Review of the Last Lecture

1. Review of the Last Lecture • began our discussion of why there is a demand for health insurance • basic reason => people are risk averse (declining marginal utility of wealth) • showed that if people are risk averse there is a utility gain (vis-à-vis self insurance) if insurance can be purchased at the actuarially fair premium • today show how the utility gain from insurance (and thus the demand for insurance) depends on: the degree of risk aversion (curvature of the utility function), the load factor, the size of q and L • then begin our discussion of the case for public rather than privare health insurance

2. Utility Gain From Health Insurance • utility gain from health insurance is the difference between the utility from (wealth - insurance premium), and the expected utility in the absence of insurance (SEE DIAGRAM) • without insurance the combination of expected utility and expected wealth lies on the straight line joining the two extreme outcomes without insurance (wealth and utility if ill and not ill), since the same weights are used in computing expected wealth and expected utility [q and (1-q)]. • the utility gain depends on the degree of risk aversion (the rate at which MU of wealth declines as wealth rises (SEE DIAGRAM) • if no risk aversion [MU(W) constant], no gain from insurance (see diagram)

3. Utility Gain When the Insurance Premium > Expected Loss • can’t purchase insurance at a premium = expected loss (qL) • insurer needs to charge more than the expected loss to cover the cost of running the business and to earn a return on investment. This extra amount is caller the load factor. • insurance premium = expected loss + load factor • Thus wealth with insurance is (W0 – premium) < (W0 – qL) • with the load factor included in the premium ~> utility associated with insurance  since W  • load factor reduces potential gain from insurance (see diagram)

4. q, L and the Utility Gain from Health Insurance • holding the expected loss, qL, constant the gain from insurance rises as q  and L . (see diagram) • if q1 < q2 and L1 > L2 and q1L1 = q2L2 ~> utility gain from insuring against large loss with a low probability is greater than the utility gain from insuring against a small loss with a high probability (provided the expected losses are the same).

5. Why Insurance First for Hospital Care, Then for Physician Care, Then Dental Care? • Utility gain largest from insuring hospital costs, smallest from insuring for dental costs • Two Reasons: - size of q and L for each type of loss • - size of load factor for each type of insurance • hospital costs ~> small q and large L, AND small load factor (why?) • Physician costs ~> larger q and smaller L, AND larger load factor • dental costs ~> largest q and smallest L, AND large load factor

6. Why Is There a Demand for Dental Insurance? • with large q, relatively small L, and large load factor ~> utility gain from dental insurance may well be negative (see diagram) • why opt for dental insurance if the utility gain is negative? • Reason ~> tax advantage => dental insurance often a tax free employment fringe benefit • suppose your expected dental costs are $500/yr, dental premium is $600/yr ~> likely won’t buy dental insurance (self insure) • now suppose employer offers a raise of $600/yr or free dental insurance ~> after tax raise  $400, tax free dental plan frees up $500 on average and removes some risk ~> choose dental plan.

7. Prescription Drug Insurance • for most people L quite small, q quite large, large load factor to process many small claims => high premium relative to expected loss • potential utility gain from insuring prescription drugs: low or -ve • however, some people are hit by large prescription drug costs • design a Pharmacare plan with a large deductible to keep the load factor down (keep premium close to expected loss) and protect against large losses

8. Losses Covered by Health Insurance • what is included in L? • in theory L includes cost of HC, lost income, pain and suffering • in practice can’t insure for all aspects of a loss~> 2 reasons • not feasible: no observable $ price for some aspects of the loss, e.g., pain and suffering; also Moral Hazard (size and probability of a loss  if insured) • not optimal: if many small claims ~> large load factor ~> can wipe out gain from insuring.

9. V.2(b) Why Public Universal Health Insurance in Canada? • by early 1960’s health insurance in Canada: - private - major losses (hospital/medical costs) - high deductible (control load factor) - co-insurance (reduce moral hazard) - optional

10. Hall Commission, 1964 • Hall Commission (Royal Commission on Health Services, 1964, Chaired by Justice Emmet Hall) recommended: - public health insurance, - no deductible, - no coinsurance - universal coverage. • Why so different from what we had?

11. Why Public Universal Health Insurance? Reason =>Market Failure. • what is market failure in the health insurance market (not the same as market failure in HC market)  individuals are able and willing to pay a fair premium (expected loss plus reasonable load factor) but insurance coverage not offered at such a premium. • four sources of market failure in private health insurance market: - decreasing admin costs as # subscribers  - pre-existing conditions - adverse selection - moral hazard • will discuss each one and why it causes failure in the private health insurance market