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 Abri-Cro 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

P ³ (1-C)X

Bankrupt if expenses greater than revenue

– Revenue = p

– Sum of all premiums

– Expenses= (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= (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 500-

1000 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

Insurance Effect on Health Spending

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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