Week 2 – Healthcare Economics

Video 1: Introduction to Insurance

In this segment, we will introduce the concept of health insurance which is essentially a contract
between a payer, could be a company like Blue Cross or a government agency like Medicare, and a
member. This contract offers financial protection against medical care expenses incurred due to
illness or injury. That is health insurance provide some peace of mind. If a person is ill and needs to
see the doctor, insurance coverage would render the visit affordable and this person would be less
likely to shear from care for financial reasons.

As with any contract, both parties, the policyholder and the insurance company, must give
something up. The insurance company guarantees to cover a portion of the medical bill and in
doing that substantially reduces financial risks associated with negative health shocks. In return,
the policyholder must pay a fee to the insurance company for this protection. This fee is called a
premium.

In our next segments, we will discuss what determines the size of insurance premiums. But for
now, let's introduce what else we might find in a typical health insurance contract. In addition to a
premium, most insurance contracts include a deductible, copayments, and coinsurance. These are
ways in which insurers share the costs of medical services with policyholders.

 A deductible is a specified amount that the insured member must pay during a policy
period, which is usually one year, before the insurance plan kicks in and starts to provide
financial protection.
 A copayment or a copay is a specific flat fee you pay for each medical service. For example,
if an individual went to visit the cardiologist before signing up for surgery, she may have
had to pay a $25 copay for her visit.
 A coinsurance represents a fraction of the medical expenses that the insured member has
to pay. For example, if you have an 80/20 coinsurance on your health insurance plan, it
means that the insurance plan will cover 80 percent of covered medical bills, while you are
responsible for paying the other 20 percent.

Some individuals may experience high medical expenses in a given year. A typical heart bypass
surgery in the US costs more than $100,000. If a patient needs such intervention at 20 percent
coinsurance rate represents a considerable financial burden. This is why many policies include an
out-of-pocket limit which sets an upper bound on the amount that a policyholder owes during a
policy period, again, usually one year before the insurance plan starts to pay 100 percent of all
coverage medical expenses.

These covered medical expenses are typically limit to what are often known as essential health
benefits which include 10 essential domains of medical care (Hospitalization, Ambulatory patient
services, pediatric services, mental health services, prescription drugs, preventive and wellness
services, laboratory services, emergency care, rehabilitative and habilitative services and
maternity and newborn care).

You're not expected to know all of these essential health benefits by heart, but it's useful to
understand what situation coverage falls under. To better understand how these components
work together, let's look at how health insurance works over the course of the policy period.

On the y axis, we have healthcare spending, and on the x axis, we have days, which in our case
span a year. So we have the beginning of the year, and we have, the end of the year. Our insured
member, in this example, is using medical care quite routinely. Here are the medical expenses this
person incured over the year. If this individual was uninsured this would be the amount they owe.
But luckily, our individual did purchase health insurance. And so, the first component of this health
insurance policy is a deductible. This line tells you when the insured member has paid their
deductible. So, up to this point, the member pays for care out of pocket.

The next element is the out-of-pocket limit. In this area, between the deductible and the out-of-
pocket limit, the member pays a fraction off the medical expenses in the form of copayments or
coinsurance. Know that the actual medical expenses are higher than what the member pays. Once
the insured member hits the out-of-pocket limit, all medical expenses are paid in full by the
insurer.

So while medical expenses keep on accumulating, the individuals does not share in the payment.
At the end of the year, this is the amount paid by the member and this is the amount paid by the
insurance plan. So what is missing from this picture? Right. The premium.

The premium is paid to the insurer regardless of medical expenditure. If the average amount paid
to the insurer for all its members exceed the average premium this insurer collect, this insurance
company will lose money.

Up until now, we discussed the key components of all health insurance plans, but plans have
different rules. So we are going to discuss the three major types of health plans being offered and
how they differ from one another. These three health plans are HMO, PPO, and HDHP.
We'll start with health maintenance organization, or HMO. Which is an insurance plan that offers
relatively lower premium, but restricts the members access to providers, services, and products.
For example, a policyholder will have fewer physicians to choose from, fewer procedures available
to them, and fewer drugs covered under their plan.

Additionally, policyholders are required to identify a primary care physician, who then serves as a
gatekeeper when patients desire a referral to a specialist. The policyholder must pay a fixed copay
at each visit to the primary care physician. Preferred provider organization or PPO is an insurance
plan that gives policyholders more freedom of choice but generally involves a higher premium.

Under a PPO, though the network of providers that a patient may visit is larger, there are still
providers that are out of network. A patient may still visit those providers, but the insurance will
likely cover less of the cost than for an in network provider.

A key difference between a PPO and an HMO, is that the PPO does not require seeing a primary
care physician, so patients can make appointments with specialists at their discretion.

Finally, a high deductible health plan, or HDHP. Is an insurance plan that gives policyholders the
most freedom over the providers they visit, and the services they receive. This plan is sometimes
called consumer driven health plan or CDHB, which reflects the patients freedom to choose. The
plan is structured in a way that policyholders bear substantial risk by selecting a high deductible
plan. Since the insurer bears relatively less risk, they will offer lower premiums.

HDHP are popular among individuals who have access to health savings accounts through their
employers. These health savings accounts or HSA help individuals save money so they can pay the
high deductibles in the case of a negative health shock. These plans are recommended for
individual who use medical services infrequently. An HDHP plan would still provide coverage for
catastrophic events.

Video 2: Risk Aversion

In the last segment, we learned about the structure of insurance, including components like
deductibles, copays, and premiums. In the insurance markets, premiums are of particular interest
because they represent our willingness to pay for coverage even if the insurance is not used. But,
why are people willing to pay for insurance? And how would an insurance company quantify how
much people are willing to pay? We are going to answer these questions by the end of this
segment. Let's begin with why are people willing to pay for insurance. The answer is, people
exhibit risk aversion, which refers to the idea that people typically dislike uncertainty, and are
willing to pay money to avoid it. Risk aversion is therefore the behavior of a person who is willing
to pay to reduce or avoid uncertainty even though, on average, they would be better off financially
by accepting the uncertain payoff. Let's take a simple example. Picture you're in a game show, and
already accumulated $400,000. Now you come to the final question. What was America's first
organized sport? There are two options: A, horse racing, or B, baseball. If you answer correctly,
you will win one million dollars. But since you don't know the answer, you have a 50 percent
chance of winning. The game show host gives you two options, stop playing and take home
$400,000, or keep playing for the chance to win one million dollars. But then, you lose it all if you
get the answer wrong. Which would you choose? If you chose to stop playing and take home the
$400,000, you are risk averse. But why? Well, let's see. If you choose to keep playing, you have a
50 percent chance of winning one million dollars, and a 50 percent chance of taking home nothing.
This is simply a gamble with an expected value of $500,000. A risk averse person is willing to take
home 400,000 in certainty, rather than a risky bargain that has a value of 500,000. Put differently,
a risk averse person just paid $100,000 to avoid this risk altogether. In the case of medical care,
risk aversion leads the public to demand health insurance, that is, pay a premium, money they
forgo in certainty in return for a reduction in exposure to financial consequences of unexpected
negative health shocks. We turn now to a graphical representation of the decision making process
of a risk averse individuals. To do so, we will graph the relationship between wealth on the X-axis,
and how much people value that level of wealth on the Y-axis. When we say how much people
value their wealth, we are referring to a measure of their satisfaction, or usefulness which
economists call utility. Utility refers to the total satisfaction received from consuming a good,
receiving a service, or accumulating wealth. The curve illustrates a positive relationship, but note
that it is concave, representing a diminishing marginal utility. In other words, incremental changes
in wealth have a smaller effect on utility when the wealth level is high. For example, if your wealth
increased by 50 percent from $50,000 to $75,000, you'd be very happy about it. We can see it in
the substantial increase in the level of utility. However, if your wealth increased from 8 million
dollars to $8,025,000, same size increase, the change in utility is barely noticeable. Using the utility
curve, we can describe risk aversion, and how its level dictates the magnitude of the insurance
premium. So what we have now is a curve that shows us the level of utility an individual gets from
each additional unit of wealth, where each additional dollar raises the utility level in smaller and
smaller increments. Let's assume that this individual has a wealth level of $250,000. This level of
wealth corresponds to a utility level, U of 250,000. That is the level of satisfaction one gets from
this level of wealth. Now assume that this individual has a 50 percent chance of not requiring any
medical care, and 50 percent chance of needing intense medical care at a cost of $200,000. This
individual faces a substantial risk. A simple way to think about this risk is to recognize the fact that
if this person experiences a loss of $200,000, her wealth will fall to $50,000. In other words, we
have a lottery with a 50 percent chance of keeping the original wealth at $250,000, and a 50
percent chance of ending up with a wealth level of just $50,000. The expected wealth is therefore
50 percent times 250,000 plus 50 percent times 50,000 which equals $150,000. With this
information, we can now graph the average utility level, or expected utility which is simply an
average of the utility at 250,000, and the utility at 50,000. We can identify the expected utility
graphically by connecting the utility levels with a straight line. This line allows us to find the
expected level of utility that corresponds with our expected wealth. So, if we trace a line from our
expected wealth of a $150,000, we get to the expected utility denoted as point A. This is a way to
illustrate the risk faced by a person who is uninsured. Her wealth may be depleted, or remain
unchanged, a major gamble to be taken. This uncertainty can largely be avoided by purchasing
health insurance. But how much would this person be willing to pay for insurance? Since our
individual is averse to risk, we can ask ourselves what would be the wealth level that would make
these individuals exactly indifferent between that amount, and bearing financial risk. By keeping
the same level of utility, we make sure that this individual is neither worse off nor better off. And
so, we started to point A, and move to the left until we hit the utility curve. We mark this as point
B. This point represent the lowest level of wealth that this individual is willing to tolerate to avoid
uncertainty. That level of wealth is called the certainty equivalent, or CE. And it represents the
wealth level that people are willing to have under certainty that is identical to the expected wealth
under uncertainty which is $150,000. The distance between point A and B, or between the
expected wealth and the certainty equivalent is simply the premium, or the maximum willingness
to pay to avoid the risk. The more risk averse we are, the higher will be the premium we would be
willing to pay to avoid risk. The insurer on the other hand can spread risk across a large population
of members, and therefore can be thought of as risk neutral. In this segment, we assume that the
risks are known to both the individual and the insurer, which is why by simply paying a premium,
the insurance company can eliminate all financial risk without requiring additional risk sharing like
deductibles, or copayments, or coinsurance. However, as we've learned in the previous segment,
insurance plans typically involve deductibles and copayments. The rationale for these risk sharing
arrangements is the topic of our next segment.

Video 3: Moral Hazard

In the previous segment, we discussed risk aversion. Aversion to risk is what makes people
demand health insurance. We also discussed how the premium is derived. It reflects payment in
return for lessening or eliminating financial risk. But this all assumes that risk is fixed and known to
both the insurer and the individual seeking insurance. If risk is fixed and known, we can find a
premium that would make the insurer and the individual better off. But what if risk is known to
individuals but not to insurers? We call the situation asymmetric information. Individuals know
more about their health issues, family history and lifestyle choices than their insurer. In this
segment, we will discuss how asymmetric information can lead to a problem of moral hazard and
why the solution to this problem requires cost sharing arrangements like deductibles, co-payments
or co-insurance. Moral hazard reflects the notion that under certain circumstances, individuals will
alter their behavior and take more risk. The specific circumstances we will discuss in this segment
is the presence of insurance. Moral hazard occurs when individuals have the opportunity to
assume additional risks that negatively affects the insurer. The decision is based not on what is
considered right but on what provides the highest level of benefit. Hence the reference to
morality. So what is the solution to the moral hazard problem? To answer this question, let's look
at a simple example of property insurance. When a property owner obtains insurance on a
property, you might think that the contract is based on the idea that the owner will avoid
situations that may damage the property. Moral hazard exist when the property owner, because
of the availability of insurance, is less inclined to protect the property, since the guaranteed
payment from the insurer lessens the burden on the owner in case of a disaster. Let's consider the
risk averse owner of a warehouse that is valued at $100,000. The warehouse contains hazardous
materials that can be very flammable, and the annual likelihood of a fire is assessed at 1%. It turns
out that the owner can reduce the risk of fire by providing fire extinguisher training to all
warehouse employees. The training is subsidized by the local fire department and only costs $50.
This training was shown to be effective in reducing the number of fires by half. That is, if the
owner provides the program, the probability of fire will be reduced from 1% to half a percent. The
question is, should the warehouse owner provide this training? You might want to pause the video
and answer this question yourself. The answer is yes. The warehouse owner should provide this
training to his employees. If he doesn't, he faces an expected loss of a $1,000. That is the value of
the warehouse 100,000 times the probability of a loss 1%. On the other hand, the expected loss
falls to $500 when providing the training plus the $50 training cost. So together, the expected loss
is $550. Providing training lowers the expected loss from $1,000 to $550. So exposure to risk leads
the owner to be proactive about mitigating it. Now assume that the owner can buy property
insurance and that the insurance company cannot observe, verify or force the owner to provide
fire prevention training. Since the expected loss is $1,000, the insurer would charge the owner a
premium of no less than $1,000. A risk averse owner is thrilled as he is no longer exposed to risk.
Even in a case of a fire, the insurer will pay the owner $100,000, the original value of the
warehouse. But notice, that with no risk there is no incentive to provide fire prevention training.
This is the essence of moral hazard. The owner behaves differently with and without insurance.
Without insurance, the owner would find it advantageous to provide training and when insured,
training is just a waste of $50. So how do we fix this moral hazard problem? The only way to do
this is by not fully insuring the owner and expose him to sufficient level of risk that would make
him take proper action. For example, the insurance company could choose a coinsurance rate C,
which means cover only one minus C times the value of the warehouse. That is if the coinsurance
rate is 20%, the insurance company would only pay 80% in a case of a loss. In our example, the
owner will be covered for $80,000 and in a case of the fire, will still stand to lose $20,000. The
question is what is the minimum level of cost sharing that would eliminate moral hazard? Let's
assume that we found the coinsurance rate that would make the owner provide training. If that is
the case, then the expected loss would be $500 and the expected payment from the insurer would
be one minus C times $500. Since this is the expected payment, this would be the lowest premium
that the insurer will charge the owner. So let's assume the owner buys this insurance and pays a
premium of one minus C times $500. But the insurer cannot observe if the owner provided
training or didn't. So the owner may decide to provide training or may decide not to provide
training. Let's compare the two scenarios. In both cases, the premium would be identical, one
minus C times $500. But if the owner chooses to train his employees, he will pay $50 for training
and if he decides to forgo training, he pays nothing. But that comes at a cost because the owner is
now exposed to risk on his coinsurance rate. So if he trains his employees, his expected loss or risk
exposure would be C times $500 but if he does not train his employees, he's expected loss will be
C times a $1000. So what level of coinsurance rate makes the owner's expected loss with training
lower than the expected loss without training? Let's see. The premiums are the same so we can
ignore them. This leaves us with this expression where we can substract C times 500 dollars from
both sides and now, divide both sides by C times 500 dollars. Here's our solution. The minimum
level of cost sharing that would make the owner take action requires C to be greater than 0.1. So
any coinsurance rate above 10% in this example, will eliminate the moral hazard problem. So we
eliminated the moral hazard problem. Yay! But unfortunately, the only reason we did was because
this example is very simplistic. In reality, there are many types of actions that the owner can take
to reduce the likelihood of fire. The owner can invest in adequate fire evacuation plans, waste and
trash management, no smoking signs, automatic sprinkler system and much more. So there is
really a continuum of action that the owner can take. More actions means lower probability of fire
but it also means more investment in fire prevention. The more exposed the owner is to risk, the
more actions would be taken. But moral hazard would be eliminated only if the owner bears all
the risk. That is, if the owner has no insurance. So insurance will always create moral hazard and
coinsurance will mitigate it. In the next segment, we will discuss how deductibles and coinsurance
rates relate to medical care consumption.

Video 4: Cost Sharing

In the previous segment we discussed moral hazard. We showed that in order to mitigate the
moral hazard problem, the insurer must transfer some of the risk back to the insured the
individual by offering partial coverage or cost sharing. That is, the insurer and member share the
costs of medical care expenditures. We already discussed the common cost sharing arrangements,
deductibles, coinsurance and copays. In this segment, we will discuss the impact of these cost
sharing arrangements on medical care consumption. But before we do that let's quickly see what
moral hazard means in the case of health insurance. The presence of health insurance lowers the
effective price that people pay for care. For example imagine you're coming down with a cold and
when visiting your primary care physician, you're asked to pay $20 copay but does this visit really
cost $20? Of course not. Let's say this visit really cost $300 and if you had to pay their full cost of
the visit, would you still go and see your physician. Or would you try and use over the counter cold
or cough medication. But for you, the insured individual, the effective cost of the visit is $20. So
why not go see your physician. If you think about it, this is simply the law of demand. If we had to
pay $300 per visit, we would have fewer visits than if we had to pay $20. Therefore, moral hazard
in health insurance refers to the idea that insured individuals increase their consumption of
medical care specifically because they have insurance. So let's revisit the role of cost sharing,
starting with co- insurance rates. The fraction of the cost of a covered healthcare service that the
policyholder pays. Take the demand for specialist care visits. Here is our downward sloping
demand curve. Let's assume that a visit costs $500. If you're asked to pay this amount out-of-
pocket you would visit the specialist three times a year. If the cost of a visit was $300, you would
increase your number of yearly visits to four. Now imagine that you are insured and the
coinsurance rate is 10 percent. If the visit costs $500, you pay $50 out-of-pocket and if the visit
cost $300, you pay $30 out-of-pocket. The out-of-pocket payment is the price that consumers see
as insurance insulates them from the actual cost of the service. So at $50 you would see a
specialist 10 times a year and for $30 you'll visit your specialist every month. There is a disconnect
between the real costs of care and the price that the member sees, because the cost of care is not
accurately represented. It's as if we are on a different demand curve altogether. In fact we can see
that by linking the actual cost with the actual number of visits. For example, under this 10 percent
coinsurance rate we can link $500, the actual cost with 10 annual visits. And we can do the same
for $300 and 12 annual visits. It is easy to see that these two points belong on a higher demand
function. That is, the lower the coinsurance rate the greater is the demand for medical care. Now
let's discuss deductibles. The amount you pay for covered healthcare services before your
insurance plan starts to pay. With a $1,500 deductible you pay the first $1,500 of covered services
yourself. Once you are done paying your deductible, you usually pay only a copayment or
coinsurance for covered services. Your insurance company pays the rest. Some plans have
separate deductibles for certain services, like prescription drugs. Let's look at the demand for
medical care. We have price on the y axis and quantity on the x axis to simplify our analysis,
quantities measured in unspecified units of care. Here is your insurance contract. It involves a
$1,500 deductible and a 10 percent coinsurance rate. Let's assume that every unit of care costs
$250. If that is the case, how many units of care would you have to consume before you have paid
your deductible in full. If you said six, you are correct. We can represent the deductible as a
rectangle with unit price as its height and the number of units as its base. This is the sum of money
you would have to pay out-of-pocket before your insurance plan starts paying. So the price that
members pay in this range is the actual cost of care, $250 per unit. Beyond the first six units the
member will pay 10 percent coinsurance, in this case twenty five dollars for each additional
medical care unit she consumes. So what is the rationale behind the deductible. Why not simply
have a coinsurance rate from the get go. To answer this question consider the following two
demand curves. The one on the left represents demand for relatively minor medical interventions
like visiting your primary care physician, while the one on the right represents demand for acute
medical interventions like surgery. The deductible creates an interesting situation where for minor
events members must internalize the real cost of care and be somewhat calculated when making
care consumption decisions. However, for catastrophic events where Kerry is essentially
unavoidable they will be able to use their insurance without worrying about its financial
implications. Minor events happen in a higher probability than major events and insurance tend to
be more effective as the events it insurers against have a lower likelihood of occurring. It is
important to note that many plans pay for certain preventive services before one meets their
deductible. These services typically include vaccinations, screening checkups and disease
management programs. The reason for that is that insurance plans benefit when health conditions
are detected early. And addressed using cheaper and less intense measures. For these types of
care, the insurance would typically not require a copay or coinsurance. So people pay zero out-of-
pocket. In other words, the insurance company is creating moral hazard for preventive care. If
people are generally under utilizing these services, creating moral hazard to increase the use of
these services is a good thing. The key takeaway from this discussion is that the lower the
insurance rate, the higher is the consumption of medical care. With this takeaway in mind, in the
next segment we will discuss the elements that govern the pricing of insurance premiums.

Video 5: The price of Insurance

In the previous segment, we discussed deductibles and coinsurance. In this segment, we will focus
on premiums but do so from the point of view of the insurer. That is, we will discuss how
premiums are priced. To begin our discussion of pricing, we will consider the case of
insurance contracts that are actuarially fair. An actuarially fair insurance contract is one
where the premium paid by the consumer will equal the expected benefit paid back to the
consumer in a case of a loss. Consider PM to be the price of medical care and M to be the
quantity of medical care. Therefore, PM times M represents the expected healthcare
expenditures. The expected benefits to the individual will depend on the coinsurance rate,
C, such that the expected benefit E of B will equal one minus C, that is the portion covered
by insurance, times the expected medical care expenditures PM time M. This equation is
easy to understand from an accounting perspective. If my expected medical care spending
in the coming year is $2000 and I have a coinsurance rate of 20 percent, my expected
benefit from the contract would be 80 percent times $2000 dollars, which is $1600. But
these equations embeds the economic problem of moral hazard. As we've seen in the
previous segment, C, the coinsurance rate and M, the medical care consumption are
interdependent. When the coinsurance rate decreases, medical care consumption
increases. When the coinsurance rate is high, people are exposed to risk, financial risk they
were hoping to eliminate by purchasing insurance. On the other hand, when the
coinsurance rate is low, moral hazard is stronger and people over utilize medical care. So
the insurance company is charging us for risk bearing activities, that is, the lessening of
financial risk. But when we pay for insurance, there is another service the insurance
company is providing and that is processing claims. The insurance company will load this
cost to the premium they charge us. This element is called the loading fee. The loading fee
represents an additional charge to cover the operation of the insurance company which
include salaries for employees, rent for office space, and all other costs of running a
business. Think of the loading fee as the percentage of the expected payout that is
required for the insurer to stay in business. We can now write the expression for
premiums as one plus L, the loading fee, times the expected benefit to the individual
which is one minus C, times PM, times M. So, what affects the size of the loading fee L?
Wages and facilities an obvious reason, so is the complexity of insurance contracts. The
more sophisticated the insurer is, the higher the human capital has to attract and that
would raise the loading fee. Some elements lower the loading fee. Two in particular,
deductibles and portfolio earnings. As we showed in the previous segment, high
deductibles lower the use of routine medical care and therefore lower the claim
processing volume, which would lower the loading fee. Similarly, insurers collect
premiums in the beginning of the year or the month but pay out claims during the course
of that period. This time discrepancy allows insurers to generate portfolio earnings. Mostly
during investments, these money generating activities would allow insurers to lower the
loading fee. When the loading fee increases, premiums increase and insurance coverage
becomes more expensive. Faced with higher premiums, people would alter their insurance
generosity to keep it affordable. That is, people with buy insurance with higher
coinsurance rate. So, a higher loading fee would lead to higher coinsurance rates which in
turn reduce medical care consumption. On the other hand, lower loading fee would result
in lower coinsurance rates and worsening of moral hazard. One last component is missing
in order to give us a full picture of the pricing of insurance premiums. This factor is tax
subsidies embedded in employer-based insurance. Based on the IRS tax code, employer
payment for health insurance are not taxed as income to the employee but remain a
legitimate deduction for the employer. As a result, this makes health insurance cheaper for
the employee. Here is a simple example. Sarah and Roy both work as interior designers.
Sarah works for a large architecture company that offers employer-based health insurance
to its employees, while Roy works in a small business which does not offer such coverage.
Let's assume that both of them earn $5000 dollars per month before taxes. Sarah receives
her health insurance from her employer. So, her premium of $1000 dollar is deducted
from her salary. Due to that, her taxable income is $4000 dollars. Since Roy is not offered
insurance, his taxable income is $5000. Assuming both pay 30% income tax, Sara's net
 income would be $2800, and Roy's net income would be $3500 dollars. But Roy still does
not have health insurance, he will have to purchase insurance himself. Let's assume that
his health insurance premium is also $1000 dollars, same as Sara's. After buying health
insurance, Roy's net income is reduced to $2500 dollars Sara has a higher net income than
Roy. Why is that? The cost of Sarah's insurance is lower due to a tax shield. Instead of
paying $1500 dollars in taxes like Roy, she only pays $1200. In other words, her premium
was really one minus t times 1000, where 't' is the tax rate, in this case, 30 percent. That is,
her premium was subsidized and was $700 dollars instead of $1000. So consider our
revised formula. The new premium includes one minus t, to account for the tax shield
embedded in the employer based insurance system. Focus on the term one minus t times
one plus L. To some clever manipulation, this term can be rewritten as one plus L minus t
times one plus L. The term ind the square brackets is called the effective loading fee, and
it's lower than L. The bigger the tax rate, the lower is the effective loading fee.
Interestingly, if t is larger than L, for example, if the tax rate is 30 percent but the loading
fee is only 20 percent the effective loading fee would be negative. Why don't you pause
the video and plug these numbers in L minus tee times one plus L to convince yourself?
What this means is that the tax shield could be so strong that it lowers the effective
loading fee which in turn causes people to buy plans with lower coinsurance rate which
will again exacerbates the moral hazard problem. So, higher tax rates make coverage
cheaper and leads to moral hazard.

Video 6: Adverse Selection

Recall our discussion of moral hazard, where the behavior of individuals change with the presence
of insurance. The problem of moral hazard is sometimes referred to as a hidden action problem, as
the action of how much insurance a person uses is hidden from the insurer. This is an example of
asymmetric information. Another important dimension of asymmetric information is hidden
information, where individuals differ in fundamental ways, ways that are not observable to the
insurer, like their lifestyle choices. In this segment, we are going to discuss hidden information, or
as it is more commonly referred to as adverse selection. Adverse selection refers to a situation in
which the insurance company lacks important information about policyholders, leading individuals
who are more likely to use the insurance to adversely select to enroll in the plan. For an insurance
company to properly spread risk, it need to know how likely an individual is to have high medical
expenses. To understand how this works, let's look at this group of individuals which come in a
range of health states. We rank them from healthiest to sickest. We call the healthy people, who
are unlikely to use many medical services, low-risk individuals, as they do not pose much risk to
the insurer. On the other extreme, high-risk individuals will be unhealthy people with the high
propensity to use medical services. These individuals will spend different amounts of money on
medical services. Low-risk individuals will spend very little, and high-risk individuals will spend a
lot. In the US, the top five percent of health care spenders account for almost half the spending in
the country. Now, consumer know this information. But by assumption, insurers don't. From the
insurers point of view, everyone is of the same average health. This is the nature of the
asymmetric information. Consumers of health care have more information about their health
status than insurers do. In this scenario, insurers have to charge the same premium from all
members. And therefore, the premium will reflect the average expected spending. But when that's
what insurance costs, some people, those that are most healthy, will choose not to buy insurance
in the first place. This is true even if these individuals are risk-averse. They are simply better off
taking a relatively small risk, then paying so much to insure against it. If they leave the market for
insurance, individuals left in the pool will have higher average expected spending and the insurer
will have to raise the premium. The increase in premium may now lead the lowest risk individuals
left in the pool to exit the insurance market. These dynamics of exit leading to higher premium,
which leads to more exit, which leads to even higher premiums, is a snowball effect known as the
death spiral, which refers to a condition of the insurance markets, where premiums are rapidly
increasing because low-risk individuals are continuously priced out of the market. So, adverse
selection may lead the insurance market to fail. It's a serious problem. Recall the notion of risk
aversion. The more risk-averse we are, the greater our demand is for insurance. We dislike risk so
much, we are willing to pay money to avoid it. But who is more risk-averse? High-risk people or
low-risk people? Our discussion is fairly agnostic to this question and most adverse selection
models assume that while people differ in their health status, they are similar in their level of risk
aversion. But if low-risk individuals, those that exercise and eat healthy and avoid risky behaviors,
are also more risk-averse, we would be in a world where the healthy are more likely to buy health
insurance, which would help keep premiums low and prevent the death spiral. So, adverse
selection exists because the insurance company lacks the information required to tell high- and
low-risk individuals apart. So what are the ways to deal with adverse selection in practice? There
are four main solution: make the information more symmetric, sell insurance to groups and not to
individuals, mandate insurance, or offer multiple insurance contracts to separate high- and low-
risk individuals. The first approach would be to make the information more symmetric. This
solution suggests that insurers be allowed to collect health information and use that for pricing
decisions. This would result in sicker people paying higher premiums and healthy people paying
lower premiums. People with pre-existing conditions will face very high premiums, or maybe
denied coverage altogether. While this solution may solve the adverse selection problem, it may
defeat the purpose of insurance. Let's imagine that a diagnostic technology can perfectly predict
health spending for the next 12 months. Now, if the insurance company knows that I will spend
$500 in the coming year, it will charge me $500. And if they discover that I will be spending half a
million dollars, well, that is what they will charge me. So, a plan like that does not provide
insurance. It simply presents the member with the bill. The purpose of insurance is to spread the
risk. The second solution is to offer a group insurance, mainly through employers. Instead of
having people purchase insurance directly, their employers purchase it on their behalf as a part of
a group plan. In this case, the insurance company is selling insurance to a large pool of employees,
which represent a spectrum of health conditions. Since properly spreading risks requires such
spectrum of health conditions, the insurer has little to worry about adverse selection. But, group
health insurance does create problems, as it ties labor participation and job mobility to higher
coverage. The third solution was proposed under the Affordable Care Act. The idea here was to
mandate the purchase of health insurance. So, low-risk individuals stay in the pool and help
maintain affordable premiums. While forcing people to buy insurance against their will may sound
harsh, it alleviates the need to use the first approach to mitigate adverse selection. In other words,
by mandating insurance, the government can insure coverage for people with pre-existing
conditions. The forth solution involves offering multiple insurance plans, some that cater to low-
risk individuals and some that cater to high-risk individuals. Since the insurance company cannot
tell high- and low-risk individuals apart, it has to cleverly set these contracts up, balancing two key
elements of the plan, premiums and coverage.