The Demand for Medical InsuranceThe 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:Topics to cover:

A theoretical model of health insurance When theory meets the real world...

LogicLogic

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 insureesThe sum of premiums will exceed the sum

of medical expenses

Characterizing Risk AversionCharacterizing 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

$20,000

$40,000

70

90

Income Utility

Sick

Healthy

Utility

Income$20,000 $40,000

90

70

Utility when healthy

Utility when sick

A

B

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 BUtility

Income$20,000 $40,000

70

90A

B

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

Income$20,000 $40,000

90

70

A

B

$36,000

C•

•

•86

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

Income$20,000 $40,000

90

70

A

B

$36,000

C•

•

•86

$35,000

•D

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 Determinants of Health Insurance DemandDemand

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

Utility

Income$40,000$20,000

A

B

If there is no risk aversion, utility = expected utility, and there is no demand for insurance

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

Utility

Income

The horizontal distance between the utility function and the chord represents the loading fee that the consumer is willing to pay

Estimates of Price & Income Estimates of Price & Income Elasticities for Demand for Health Ins.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 Estimates of Price & Income Elasticities for Demand for Health Ins.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 Assumptions underlying the theoretical model of health insurance demandmodel 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 employer-The majority of Americans have employer-provided health insuranceprovided 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 Example: Insurance and take-home pay when income is $1,000 per week pay when income is $1,000 per week and income tax rate is 28%and income tax rate is 28%

Employee Purchased

$1,000 28% tax <280> after tax 720 insurance <50> net pay 670

Employer Purchased

$1,000 insurance <50> subtotal 950 28% tax <266> net pay 684

Employer Health Insurance Coverage of Employer Health Insurance Coverage of U.S. Population (percent)U.S. Population (percent)

5556575859606162636465

Total Employment Based

1995

1998

2000

2002

2005

2008

Consequences for costsConsequences 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 EvidenceEmpirical 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 EvidenceEmpirical 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 EvidenceEmpirical 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 CarePhysicians & 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 IncentivesManaged 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-serviceSome incentive to over-utilize

Types of Managed Care Orgs Types of Managed Care Orgs

S ta ff M od e l G ro up M o d e l N e tw o rk M o d e l IP A M o d e l

H M O P P O

M a n ag e d C a re

Preferred Provider OrganizationPreferred 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)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 QuestionPractice 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 StrategiesProvider 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 StrategiesProvider 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 Performance of MCO’s: Are they “good” or not??“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 Performance of MCO’s: Are they “good” or not??“good” or not??

In general, studies show that HMOs provide medical cost savings of 15-20%, 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