E&F - lecture 13

Question 1

Free competitive insurance market

Answer 1

Starting point: a free, unregulated competitive health insurance market.
The focus is on affordable individual health insurance, irrespective whether this is in the context of a voluntary or mandatory health insurance.

Question 2

Equivalence principle

Answer 2

A free competitive insurance market will tend towards equivalence between the premium and the expected expenses of the insurer (claims plus loading fee) for each individual contract because competition minimizes predictable profits.
Therefore, insurers cannot organize ex-ante cross-subsidies among different risk groups.

Without any external intervention individual health insurance may be unaffordable for the (low-income) high risks in a competitive insurance market.

Question 3

Risk rating and risk selection

Answer 3

• In a free competitive insurance market insurers have to break even, in expectation, on each contract either by
  1. adjusting the premium to the consumer’s risk (risk-adjusted premiums),or
  2. Adjusting the product (product differentiation),
  3. or by adjusting the accepted risk to the premium (risk selection).
• The premium differences can easily go up to a factor 1000.

Question 4

Selection

Answer 4

Actions (not including risk-rated pricing by insurers) by insurers and consumers to exploit unpriced risk heterogeneity and break pooling arrangements (Newhouse, JEL, 1996)

Question 5

Unpriced risk heterogeneity

Answer 5

a group of people who are in a pool and pay the same premium and can be high and low risks (community rating or risk rating)  pooling of relatively high and low risks. Unpriced means that the premium is not adjusted to risk factors. Cross subsidies from low to high risks.

Question 6

Adverse risk selection

Answer 6

low risks don’t want to pay the same premium as high risks and the low risks leave the pool and high risks stay.

Question 7

2 ways for an insurer to achieve equivalence

Answer 7

premium differentiation or risk rating and selection

Question 8

• Selection by insurers:

Answer 8

– Denial of coverage;
– Exclusion of preexisting medical conditions; when someone has had aids for example and then insurer says they will exclude the consumer for that medication
– Waiting periods;
– No renewal of contract.

Question 9

• Selection by consumers:

Answer 9

– Within each premium risk group the high-risks are more inclined to buy insurance than the low-risks.  adverse risk selection

Question 10

No long term insurance

Answer 10

• In a free competitive market voluntary insurance can offer protection only during the contract period.
• In a free market the premium for an insured who develops AIDS, cancer or heart disease has to be raised in the next contract period. Or the insurer may not renew the contract.
   There is no market for insurance against the risk of becoming a high risk in the future.

Question 11

Without restrictions on free competition:

Answer 11

1. a system of implicit cross-subsidies can not be sustained because unrestricted competition minimizes the predictable profit per contract.
2. individual health insurance may be unaffordable for the (low-income) high risks.
3. there is no market for insurance against the risk of becoming a high risk in the future.

Question 12

Assumption: open enrollment

Answer 12

• We assume that there is an open enrollment requirement for a specified coverage.
• As long as insurers are free in setting their premiums, this assumption is non-restrictive.
• The ‘access’-problem that would occur in case of rejection can be reformulated as an ‘affordability’-problem to be solved by subsidies.

Question 13

Two types of subsidies:

Answer 13

1. explicit premium subsidies;
2. implicit cross-subsidies.

Question 14

Explicit premium subsidies

Answer 14

• Insurers are free to set their premiums;
• A subsidy system is organized by a sponsor (e.g. government) such that high-risk persons with unaffordable premiums receive a subsidy from a Fund that is filled by mandatory contributions.
• High risks pay their premium partly with the subsidy and partly out of pocket.

Question 15

Several types of subsidies

Answer 15

1. Risk-adjusted subsidies;
   * Subsidy related to your risk factors
2. Premium-adjusted subsidies;
   * The higher your premium, the higher the subsidy
3. Excess loss compensations to insurers.
   * Retrospectively after a year the insurer receives certain compensation based on the actual expenses. For instance, for expenses above 10.000 the insurer receives full compensation. So for a person whose predicted expenses is 40.000, the premium is no longer 40.000 but 10.000. these excess loss compensations are an indirect subsidy to the high risks

Question 16

Premium-adjusted subsidies are not optimal:

Answer 16

1. they reduce the incentive for high-risk consumers to shop around for the lowest premium, and thereby reduce the insurers’ incentives for efficiency;
2. They reduce the competitive advantage of the most efficient insurer.
3. they induce over-insurance resulting in additional moral hazard;
4. they create a misallocation of subsidies.

Question 17

Risk-adjusted subsidies

Answer 17

Risk-adjusted premium subsidies can be based on the risk factors X that insurers use, such as age and health status.

If consumers received a risk-adjusted subsidy based on the same risk factors that insurers use, the differences in out-of-pocket-premiums ( premium minus subsidy) would be minimal and would primarily reflect differences in quality, taste, loading fee, or efficiency.

Risk-adjusted subsidies can make health insurance affordable at every new contract period. If the insurer increases a person’s premium as the person’s health status deteriorates over time, the future subsidy value will be adjusted to the change in the individual’s risk characteristics.
 Risk-adjusted subsidies provide protection against the financial risk of becoming a future high-risk.

Question 18

Additional subsidies

Answer 18

To the extent that some high-risk consumers are insufficiently subsidized, the risk-adjusted premium subsidies can be complemented by premium-based subsidies or by excess loss compensations to the insurers (= compensations by the sponsor for some or all expenses above a certain threshold for each individual).
 tradeoff affordability - efficiency.

Question 19

Premium subsidies (Modality A), 2 problems

Answer 19

1. high transaction costs; fund has to know for everyone in the Netherlands what the risk factors are
2. if you get the subsidy before you pay the premium, the insurer is not sure that they will receive that subsidy. People can spend it on something else. If the subsidy is paid after premium is paid, consumer can get a problem. If it is an extreme high premium, they cannot pay it themselves.

Question 20

Risk Equalization

Answer 20

All countries that apply risk-adjusted subsidies give the subsidy to the insurer who deducts it from the premium. In this way the different risks that consumers represent for the insurer are equalized. We refer to this as Risk Equalization.
Two modalities of risk equalization are observed:
* The consumer pays the contribution C directly to the Subsidy Fund (Modality B);
* The consumer pays the contribution C to the Subsidy Fund via the insurer (Modality C).

Question 21

Implicit cross-subsidies

Answer 21

1.Guaranteed renewability (GR);
2. Premium rate restrictions

Question 22

Guaranteed renewability (GR);

Answer 22

after a year you get a new contract, even if you have developed a new disease. Ypu pay the same premium
– GR reduces competition; lock-in of high risks;
– Guaranteed standard premium after 40 years?
– Guaranteed standard coverage after 40 years?

Question 23

Premium rate restrictions

Answer 23

– Community rating;
– A ban on certain rating factors;
– Rate-banding.

Question 24

Premium rate restrictions

Answer 24

• Goal: to create implicit cross-subsidies from the low-risks to the high-risks.
• Effect: such pooling of people with different risks creates substantial predictable profits and losses for subgroups, and thereby
• may create an unlevel playing field for insurers, and
• create incentives for risk selection.

Question 25

Forms of selection (despite open enrollments)

Answer 25

• Design of benefits package: attractive for low risks
• selective contracting,
• selected managed care techniques;
• selective advertising;
• the design of supplementary health insurance;
• internet health plans,
• software to distinguish high- and low-risk applicants during phone-calls;
• Bonusses for risk-selecting insurance agents;

Question 26

Effects of selection

Answer 26

• Disincentive for insurers to be responsive to the high-risk consumers and to contract the best quality care for them;
• Contract 90% of the providers, but not those who are most preferred by the people who are ill
• Disincentive for providers to acquire the best reputation for treating chronic diseases;
• Because then they would not be contracted
• Selection more profitable than efficiency;
• High premiums for high-risk patients;
• Instability in the insurance market.

Question 27

How can we prevent selection?

Answer 27

• Risk equalization;
• Less severe premium rate restrictions:
   tradeoff selection - affordability;
• Excess loss compensations to insurers (‘risk sharing between the sponsor and the insurers’):
   tradeoff selection - efficiency.

Question 28

The preferred strategy: Risk-adjusted subsidies or risk equalization is the preferred strategy because:

Answer 28

Ø The better the risk equalization is, the less severe is the resulting tradeoff.
Ø In the (theoretical) case of perfect risk equalization there is no need for any other strategy and the tradeoff no longer exists.
Ø Each of the other strategies alone inevitably confronts policymakers with a tradeoff.

Question 29

Acceptable costs

Answer 29

Ideally: only medically necessary and cost-effective care.
Because the cost level of such a benefits package is hard to determine, in practice equalization payments are based on observed expenses rather than needs-based costs.
Observed expenses: For which risk factors should the equalization payment be adjusted?

Question 30

S-type and N-type risk factors

Answer 30

Assume that the full set of risk factors that predict variations in health spending across individuals can be divided into two subsets:
1. Those factors for which solidarity is desired, the S-type risk factors;
2. And those factors for which solidarity is not desired, the N-type risk factors.

Question 31

Criteria for equalization-models

Answer 31

Appropriateness of incentives:
Fairness
Feasibility.

Question 32

Appropriateness of incentives:

Answer 32

– No incentives for risk selection;
– Incentives for efficiency;
– Incentives for health-improving activities;
– No incentives to distort RA-information;

Question 33

Fairness

Answer 33

– No compensation for N-type risk factors;
– No compensation for risk factors which reflect underutilization;
– Predictive value.

Question 34

The goal of risk equalization

Answer 34

If efficiency plays a role, a comprehensive analysis of the total effect of risk equalization on efficiency needs to be done. An improvement of the performance of a risk equalization scheme has both negative and positive effects on efficiency.
Negative effects include the reduction in efficiency via cost- or utilization-based risk adjusters.
Positive effects result from leveling the playing field and reducing the incentives for risk selection, which increase efficiency as the outcome of a competitive market.
In practice many regulators and policy makers take efficiency into consideration by looking at the negative effects, but hardly at the positive effects.

Question 35

Effects of risk equalization on efficiency

Answer 35

Risk equalization will increase efficiency because, e.g., :
1. insurers will be less focused on selection activities and more focused on efficiency;
2. quality skimping will be reduced which, keeping costs equal, improves efficiency;
3. the premium competition on the health insurance market will increase the insurers’ incentives for efficiency because the premiums are less selection-driven and more efficiency-driven;
4. selection-driven product differentiation will be reduced which increases transparency on the health insurance market and thereby facilitates a value-for-money consumer choice of health insurance;
5. the probability of bankruptcies of (efficient) insurers resulting from adverse selection will be reduced; and
6. wasteful resources spent on selection activities will be reduced.

Question 36

Potential explanations of why selection may not be a major issue in the early stage of the implementation of risk equalization

Answer 36

1. In the early stage many parties are unfamiliar with the new rules. Over time they become better informed, and react to incentives.
2. In the early stage the differences among insurers with respect to benefits package, premiums and contracted providers are restricted; over time, as competition increases, they increase.
3. The risk equalization has often been implemented in the social health insurance. Traditionally these (nonprofit) insurers were driven by social motives rather than financial incentives. Over time the increasing competition makes the market more incentive driven.
4. One may argue that selection is not so much a problem because of medical ethics. However, ethics may change over time as the health system becomes more competitive.

Question 37

Lessons 25 years of experience

Answer 37

• Implementation of risk equalization appears to be complex in practice. No easy solution.
• Lack of data at individual level;
• Lack of data for health adjustment;
• Appropriate incentives: often no priority;
• The loading fee should be included in the risk equalization.
• Opposition by insurers with a good risk profile;
• Even the simplest risk equalization mechanisms is complex.
• Without good risk equalization there are incentives for risk selection, and the disadvantages of risk selection can be quite substantial;
• Without good risk equalization the disadvantages of a competitive market may outweigh its advantages.
• Policy makers should have a good understanding of risk equalization.