Health Insurance Essay

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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.


  1. 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.
  2. Newhouse, Joseph P. 2006. “Reconsidering the Moral Hazard-Risk Avoidance Tradeoff.” Journal of Health Economics 25(5):1005-14.
  3. Nyman, John A. 2004. “Is Moral Hazard Inefficient? The Policy Implications of a New Theory.” Health Affairs 23(5):317-18.
  4. 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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