What Makes Health Insurance Different?

Health insurance has the same basic structure as any other insurance: you pay a premium to an insurance company that then pays your medical bills if the need arises. Like other types of insurance, there are gains from the sharing of risk. However, health insurance differs from other kinds of insurance in a couple of ways:Melissa Thomasson, “The Importance of Group Coverage: How Tax Policy Shaped U.S. Health Insurance,” American Economic Review 93, no. 4 (2003): 1373–1384. See also the related discussion of the history of health insurance: Melissa Thomasson, “Health Insurance in the United States,” EH.net, February 1, 2010, accessed February 1, 2011, http://eh.net/encyclopedia/article/thomasson.insurance.health.us. (1) health insurance is largely provided by employers, and (2) informational problems are particularly acute.

Adverse Selection

One complication of health insurance markets is that those who demand insurance are the ones who are more likely to need insurance. This in itself might not be a problem, except that individuals also know more about their own health than do the companies that are insuring them.

Suppose that half the population carries a gene that gives them a 1 percent risk each year of contracting a particular kind of cancer. The other half does not carry this gene and has only a 0.1 percent risk of this cancer. If an individual becomes sick, suppose that the cost of treatment plus lost work time is $100,000. Table 15.5 "Probabilities and Expected Losses" summarizes the situation. Group A has a 0.1 percent chance of contracting the cancer, so the expected loss for them is $100 (= 0.001 × $100,000). Group B has a 1 percent chance of contracting the cancer, so their expected loss is $1,000 (= 0.01 × $100,000).

Now let us think about an insurance company that wants to make money by selling insurance policies against this loss. Suppose these policies completely cover all losses in the event that the individual contracts the disease. If the insurance company were to set the price of a policy very high (say, $5,000), then only very risk-averse people would buy the policy. If it were to set the price very low—say, $50—then everyone in the population would want this policy, but the insurance company would make a loss on every individual.

However, suppose that the insurance company were to offer a policy for $550. It might reason as follows: if everyone buys this policy, then we will lose $450 on average from the group B individuals, but we will gain $450 on average from the group A individuals. Because there are equal numbers of both groups in the population, we should expect to make no profits on average. For example, if there are 2,000 typical individuals (1,000 of each type), then on average one group A person will become sick (because their chance is 1 in 1,000) and 10 group B individuals will become sick. In total (reasons the firm), we expect to have to pay out for 11 people, implying payments of $1.1 million (= 11 × $100,000). We will get revenues of $1.1 million (= 2,000 × $550). At this price, our expected revenues and costs are the same. If we were to charge a slightly higher premium, then we could make profits from this contract.

As long as the individuals in the population do not know their own type, this works fine. Risk-averse individuals would find it worthwhile to buy this contract. The problem comes if individuals can make a good guess as to which group they are in—perhaps because they know the history of this cancer in their own families. Then the insurance company might be in for a shock. Group B people would definitely want to buy the contract. The premium is less than their expected loss. But group A people might reason that they are very unlikely to get this disease and might decide that an insurance policy that costs $550 is much too expensive, given that their expected loss is only $100. This means that group A people—unless they are very risk-averse—choose not to buy the contract. Now the insurance company will only sell 1,000 contracts, bringing in revenue of $550,000, but it will have to pay out $1 million (= 10 × $100,000).

If the insurance company could distinguish members of group A from members of group B, then it could offer insurance at different rates to the two groups. It could offer insurance to group A at a premium of $100. They would find it worthwhile to buy this insurance. Likewise, the insurance company could offer insurance to members of group B with a premium of $1,000, and they would also find it worthwhile to buy insurance. In practice, insurance companies often cannot classify people into such precise risk groups nor offer such targeted policies. In this case, the only kind of contract that is profitable for the insurance company is one that is aimed at the group B people only, with a premium of $1,000. Group A people are left with a choice of buying no insurance at all or buying a policy that is vastly overpriced given their actual risk of contracting the disease.

This is an example of what economists call adverse selectionA market process in which low-risk individuals leave a market, while high-risk individuals remain.: a situation in which individuals of different risk types decide whether or not to buy insurance (this is the selection). Lower-risk individuals opt out of the insurance market, leaving only high-risk individuals in the market (this is the sense in which the selection is adverse). Adverse selection is an information problem that is a source of market failure: low-risk individuals also want insurance, but it is unavailable to them at a reasonable price.

How do insurance companies deal with their informational disadvantage? One thing they can do is look for other sources of information. For example, firms presumably want to hire healthy, responsible individuals and put some time and effort into making good hires. Insurance companies can use the fact that you work for a firm as a (highly imperfect) signal of your health risk. This is one of the reasons why it is usually cheaper to get insurance through your firm than directly from an insurance company.

A second form of information about you comes from your history. If you have a car accident, your car insurance premium will increase. After an accident, your car insurance company revises its view of your riskiness and resets the price of your insurance. The analogous situation in health care is called preexisting conditions, meaning some disease or disability you already possess when you apply for insurance. For example, someone who has previously suffered a heart attack will find that insurance coverage is more expensive because the insurance company knows that this person is at greater risk of another attack.

If you apply for insurance and have a preexisting condition, then the terms of the insurance will reflect the chance that the condition will recur. This is reasonable enough: insurance is meant to provide protection against things that might happen to you in the future, not those that happened in the past. But it raises a problem with employer-provided health insurance. Suppose an individual has health-care coverage on the job and then suffers a heart attack. His current policy covers him because the heart attack was not a preexisting condition when he obtained insurance. But if he wishes to change jobs, his heart attack becomes a preexisting condition for his new insurer. This can make it very costly to change jobs—in turn making the economy function less efficiently.

Moral Hazard

Another complicating element for insurance is the moral hazardAn incentive problem that arises when the provision of insurance leads individuals to make riskier choices.: the idea that, after purchasing insurance, individuals may behave in riskier ways. For example, think about your likelihood of being in a car accident. The probability that you will have an accident depends on many things: road conditions, the actions of other drivers, luck, and many others. It also depends on the actions you take as a driver of the car. There are many things we do that influence our likelihood of having an accident, including (but not limited to) the following:

• Properly maintaining the car
• Paying attention when driving
• Driving when tired
• Driving after consuming alcohol

These items are influenced by decisions that we make. The link back to insurance is that, if we are insured, we may make different choices about the condition of our car, the way we drive, and our physical state when we drive. The analogous idea with health insurance is that we may choose to live a less healthy lifestyle or engage in riskier behavior if we know that we have health insurance to cover our expenses if we become sick or injured.

Insurance companies understand very well that their policies influence the choices that people make. Their response is to design insurance contracts that provide insurance without affecting individuals’ incentives too much. In the case of automobile insurance, you will not receive full coverage for your loss in case of an accident. Instead, insurance contracts typically include the following: (1) a deductible, which is the amount of a loss you have to cover before any insurance payment occurs, and (2) a copayment, which is the share of the loss for which you are responsible. The same applies to medical insurance. In the event you are ill, health insurance will typically cover a wide variety of medical costs, but there will usually be a deductible and often a copayment as well. As with property or automobile insurance, the deductible provides an incentive for you to take actions that make you less likely to claim against the policy.

There are two main moral hazard issues with health care. First, health care is an individual investment. Although no one wants to get sick, the more you pay for your own treatment, the more likely you will invest in your own health. Choices pertaining to exercise, diet, and preventive care can all depend on the insurance payments we anticipate if we need health care. The more insurance we have, the less incentive we have to take care of ourselves. And the less we take care, the more likely we are to present the insurance company with a sizable health bill.

Second, the size of the health bill also depends on your choices about treatment. When you are ill, you will meet with your doctor to jointly decide on treatments. Although your doctor will probably talk to you about various treatment options, their price will not be the focus of the discussion. Eventually you will meet with someone else in the office to discuss how your treatment will be paid for and, in particular, how much will be covered by your insurance. In the end, you have a menu of treatments and a menu of prices that you have to pay. You will then make a choice from this menu that is in your best interest.

The insurance company pays some of your bill, so the amount you pay is lower than the actual price of treatment. By the law of demand, you purchase more than you would if you had to pay the full price. For example, you might be much more inclined to get second and third opinions if you don’t have to pay the full price for these.

Even if you are not ill but are instead going to see your doctor for a checkup, incentives still come into play. Many insurance policies include funding for an annual checkup with a small copayment. We respond to those incentives by going for the annual checkups covered under the policy. We don’t go for checkups every month because such visits are not covered by most policies. The insurance company deliberately designs the incentives so you are likely to find it worthwhile to engage in basic preventive care.

Health Insurance and the Law of Demand

Now that we have a better understanding of health insurance contracts, we can say more about the demand for health care. We start with the cost of health care to us as households. We have just seen that if you have health insurance, the cost to you of a trip to the doctor is determined by your health insurance contract. Many of these contracts have a copayment provision—for example, you must pay $20 for an office visit. Of course, the doctor charges the insurance company much more for the visit, but you don’t pay that cost. To you, a trip to the doctor costs $20.

The economic approach to individual choice still applies. Your demand for visits to the doctor comes from comparing the marginal valuation of these visits against this cost of $20. The law of demand works in the usual way: if your insurance company increased its copayment to, say, $50, you would make fewer visits to the doctor. The extent to which the quantity demanded responds to the price depends, of course, on what exactly is wrong with you. If you are seriously ill, your demand is likely to be inelastic. If you have only a sore throat, you might wait a few days to see if you really think you need medical care.

There is another element of the health insurance contract that has a direct effect on your demand. Consider a dental contract. These contracts often provide insurance up to an annual limit. If you need dental work, your dentist may design a treatment plan spread out over several years so that you can obtain maximum insurance coverage for the plan of work. In this case, you and your dentist are responding to the incentives of the dental contract.