Economic Analysis of the Demand for a Product/Service in Healthcare Sector

UMUC HMGT 435

Week 3: The Demand for Health Insurance

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Understand how health insurance markets work and the role of risk and risk mitigation

Understand potential market failures in health insurance markets

Understand the impact of health insurance on the demand for health care

Understand how deductibles and copays improve price sensitivity

Key Learning Objectives Week 3

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Uncertainty exists when any number of events may occur and we do not know which one will arise.

Risk exists when the probability of each even can be estimated

Expected value(EV) = probability of event occurring * expenditure of health care treatment

Understanding Risk and Uncertainty

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Fair and unfair gamble

A “fair” gamble is when EV profit = 0

An unfair gamble where EV of profit <0

A favorable gamble is where EV of profit > 0

Risk Averse Individual will refuse a “fair” gamble

The more risk-averse an individual is the more favorable the gamble must be

Risk-Neutral is indifferent between accepting and not accepting a fair gamble

Risk Loving individual will accept a fair gamble and may even accept non-fair gamble

Attitudes Toward Risk

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Health care is consumed under the condition of uncertainty with respect to:

The timing of health care expenditures

Costs of health care spending

This uncertainty poses a “risk” of incurring large unplanned health expenditures due to ill health

Health expenditures for catastrophic care (heart surgery, etc) are quite high

Some individuals are more “risk averse” than others

Risk and Uncertainty in Health Care

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Health insurance is:

Used to mitigate risk

Represents a contract between an insurance provider and an individual

Pay an agreed upon price for health insurance (called a premium)

In exchange for payment for all or portion of health care costs

Role of Health Insurance

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Group (employer-sponsored) market

Employers purchase policy from insurers and offer to employees

Covers almost 70% of working adults

Employers pay large share of premiums, as a result, participation rate very high so risk is spread across large group

Individual market

Individuals purchase policies directly from insurers

Risky individuals or those needing care more likely to purchase policies

Participation rate low

Markets for Health Insurance: Demand Side

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How risk averse an individual is

The probability of the event (illness) occurring

The magnitude of the loss (cost of getting necessary care)

The price of insurance

The income of the individual

Factors Impacting the Demand for Health Insurance

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Price willing to pay for health insurance = “fair” premium =

Expected value + risk premium based on their level of risk aversion

where expected value = (probability of falling ill * cost of care)

Simplified Example:

Probability of catastrophic illness = 10%

Cost of catastrophic illness = $100,000

Probability of no catastrophic illness= 90%

Risk Premium = $0 for risk neutral individual (would be positive for risk averse individual)

Fair Premium = (.10*100,000) + (.90 x 0) + 0 = 10,000 +0 + 0 = $10,000

What Price are Consumers Willing to Pay for Health Insurance

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Premiums set by health insurers based on expected risks and costs

Attempt to pool risk across a large number of insured individuals

Total premium =

“fair” premium + administrative costs + profit margin

Two key risks health insurers face:

Adverse selection

Moral Hazard

Suppliers of Health Insurance: Insurance Companies

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Individuals most in need of care (e.g. the sickest and those with chronic conditions) are the most likely to want health insurance

Individuals less likely to need insurance (e.g. the young and healthy) are less likely to voluntarily purchase coverage

Adverse selection arises because of “asymmetry of information” between the individual purchasers and insurance provider

Individuals with high risk don’t tell insurer they are high risk

To address “asymmetry of information issues” insurers charge community rates for insurance:

Community rate attractive for high-risk individuals but still too high for low-risk indiviudals

Adverse Selection

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If can’t control adverse selection, premiums tend to be higher than they otherwise would have been (for both healthy and less healthy) populations

The SMALLER the covered population the higher the impact of adverse selection on premiums

The LARGER the covered population the lower the impact of adverse selection on premiums

Impact of Adverse Selection

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Group health (employer-sponsored) plans:

Generous employer premium subsidies (cover about 71% of premiums) lead to higher participation rates

Higher participation rates lead to larger risk-pool

Individual insurers:

Medical underwriting (using age, health status, existence of pre-existing conditions)

Exclude coverage for pre-existing conditions (**recently banned under Affordable Care Aact)

How Insurers Control Adverse Selection

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Also a type of information asymmetry

Occurs when the insured has a tendency or incentive to behave inappropriately (engage in more risky behavior)

Examples:

Not wearing seat belts

Smoking in bed

Moral Hazard

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Copays and deductibles help discourage risky behavior as it imposes some cost of care if get in accident for not wearing a seatbelt

Lower premiums for smokers and individuals who participate in wellness programs

How Insurance Companies Reduce Impact of Moral Hazard

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