Health insurance is a contractual arrangement through which individuals spread the financial risk of unexpected and costly medical events. By enabling the voluntary pooling of health-related financial risks, health insurance enhances social welfare. However, incentives inherent in a health insurance contract can result in the inefficient use of health services, leading to reductions in social welfare. Additionally, disparities in information about health status between persons seeking insurance and entities providing coverage can affect the efficient and equitable pricing and provision of health insurance and result in welfare losses. Consequently, the conflict between the welfare gains from risk pooling and the welfare losses from the inefficient use of medical care (known as moral hazard) and asymmetric information (the problem of adverse risk selection) remains an ongoing tension in the design of health plans and in efforts to expand coverage.
Standard Theory of Health Insurance
According to standard theory, risk-averse individuals prefer a monetary loss with certainty to a gamble with the same expected value. To protect against health-related financial losses, such individuals are willing to transfer income (pay a health insurance premium) to a risk-bearing entity (an insurance company) to protect themselves against monetary losses associated with illness. When these income transfers capture the expected value of an individual’s medical care expenses over a contractual period, they represent an actuarially fair health insurance premium. Because such monetary transfers are voluntary, the pooling of resources by individuals with similar risk profiles is welfare enhancing.
Standard theory also suggests that risk-averse individuals will pay a “risk premium” above the actuarially fair premium to obtain health insurance. This additional payment enables insurers to make coverage available, because it compensates them for their administrative and marketing costs and allows a margin for profit. This insurance “load” represents the true economic price of insurance as it is the minimal monetary transfer above an actuarially fair premium necessary to induce insurers to provide coverage. An individual’s demand for coverage will depend on its price (in theory, the insurance load, but in practice, the out-of-pocket premium), the individual’s risk aversion, and the probability and size of a health-related financial loss.
Setting Health Insurance Premiums
Despite the theoretical construct of an actuarially fair health insurance premium, controversy remains as to how premiums should be established. Some view health insurance as a form of mutual aid and social solidarity among citizens and believe that premiums should be community rated, reflecting the health care experience of an entire insured group. Under this principle, all individuals pay the same premium regardless of their own health care experience. In contrast, others suggest that premiums should more appropriately reflect the actuarial value of individual health care experience (or the experience of a group of very similar individuals) and should be experience rated. These analysts assert that community rating is unfair because it imposes an implicit tax on low risks that is used to subsidize high risks. Such pricing also results in the inefficient provision of coverage as the low risks purchase too little insurance and high risks overinsure.
Moral Hazard and Adverse Selection
Because health insurance reduces out-of-pocket costs, individuals and their providers have an incentive to overuse health care. In doing so, individuals obtain additional health services whose value to them is less than the resource costs incurred in its production. This moral hazard welfare loss represents a major source of inefficiency in the provision of health care.
Efforts to address moral hazard include the use of deductibles and coinsurance. The growth of managed care added a number of innovations to control utilization, including constraints on provider choice, capitated or fixed-dollar payments for the care of each enrollee, utilization review, and case management and quality assurance activities.
Most recently, efforts to instill greater cost consciousness on the part of consumers have led to the development of consumer-driven health plans, typified by health savings accounts combined with high-deductible health plans. Individuals and their employers make tax-free contributions to a health savings account up to a proscribed dollar limit. By assuming responsibility for substantial first-dollar expenditures, the expectation is that consumers will use services prudently. However, some individuals with these plans have delayed or postponed care and have expressed dissatisfaction with such plans. Concern also exists that tax-free health accounts will attract high-income persons in good health, leaving low-income persons with health problems in traditional insurance plans.
Moral hazard remains a concern, and its interpretation and policy implications may be more complex than generally appreciated. A distinction exists between inefficient moral hazard (resulting from the insurance-induced reduction in out-of-pocket price) and efficient moral hazard (resulting from the income transfer the ill receive from members of the insurance pool). Efficient moral hazard is welfare enhancing, as it enables individuals to overcome barriers to affordability.
In certain cases, such as the treatment of chronic illnesses, cost-sharing provisions to address moral hazard may need to be relaxed. The out-of-pocket costs of such provisions may deter compliance with treatment and lead to future health care costs.
Informational asymmetries between potential enrollees and insurers regarding enrollee health status can contribute to adverse risk selection. Because potential enrollees are often better informed than insurers, they may be able to enter health plans and pay premiums that do not reflect their expected health care use. Instead, they may pay the lower premiums faced by good risks. Such behavior can yield inefficiencies over time, as enrollment by poor risks causes health plan costs to rise and low-risk enrollees respond by seeking lower-priced but more restrictive coverage. In the extreme, adverse selection may lead to unsustainable health plans as low-risk enrollees defect and plans become dominated by high-risk enrollees.
To avoid adverse selection, health insurers compete by selecting favorable health risks. Such behavior is inefficient because it diverts resources from efforts to reduce plan costs and enhance quality and may leave certain individuals uninsured. State and federal reforms have sought to counter such insurer behavior by requiring open enrollment and guaranteed renewal of coverage and by limiting exclusions and waiting periods for preexisting health conditions.
Efforts to counter adverse selection have included reinsuring the expenses of high-cost enrollees, establishing high-risk insurance pools, and risk-adjusting payments to health plans.
Health Care Insurance in the United States
Whereas most industrialized countries have established national health insurance systems, the United States stands out as providing a patchwork of private and public sources of coverage that leave a sizable proportion of its citizenry uninsured (15.3 percent, or 44.8 million persons in 2005). Of the insured U.S. population in 2005, coverage from employers represents the largest source (60.2 percent, or 176.3 million persons), followed by Medicare (13.7 percent, or 40.1 million persons), Medicaid (13 percent, or 38.1 million persons), and private health insurance purchased directly from an insurer (9.2 percent, or 26.9 million persons).
The lack of a uniform health insurance system in the United States has resulted in significant gaps in coverage. Persons most likely to lack insurance are young adults (ages 19 to 34), racial and ethnic minorities (especially Hispanics), persons with low educational attainment, persons with low incomes, those in fair or poor health, low-wage earners, workers in small firms, and the self-employed. Compared with insured persons, the uninsured are less likely to have a usual source of health care, more likely to report difficulties obtaining timely care, and less likely to use medical care.
The provision of health insurance in the United States has also raised a number of equity and efficiency issues, especially with regard to employment-based coverage. For example, employer contributions to an employee’s health insurance premium are tax deductible, representing a revenue loss of $209 billion in 2004. This “tax subsidy” exacerbates moral hazard by creating incentives for individuals to purchase more generous coverage. Because the value of the tax deduction depends on an individual’s marginal tax rate, it represents a regressive subsidy favoring higher-rather than lower-income workers.
Providing coverage through the workplace also yields labor market inefficiencies. Workers may be discouraged from changing jobs or retiring early, and they may alter their labor force activity to qualify for coverage. Means-tested public insurance, such as Medicaid and the State Children’s Health Insurance Program (SCHIP), can also create perverse incentives whereby individuals adjust hours of work and earnings so that family members qualify for coverage. Expanded Medicaid eligibility and SCHIP implementation have also resulted in private insurance “crowd out.” In this case, privately insured low-income workers with dependents eligible for public coverage substitute public for private coverage.
Although the United States has failed to address these problems through comprehensive health insurance reform, public policy has not been entirely passive. Medicaid expansions and SCHIP implementation during the 1990s contributed to a reduction in the number of uninsured children. In 2007, however, President Bush vetoed legislation that had bipartisan support to expand the number of children covered by SCHIP. Moreover, recent policy initiatives stressing voluntary enrollment in private coverage through the use of tax credits, small-group and individual insurance market reforms, and premium subsidies for employers have not reduced the number of uninsured. In response, several states have mandated that individuals obtain private coverage. In addition, outreach efforts have sought to provide information to those eligible but not enrolled in public coverage. It remains to be seen whether public policy can effectively expand coverage and address the problems of moral hazard and adverse selection.
- Cutler, David M. and Richard J. Zeckhauser. 2000. “The Anatomy of Health Insurance.” Pp. 563-644 in Handbook of Health Economics, edited by A. J. Culyer and J. P. Newhouse. Amsterdam: Elsevier.
- Newhouse, Joseph P. 2006. “Reconsidering the Moral Hazard-Risk Avoidance Tradeoff.” Journal of Health Economics 25(5):1005-14.
- Nyman, John A. 2004. “Is Moral Hazard Inefficient? The Policy Implications of a New Theory.” Health Affairs 23(5):317-18.
- Selden, Thomas M. and Bradley M. Gray. 2006. “Tax Subsidies for Employment-Related Health Insurance: Estimates for 2006.” Health Affairs 25(6):1568-79.
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Essay About Insurance
Insurance and Growth
Insurance and economic growth mutually influence each other. As the economy grows, the living standards of people increase. As a consequence, the demand for life insurance increases. As the assets of people and of business enterprises increase in the growth process, the demand for general insurance also increases. In fact, as the economy widens the demand for new types of insurance products emerges. Insurance is no longer confined to product markets; they also cover service industries. It is equally true that growth itself is facilitated by insurance. A well-developed insurance sector promotes economic growth by encouraging risk-taking. Risk is inherent in all economic activities. Without some kind of cover against risk, some of these activities will not be carried out at all.
Also insurance and more particularly life insurance is a source of long term savings and life insurance companies are thus able to support infrastructure projects which require long term funds. There is thus a mutually beneficial interaction between insurance and economic growth. The low income levels of the vast majority of population has been one of the factors inhibiting a faster growth of insurance in India. To some extent this is also compounded by certain attitudes to life. The economy has moved on to a higher growth path. The average rate of growth of the economy in the last three years was 8.1 per cent. This strong growth will bring about significant changes in the insurance industry.
At this point, it is important to note that not all activities can be insured. If that were possible, it would completely negate entrepreneurship. Professor Frank Knight in his celebrated book “Risk Uncertainty and Profit” emphasized that profit is a consequence of uncertainty. He made a distinction between quantifiable risk and non-quantifiable risk. According to him, it is non-quantifiable risk that leads to profit. He wrote “It is a world of change in which we live, and a world of uncertainty. We live only by knowing something about the future; while the problems of life, or of conduct at least, arise from the fact that we know so little. This is as true of business as of other spheres of activity”. The real management challenges are uninsurable risks. In the case of insurable risks, risk is avoided at a cost.
Assessment of Risks
An important function of an insurer is to assess the average level of risk borne while offering a product. This assessment depends upon a variety of factors and actuarial calculations become necessary. This is a highly technical area involving theories of probability. The premium charged by an insurer is based on the calculated average risk. Obviously this premium will be high for people who perceive themselves to be in a low risk category. However, for insurance as an activity to succeed, the population to which a product is offered must consist of categories with different degrees of risk. That is why the larger the coverage, the lower the average risk and lower the premium. Diversification is the way to reduce the average risk.
As in the case of all financial institutions, insurance is an activity that needs to be regulated. This is so because the smooth functioning of business depends on the trust and confidence reposed by the customers in the solvency of the financial institutions. Insurance products are of little value to customers, if they cannot trust the company to keep its promise. The regulatory framework in relation to the insurance companies seeks to take care of three major concerns –
(a) protection of consumers’ interest,
(b) to ensure the financial soundness of the insurance industry, and
(c) to help the healthy growth of the insurance market.
So long as insurance remained the monopoly of the Government, the need for an independent regulatory authority was not felt. However, with the acceptance of the idea that there can be private insurance entities, the need for a regulatory authority becomes paramount. With the passing of the Insurance Development and Regulatory Act in 2000, the insurance regulatory authority has become a statutory authority. Protecting consumer interest involves proper disclosure, keeping prices affordable, some mandatory products and standardization. Most importantly, it has to make sure that consumers get paid by insurers. From the consumers’ point of view, the most important function of the regulatory authority will be to ensure quick settlement of claims without unnecessary litigation. With respect to solvency and financial health, regulations will have to be introduced to ensure that insurance companies follow appropriate prudential norms such as solvency margins. Large funds are under the custody of the insurers and they get invested to produce additional returns. The management of these funds is important to the insurer, the insured and the economy. Entry into the insurance industry must also be regulated with suitable capital adequacy norms. The third role should be one of development. The insurance industry in India has a large potential and the framework of regulation must enable the industry to tap this vast potential.
IRDA over the last decade has brought into force a number of regulations which are well conceived. They have received wide spread appreciation. The recent decision of IRDA to move to a free tariff regime for several general insurance products is welcome. The prescription of tariff is contrary to market principles and insurance products need to be priced based on market forces.
The reform of the insurance sector is part of the overall economic reform process that is underway. The basic philosophy underlying the new economic policy is to improve the productivity and efficiency of the system. This is sought to be achieved partly by creating a more competitive environment. The growth of the real economy depends upon the efficiency of the financial sector. A greater element of competition is being injected into the financial system as well.
All regulators need to keep in mind that there is a fine distinction between regulations and controls. Regulations lay down norms while controls have a propensity to micromanage institutions. Regulators must take care to ensure that regulations do not slide into controls.
The insurance industry in our country underwent a big change in 2000 when private participants were allowed into the industry along with a streamlined regulatory and supervisory regime. There are at present 14 private life insurance companies along with LIC and 12 entities in non-life sector. There is evidence to show that competition has done good to insurance industry. The rate of growth of the industry in the post liberalization period has been faster. It has also developed in terms of product innovation and the use of alternative distribution channels.
The insurance sector has a vast potential not only because incomes are increasing and assets are expanding but also because the volatility in the system is increasing. In a sense, we are living in a more risky world. Trade is becoming increasingly global. Technologies are changing and getting replaced at a faster rate. In this more uncertain world, for which enough evidence is available in the recent period, insurance will have an important role to play in reducing the risk burden individuals and businesses have to bear. In the emerging scenario, the insurance industry must pay attention to
(a) product innovation,
(b) appropriate pricing, and
(c) speedy settlement of claims.
The approach to insurance must be in tune with the changing times.
Insurance should be extended to coverage a larger section of the population and a wider segment of activities. The three guiding principles of the industry must be to charge premium no higher than what is warranted by strict actuarial considerations, to invest the funds for obtaining maximum yield for the policy holders consistent with the safety of capital and to render efficient and prompt service to policy holders. With imaginative corporate planning and an abiding commitment to improved service, the mission of widening the spread of insurance can be achieved.
All about Insurance