The Demand for Medical Insurance

1
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
2
Topics to cover

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

3
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

4
Characterizing Risk Aversion

• Recall the consumer maximizes utility, with
  prices and income given
• Utility U (health, other goods)
• health h (medical care)
• Insurance doesnt guarantee health, but provides
  to purchase health care
• We assumed diminishing marginal utility of
  health and other goods

5

• In addition, lets assume diminishing marginal
  utility of income

Utility
Income
6

• 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
20,000
70
Sick
40,000
Healthy
90
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Utility when healthy
Utility
90
A
B
70
Utility when sick
Income
20,000
40,000
8

• Individual doesnt 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

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• An individuals subjective probability of illness
  (P1) will depend on her health stock, age,
  lifestyle, etc.
• Then without insurance, the individuals expected
  utility for next year is
• E(U) P0U(40,000) P1U(20,000)
• P090 P170

10

• For any given values of P0 and P1, E(U) will be a
  point on the chord between A and B

Utility
A
90
B
70
Income
20,000
40,000
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• Assume the consumer sets P1.20
• Then if she does not purchase insurance
• E(U) .8090 .2070 86
• E(Y) .8040,000 .2020,000 36,000
• Without insurance, the consumer has an expected
  loss of 4,000

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Utility
90

A

86
C
B

70
Income
20,000
40,000
36,000
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• The consumers 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

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Utility
90

A
D

86

C
B

70
Income
20,000
40,000
36,000
35,000
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• 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

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Determinants of Health Insurance Demand

• Price of insurance
• In the previous example, the consumer will forego
  health insurance if the premium is greater than
  5,000
• Degree of Risk Aversion
• Greater risk aversion increases the demand for
  health insurance

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If there is no risk aversion, utility expected
utility, and there is no demand for insurance
Utility
A
B
Income
40,000
20,000
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• Income
• Larger income losses due to illness will increase
  the demand for health insurance
• 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

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The horizontal distance between the utility
function and the chord represents the loading fee
that the consumer is willing to pay
Utility
Income
20
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 SN, Table 6-2
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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

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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

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The majority of Americans have employer-provided
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

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Example Insurance and take-home pay when income
is 1,000 per week and income tax rate is 28

• Employee Purchased
• 1,000
• 28 tax lt280gt
• after tax 720
• insurance lt50gt
• net pay 670

• Employer Purchased
• 1,000
• insurance lt50gt
• subtotal 950
• 28 tax lt266gt
• net pay 684

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

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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
• N32

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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

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Empirical Evidence

• How does an increase in the marginal tax rate
  affect the workers 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?

30
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

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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

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• Network model HMO contracts w/ gt1 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

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Types of Managed Care Orgs
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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

35
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

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Source Kaiser Employer Health Benefits 2006
Annual Survey, Section 5
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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?

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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

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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

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Performance of MCOs 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?

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Performance of MCOs Are they 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