The Demand for Medical Insurance
Professor Vivian Ho
Health Economics
Fall 2009
These slides draw from material in Santerre & Neun, Health Economics: Theories,
Industries and Insights, Thomson, 2007
Topics to cover:
A theoretical model of health insurance
 When theory meets the real world...

Logic

The consumer pays insurer a premium
to cover medical expenses in coming
year
– For any one consumer, the premium will be
higher or lower than medical expenses

But the insurer can pool or spread risk
among many insurees
The sum of premiums will exceed the sum
of medical expenses
Characterizing Risk Aversion

Recall the consumer maximizes utility,
with prices and income given
– Utility = U (health, other goods)
– health = h (medical care)
Insurance doesn’t guarantee health, but
provides $ to purchase health care
 We assumed diminishing marginal utility
of “health” and “other goods”


In addition, let’s assume diminishing
marginal utility of income
Utility
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

Income
Utility
Sick
$20,000
70
Healthy
$40,000
90
Utility when
healthy
Utility
90
70
A
B
Utility when
sick
$20,000
$40,000
Income
Individual doesn’t know whether she will
be sick or healthy
 But she has a subjective probability of
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
Utility
A
90
70
B
$20,000
$40,000
Income
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 loss of $4,000
Utility
90
86
70
•
B•
•A
C
$20,000
$40,000
$36,000
Income
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
Utility
90
86
70
D
•
B•
$20,000
$35,000
•
•A
C
$40,000
$36,000
Income

At most, the consumer is willing to pay
$5,000 in insurance premiums to cover
$4,000 in expected medical benefits
$1,000  loading fee  price of insurance

Covers
– profits
– administrative expenses
– taxes
Determinants of Health Insurance
Demand
1
Price of insurance
– In the previous example, the consumer will
forego health insurance if the premium is
greater than $5,000
2
Degree of Risk Aversion
– Greater risk aversion increases the
demand for health insurance
If there is no risk aversion, utility = expected utility,
and there is no demand for insurance
Utility
A
B
$20,000
$40,000
Income
3
Income
– Larger income losses due to illness will
increase the demand for health insurance
4
Probability 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
The horizontal distance between the utility function
and the chord represents the loading fee that the
consumer is willing to pay
Utility
Income
Estimates of Price & Income
Elasticities for Demand for Health Ins.

Price elasticities b/w -.03 and -.54
– At the individual level
– Enrollment or premium expenditure
– Elastic or Inelastic demand?

Income elasticities b/w 0.01 and 0.13
From S&N, Table 6-2
Estimates of Price & Income
Elasticities for Demand for Health Ins.

What about when employees are
choosing between the menu of plans
offered by their employer?
– Range of choices is more limited
– Price elasticites are found to range
between -2 and -8.4, depending on age,
job tenure, medical risk category

Dowd and Feldman 1994, Strombom et al. 2002
Assumptions underlying the theoretical
model of health insurance demand
Consumers bear the full cost of their
own health insurance
 Insurance companies can appropriately
price policies
 Individuals can afford health
insurance/health care
The above 3 assumptions do not always
hold in the real world

The majority of Americans have employerprovided health insurance
Employer-paid health insurance is
exempt from federal, state, and Social
Security taxes
 Employee 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%

Employee Purchased





28% tax
after tax
insurance
net pay
$1,000
<280>
720
<50>
670

Employer Purchased





insurance
subtotal
28% tax
net pay
$1,000
<50>
950
<266>
684
Employer Health Insurance Coverage of
U.S. Population (percent)
65
64
63
62
61
60
59
58
57
56
55
1995
1998
2000
2002
2005
2008
Total Employment Based
Consequences for costs

“Too many” services were covered by
insurance
– Coverage of more small claims increased
administrative costs
– Employers offering more than 1 plan often
fully subsidized the more expensive plans
Empirical Evidence

Long & Scott (1982)
– Regression analysis of the determinants of
% of compensation paid to employees as
health insurance
–
– Annual U.S. data 1947-1979
 N=32
Empirical Evidence
PCTHLINS = -8.64 + .0284 MTR + .0498 RFRAMINC
(6.22) (3.98)
(1.14)
-.0094 UNION + .088 PCTFEM + .1283 PCTSERV
(.57)
(3.72)
(5.52)
R2 = .9968
PCTHLINS = % of compensation as health insurance
MTR = average marginal tax rate
RFAMINC = average real family income
UNION = % of labor force unionized
PCTFEM = % employees female
PCTSERV = % employees in service industries
Empirical Evidence

How does an increase in the marginal tax
rate affect the worker’s compensation
package?

The implied elasticity of PCTHLTINS with
respect to MTR is 0.41. If a cut in the
income tax rate is approved, will demand
for health insurance rise or fall?
Physicians & Managed Care
Traditional fee-for-service gives
physicians incentive to “overutilize”
medical services
 Managed care: A broad set of policies
designed by 3rd-party-payers to control
utilization and cost of medical care:

utilization review
alternative compensation schemes
quality control
Managed care and Physician Incentives

•
•
HMOs are a type of managed care
organization, but there are a variety of
HMOs
Staff model: Physicians employed by
HMO on a salary basis
 No incentive to over-provide care
Group model: HMO contracts w/ group
practice, which is paid by capitation
 Incentive to limit services
• Network model: HMO contracts w/ >1
group practice, all paid by capitation.
Incentive to limit services
• IPA model: HMO contracts w/ multiple
docs in various practices; paid by
discounted fee-for-service
Some incentive to over-utilize
Types of Managed Care Orgs
Managed Care
HMO
Staff Model
Group Model
PPO
Network Model
IPA Model
Preferred Provider Organization

Insurer contracts w/ multiple physicians:
but enrollees can pay higher deductible
or copay to see physician outside
network
– Discounted fee-for-service
– Some incentive to over-utilize
Point-of-Service Plan (POS)

Insurer contracts w/ multiple physicians:
but enrollees can pay higher deductible
or copay to see physician outside
network
– Like a PPO

However, enrollees are also assigned a
primary caregiver who acts as a
gatekeeper to specialists and inpatient
care
Source: Kaiser Employer Health Benefits 2006 Annual Survey, Section 5
Practice Question

If you had the choice between a traditional
FFS plan with a 10% copay and a staff
HMO with no copay, at what percentage
difference in premiums (10%, 20%, 30%)
would you be indifferent between the 2
plans? Do you think your choice is a
function of your age/health status?

If you were elderly and/or sick, which plan
would you prefer if they cost the same
amount? Why?
Provider Management Strategies

Selective contracting
– MCOs will contract with an exclusive set of
providers
– Based on quality or cost-effective practice
patterns

Physician profiling
– MCOs monitor physicians’ track record
regarding referrals, quality, patient
satisfaction
Provider Management Strategies

Utilization review
– “determine whether specific services are
medically necessary and whether they are
delivered at an appropriate level of
intensity and cost

Practice guidelines
– Inform providers of the appropriate medical
practice in certain situations

Formularies
– restricted list of drugs physicians may
prescribe
Performance of MCO’s: Are they
“good” or not??

Ideally, MCOs should encourage
preventive and coordinated primary
care, which reduces the need for more
expensive specialty/inpatient care

But most MCOs are concerned with
short-term profitability
– Why pay for cholesterol-lowering pills when
the enrollee is likely to leave your HMO
years before he has a heart attack?
Performance of MCO’s: Are they
“good” or not??

In general, studies show that HMOs
provide medical cost savings of 1520%, mostly through reduced hospital
care

The impact of HMOs on quality of care
is less definite
– Health care providers treat patients
belonging to a variety of plans