Health Insurance Module: why people

buy health insurance?

Presentation is organized in the following
manner:
Traditional Demand theory
concepts of risk and uncertainty
Methods for measuring risk and analyzing
individuals attitude towards risk
Health insurance: supply and demand
Choice Under Uncertainty
Traditional demand theory assumed a riskless
world

But People mostly make choices under uncertainty
Most economic decisions are made in the face of risk or
uncertainty (e.g., choosing an occupation, financing large
purchases)

Extension of traditional economic theory

Consumer choices are made under conditions of
certainty, risk or uncertainty
Uncertainty and Consumer Behavior
To examine the ways that people can compare and
choose among risky alternatives, we take the
following steps:
1. In order to compare the riskiness of alternative
choices, we need to quantify risk.
2. We will examine peoples preferences toward risk.
3. We will see how people can sometimes reduce or
eliminate risk.
4. In some situations, people must choose the amount
of risk they wish to bear. Such investments involve
trade-off between monetary gains and the
riskiness of that gain.
Risk and uncertainty in demand
choices
Certainty
One possible outcome to a decision
Risk
More than one possible outcome and the prob.
of each outcome is known or can be estimated
Uncertainty
More than one possible outcome and prob. of
each outcome occurring is not known (e.g.,
drilling for oil in an unproven field)
In the analysis of choices involving risk, we
utilize the following concepts
Strategy

States of nature

Pay-off matrix
QUANTIFYING RISK
Probability
The probability of an event is the chance that the event will occur. By listing all the
possible outcomes of an event and the probability attached to each, we get a
probability distribution. The concept of P.D is essential in evaluating and
comparing different outcomes.

expected value associated with an uncertain situation is a weighted average of all
possible values with all possible outcomes. The probabilities of each outcome
are used as weights.
The expected value measures the central tendencythe value that we would
expect on average.
Expected value = Pr(success)($40/share) + Pr(failure)($20/share)
= (1/4)($40/share) + (3/4)($20/share) = $25/share
E(X) = Pr
1
X
1
+ Pr
2
X
2
E(X) = Pr
1
X
1
+ Pr
2
X
2
+ . . . + Pr
n
X
n


DESCRIBING RISK
Variability
variability is the extent to which possible outcomes of an
uncertain situation differ.
deviation Difference between expected payoff and actual payoff.
OUTCOME 1 OUTCOME 2
Probability Income ($) Probability Income ($)
Expected
Income ($)
Job 1: Commission
Job 2: Fixed Salary
.5

.99
2000

1510
1000

510
.5

.01
1500

1500
TABLE 1 Income from Sales Jobs
TABLE 2 Deviations from Expected Income ($)
Outcome 1 Deviation Outcome 2 Deviation
Job 1
Job 2
2000

1510
500

10
1000

510
-500

-990
DESCRIBING RISK
Variability
Outcome 1
Deviation
Squared
Deviation
Squared Outcome 2
Deviation
Squared
Weighted Average
Standard
Deviation
Job 1
Job 2
2000

1510
250,000

100
1000

510
250,000

980,100
250,000

9900
500

99.5
Table 3 Calculating Variance ($)
standard deviation Square root of the weighted average of the squares
of the deviations of the payoffs associated with each outcome from their
expected values.
PREFERENCES TOWARD RISK
expected utility Sum of the utilities associated with all possible outcomes,
weighted by the probability that each outcome will occur.
PREFERENCES TOWARD RISK
In (b), the consumer is risk
loving and she prefers an
uncertain income to a certain
one, even if the expected value
of the uncertain income is less
than that of the certain income.

She would prefer the same
gamble (with expected utility
of 10.5) to the certain income
(with a utility of 8).

In (c), the consumer is risk
neutral, and indifferent
between certain and uncertain
events with the same expected
income. Marginal utility of
income is constant for a risk
neutral person.
PREFERENCES TOWARD RISK

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risk neutral A person who is risk neutral is indifferent between
a certain income and an uncertain income with the same
expected value.
risk loving An individual who is risk loving prefers a risky
income to a certain income, even if the expected value of the
uncertain income is less than that of the certain income.
People differ in their willingness to bear risk. Some are risk averse,
some risk loving and some risk neutral.
Demand for Health Insurance
What is insurance?
The incidence of illness seems to be random and so,
health care expenses are uncertain. Since health care
expenses are unpredictable, they can be financially
catastrophic for the households.

Insurance reduces the variability of incomes (or
losses) of those insured by pooling a large number of
people and operating on the principle of the law of
large numbers.
Consumers actually purchase a pooling
arrangement when they buy a policy from an
insurance company. Pooling arrangements
help mitigate some of the risk associated with
potential losses.

Suppose, two individuals, Joe and Lee face
the same distribution of losses. Both of them
face a 20% prob. of losing $20 and an 80%
prob. of losing nothing. So, the expected
value of this distribution of losses:
0.2*$20+0.8*$0=$4.
Joe can expect to lose $4. We are more concerned
about the variability of the expected loss.
Variance=0.2($20-$4), S.D.=$8
Both the expected loss of $4 and its s.d. can be
thought of as measures of risk.
Lets now show how Joe and Lee might mutually
gain from entering into an pooling arrangement.

Entering into a pooling arrangement essentially
replaces each persons individual loss distribution
with the average loss distribution of the group.
16
Why People demand for health insurance?
The conventional theory or standard gamble
model, assumes that people purchase health
insurance to avoid or transfer risk. In this case,
insurance serves as a pooling arrangement to
replace the high risk or variability of individual
losses with the reduced risk or variability
associated with aggregated losses.
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 so that
The sum of premiums will exceed the sum of
medical expenses
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
In addition, lets assume diminishing
marginal utility of income
Utility
Income
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
$20,000
$40,000
70
90
Income Utility
Sick
Healthy
Utility
Income $20,000 $40,000
90
70
Utility when
healthy
Utility when sick
A
B
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: P
0
= prob. of being healthy
P
1
= prob. of being sick
P
0
+ P
1
= 1
An individuals subjective probability of
illness (P
1
) will depend on her health stock,
age, lifestyle, etc.

Then without insurance, the individuals
expected utility for next year is:

E(U) = P
0
U($40,000) + P
1
U($20,000)
= P
0
90 + P
1
70
For any given values of P
0
and P
1
, E(U) will
be a point on the chord between A and B
Utility
Income $20,000 $40,000
70
90
A
B
Assume the consumer sets P
1
=.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
Utility
Income $20,000 $40,000
90
70
A
B
$36,000
C



86
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

Utility
Income $20,000 $40,000
90
70
A
B
$36,000
C



86
$35,000

D
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
Determinants of Health Insurance
Demand
1 Price of insurance
In the previous example, the consumer will
forego health insurance if the premium is
greater than $5,000
2 Degree of Risk Aversion
Greater risk aversion increases the demand for
health insurance
Utility
Income $40,000 $20,000
A
B
If there is no risk aversion, utility = expected utility, and
there is no demand for insurance
3 Income
Larger income losses due to illness will
increase the demand for health insurance

4 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
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
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

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
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
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 <280>
after tax 720
insurance <50>
net pay 670
Employer Purchased

$1,000
insurance <50>
subtotal 950
28% tax <266>
net pay 684

Employer Health Insurance Coverage of
U.S. Population (percent)
58
59
60
61
62
63
64
65
Total Employment Based
1995
1998
2000
2002
2005
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
Insurance Terminology
Coinsurance: A cost-sharing requirement
under a health insurance policy that provides
that the insured will assume a portion or a
percentage of the costs of covered services.

Co-payment: A cost sharing arrangement in
which the insured pays a flat amount for a
specified for a specified service. It does not
vary with the cost of service, unlike the
coinsurance that is based on some percentage
of cost.
Deductibles: Amounts required to be paid
by the insured under a health insurance
contract, before benefits become payable.
In a sense, the insurance does not apply
until the consumer pays the deductible.