Care that reduces uncertainty
– More tests
• Higher quality health care
Diagnosis 2: Moral Hazard
• Moral hazard occurs when a person’s behavior
regarding health risks and utilization is affected
by their insurance coverage
– Example: Seeing the doctor to have toenails
trimmed if insurance will pay for it
• It is simply a perfectly rational price response
– Example: Taking more health risks after getting health
insurance
15
Insurance Effect on Health Spending
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Log GDP/Capita in PPP$
lowess shxpdtotlzs loggdp
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Total Health Spending as % of GDP
Moral Hazard Accelerates Costs
• Insured populations will spend more of
their income on health
– Before insurance countries spend 5% of GDP
on health
– After insurance (and with higher incomes)
countries share spent on health grows more
with income
Summary
• Covered basics of health finance principles
– Defined premiums, indemnities, co-payments
– Shown why insurance pools charge actuarially fair
premium plus a load
– Why large pools work better than small pools
• Incentives of insurers: cherry pick and
destabilize the market
• Incentives of patients: overutilize services that
are insured