Insurance

Unpredictable illness creates an uncertain need for health services. The institutional response to this uncertainty is to create an insurance mechanism in which participating individuals contribute regularly to a risk-pooling agency that provides reimbursement in the event of an illness. The insuring organization can be public or private, the contribution can be via premiums or taxes, and the reimbursement can be monetary or through direct provision of medical services.

Risk-averse individuals are willing to pay a premium to an insuring agency to avoid taking on risk. This premium is typically far more than the average loss they are likely to confront since the sum of these collected premiums from the insured pool must at least cover the expected benefits the insurance agency expects to pay out, their administrative cost, along with their profit. Three basic challenges to this model have been studied extensively: consumer information issues, moral hazard, and adverse selection.

Consumers in the healthcare market are confronted with the lack of easily available price, paucity of quality information, and the challenge of interpreting complex and technical medical information. These issues can limit the ability of the individual to make rational and informed decisions about medical insurance.

Moral hazard is neither a moral dilemma nor is it necessarily hazardous. Instead, it is a rational consum-er's predictable response to a reduction in the price of health services, resulting from participation in an insurance plan. The insurance plan reduces the out-of-pocket cost to the individual for medical services, inducing individuals to consume care that is of less value than the cost of providing that care. In the most extensive controlled experiment on health insurance, the RAND Corporation, a nonprofit research organization, and associated researchers found that being insured increased the likelihood of purchasing medical services and increased the spending amount in the event of an illness.

Insurance companies have introduced deductibles and coinsurance to limit the extent of moral hazard by having the individual feel some level of financial burden. The insurance deductible is a set monetary amount that must be incurred by the insured before the insurance company pays any part of the claim. A policy with coinsurance requires the individual to pay a fixed percentage of every claim, and this cost sharing typically ends after total out-of-pocket spaending reaches some limit. Such solutions allow a balancing between the reduction in financial risk and the effects of increased demand for care.

The third concern is that of adverse selection, whereby the purchasers of insurance have more information about their expected healthcare needs than the insuring organization. Individuals have the ability to conceal their true risk. If enough high-risk individuals conceal themselves as low-risk purchasers, the premiums set by the insurance agency based on actuarial projection will underestimate the expected benefits that will need to be paid out. This will lead to higher-than-average premiums for the pool of individuals and create an incentive for low-risk individuals to drop out of the pool, driving up premiums even more.

These even-higher premiums would drive out more low-risk individuals at the margin, driving premiums even higher. This so-called “death spiral” is prevented by insurance companies by only underwriting prospective risk, and thereby not insuring for preexisting conditions. In addition, they can risk rate [Page 924]prospective customers via having them complete a questionnaire or have a physical exam. In essence, if the insurance agency could identify low- and high-risk individuals, and charge premiums accordingly, then the problem of adverse selection could be averted. Pooling risk through a third-party mechanism such as an employer also serves to mitigate adverse selection. Alternatively, in a national health insurance program, there is no concern for adverse selection because everyone is covered.

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