Insurance is something that human beings have developed to help us deal with the risks we face in life. Here are some examples of risks that you might confront.
You can easily add to this list. We always have to worry about bad things happening. One consolation is that, for all the risks listed, you can obtain insurance. This means that we pay a fee (the premium) to an insurer; in return, we receive payment from the insurer if the bad thing happens.
Insurance is based on the idea of the diversificationThe insight that underlies insurance in which people can share their risks. of risk.Chapter 4 "Life Decisions" goes into much more detail about insurance and diversification. As an illustration, suppose you face a 1 in 5,000 chance of breaking your leg in a given year. If this happens, it will be very costly to you: between hospital bills and lost earnings, perhaps you would lose $10,000. If you are like most people, you are risk-averseBeing willing to pay more than a gamble’s expected loss in order to avoid that gamble., meaning that you don’t like facing this risk. Suppose, however, you can get together in a group of 5,000 people and agree that if any one of you breaks a leg, you will all share in the bill. The most likely outcome is that only one person will suffer a broken leg, and your share of the costs will be $2. There is still a bit of uncertainty: maybe no one will break a leg; maybe two, three, or four people will. But the likelihood that you will have to pay out more than a few dollars is very small.
Insurance companies are firms that carry out such diversification of risk by bringing together large groups of people. Insurance companies set a premium equal to the expected value of the loss (in the example, × $10,000 = $2), plus a fee to ensure the insurance company also profits from the deal.
Toolkit: Section 17.7 "Expected Value"
You can review the calculation of expected value in the toolkit.
Insurance, like other services, is traded in a market. You can choose to buy from a variety of sellers at a price that reflects the risk of the type of insurance you purchase. The gains from trade come from the fact that an insurance company is capable of pooling risk. The insurance company assumes your risk at a price you are willing to pay. Because people differ in terms of their attitudes toward risk, some people buy insurance against certain events, while others do not. If you are very cautious (more precisely, very risk-averse), then you are more likely to buy insurance.
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.
In most European countries, health insurance is largely provided by the government. In some cases, the government is also a provider of health services. In the United States, the government provides some health insurance—to the very poor, the old, and military veterans. But for the most part, the provision of health insurance in the United States is very different. Table 15.3 "Sources of Health Insurance in the United States" shows the types of health insurance that households can obtain in the United States. The “Total” column indicates the fraction of households with insurance. Since 1999, this has averaged about 85 percent but has been falling somewhat. On the bright side, this tells us that most people are covered by insurance. It also tells us that about 50 million people in the United States have no health insurance. The table reveals in addition that by far the most important source of health insurance is through employers: about 60 percent of all individuals have insurance provided through a firm. The other forms of insurance are through the government (about 30 percent) and direct purchase (about 9 percent). These numbers add to more than 85 percent because many individuals have insurance from more than one source.
Table 15.3 Sources of Health Insurance in the United States
| Year | Total (%) | Government (%) | Employment (%) | Direct (%) |
|---|---|---|---|---|
| 2009 | 83.3 | 30.6 | 55.8 | 8.9 |
| 2007 | 84.7 | 27.8 | 59.3 | 8.9 |
| 2005 | 84.7 | 27.3 | 60.2 | 9.2 |
| 2003 | 84.9 | 26.6 | 61.0 | 9.3 |
| 2001 | 85.9 | 25.3 | 63.2 | 9.3 |
| 1999 | 86.0 | 24.5 | 63.9 | 10.0 |
Source: US Census Bureau, “Health Insurance Historical Tables,” accessed March 14, 2011, http://www.census.gov/hhes/www/hlthins/data/historical/files/hihistt1.xls.
It might seem odd that your health insurance is likely to be linked to your job. After all, your employer doesn’t pay for your car insurance or for insuring your bank deposits. Historically, this phenomenon has its roots in the Stabilization Act of 1942, which was signed into law by President Franklin Roosevelt. The idea of the legislation was to stabilize wages and prices during World War II. Although President Harry Truman repealed most of the provisions of the act in 1946, some of the effects of that act remain today.The end of the act by President Harry Truman is documented at the American Presidency Project, “Executive Order 9801: Removing Wage and Salary Controls Adopted Pursuant to the Stabilization Act of 1942,” accessed March 14, 2011, http://www.presidency.ucsb.edu/ws/index.php?pid=60709.
A key provision of the act established wage and price controls. This meant that wages were no longer determined by market forces but were instead set (in part) by the government. But when the government places restrictions on the way people trade, they will often try to find ways around those restrictions.This idea is at the heart of Chapter 11 "Barriers to Trade and the Underground Economy". The loophole in the Stabilization Act was that it exempted pensions and insurance from the calculation of wages. This meant that firms could vary the overall compensation they offered workers through the provision of pensions and health insurance. Even though wage and price controls are no longer in place, the practice of offering health insurance as part of a compensation package persisted.
An employment-based health insurance system was furthered by tax actions, such as the 1954 Internal Revenue Code, which made employer contributions to employee health insurance nontaxable. Individuals were also allowed to deduct medical expenses from taxable income. So if you are paid $1,000 in extra income by your firm and you use these funds to buy health insurance, you are taxed on the $1,000 of income. But if the firm buys the insurance for you, then you do not pay tax on the $1,000 worth of benefits.
Being employed also changes the price you pay for insurance. If you contact an insurance company directly, the rates you will be quoted for health insurance are much higher than the rate (for you and your employer combined) if you buy a health policy through your job. One explanation for this is that it is cheaper to write an insurance policy for many people together than individually. A second explanation, which we explain in more detail later, is that, on average, employed people are likely to be a lower risk than those not working. A third factor is that a group of employees is already partly diversified, so the group is less risky than a single individual.
We saw in Table 15.3 "Sources of Health Insurance in the United States" that about 15 percent of individuals in the United States do not possess health insurance. But who are these individuals, and why are they uninsured? The “who” is easier to answer than the “why” because we have statistics on the uninsured. Table 15.4 "The Uninsured (in Millions)" reveals the following:This table comes from US Census Bureau, Income, Poverty and Health Insurance Coverage in the United States: 2009, table 8, page 23, accessed March 14, 2011, http://www.census.gov/prod/2010pubs/p60-238.pdf.
Many of the uninsured are poor. Of the nearly 45 million uninsured in 2005, about 14.5 million had incomes less than $25,000. (As a benchmark, according to the US Census Bureau, the 2006 poverty level for a family of four was $19,350.) Only about 17.6 percent of the uninsured had incomes in excess of $75,000. In 2009, of the 50.7 million uninsured, about 15.5 million had income less than $25,000.
Table 15.4 The Uninsured (in Millions)
| 2005 | 2009 | |
|---|---|---|
| Number of uninsured | 44.8 | 50.7 |
| Age | ||
| Under 18 | 8.0 | 7.5 |
| 18–24 | 8.2 | 8.9 |
| Household income | ||
| Under $25,000 | 14.4 | 15.5 |
| $75,000 or more | 7.9 | 10.6 |
| Work status | ||
| Full time | 20.8 | 14.6 |
| Part time | 5.5 | 14.7 |
Source: US Census Bureau, Income, Poverty and Health Insurance Coverage in the United States: 2009, table 8, page 23, accessed March 14, 2011, http://www.census.gov/prod/2010pubs/p60-238.pdf.
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 × $100,000).
Table 15.5 Probabilities and Expected Losses
| Group | Probability of Cancer (%) | Expected Loss ($) |
|---|---|---|
| A | 0.1 | 100 |
| B | 1 | 1,000 |
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.
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:
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.
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.
