What is health insurance (good) for

Robert D. Lieberthal

What Is Health
Insurance
(Good) For?
An Examination of Who Gets It, Who
Pays for It, and How to Improve It


What Is Health Insurance (Good) For?


Robert D. Lieberthal

What Is Health Insurance
(Good) For?
An Examination of Who Gets It, Who Pays
for It, and How to Improve It

123


Robert D. Lieberthal
Department of Public Health
College of Education, Health, and Human
Sciences, University of Tennessee
Knoxville, TN, USA

ISBN 978-3-319-43795-8
DOI 10.1007/978-3-319-43796-5

ISBN 978-3-319-43796-5

(eBook)

Library of Congress Control Number: 2016947399
© Springer International Publishing Switzerland 2016
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This book is dedicated to Thomas Jefferson
University, which gave me the time, space,
and resources I needed to complete this work.


Acknowledgments

I could only have written this book with an incredible amount of help from many
supportive people and institutions in my life. My family provided me with an
incredible amount of encouragement and faith, and was extremely patient in listening to me talk about health insurance, and this book, at great length. They also
taught me how to survive, and to thrive, in an academic environment, and provided
me with a great deal of my fine education.
This book is in many ways the capstone and extension of my doctoral program
and dissertation work. I received amazing training at the University of Pennsylvania,
principally at Wharton. I appreciate the resources the university devoted to my
training. Especially important were the guidance of my advisor and dissertation
chair, Mark Pauly, along with my dissertation committee, Scott Harrington, Greg
Nini, and Jessica Wachter, as well as Joanne Levy, the “den mother” for all the
doctoral students. I also want to thank the Agency for Healthcare Research and
Quality (AHRQ) for funding through a T32 training grant (5-T32-HS000009) and
R36 dissertation grant (1-R36-HS018835-01).
Several colleagues also provided support in the development and writing of this
book. Juan Leon provided feedback on the idea and a number of early drafts. Rob
Field reviewed my proposal as well as sharing his experience with publishing
academic books. Richard Derrig, Cassandra Cole, and Sandy Barth all provided
excellent feedback on my proposal. Mohammadreza Hojat connected me with
Springer and helped me learn how to work with them. The staff at Springer
including Janet Kim and Christina Tuballes helped to shepherd my book through
the proposal, contract, and publication process. The administration at Jefferson,
including David Nash, Caroline Golab, and David Glatter, helped me develop the
book from an idea to a reality, understand how to fit it into my busy academic
schedule, and how to negotiate with the publisher for the best deal I could get.
A number of books on writing and academic life were particularly useful.
While I never met any of the authors, they all helped me immensely. Paul Silvia’s
“How to write a lot” and William Germano’s “Getting it published” helped me get
the book written and published. Robert Boice’s “Advice for new faculty members”

vii


viii

Acknowledgments

facilitated my gradual approach to the book, which I wrote in “brief repeated
sessions” as he suggested. C. Wright Mills’ “The sociological imagination” showed
me how to take a social science approach to writing a book, layering each successive piece of the manuscript one on top of the other until, somehow, it was
suddenly done.
Special praise is due to three special people who helped me “get it done.” Jen
Wilson, the scientific editor at Jefferson helped me at every stage along the way,
editing the proposal as well as every chapter of the book. I, and the book, benefitted
from her editorial perspective and ability to gently deliver constructive criticism
along the way. Two of my friends, Bill and Victoria, were also important in
encouraging me to finish, reading me the “riot act” as needed. If not for them, I
would probably still be writing Chap. 2 again, and again, and again. Instead, the
book is complete, and I am glad for it. Finally, while others deserve credit for helping
me, all errors and omissions are my sole responsibility as the author. I will maintain a
list of updates and corrections at my personal website, www.lieberthal.us.


Contents

Part I

The Importance of Health Insurance

1 Defining Health Insurance . . . . . . . . . . . . . . . . . . . . . . . . .

1.1 Healthcare Finance . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1.1.1 Defining Healthcare Finance . . . . . . . . . . . . . . .
1.1.2 Demand and Supply of Healthcare Finance. . . .
1.1.3 The Subjectivity of Healthcare Finance . . . . . . .
1.1.4 Alternative Forms of Healthcare Finance . . . . .
1.2 The Growth of Health Insurance . . . . . . . . . . . . . . . . .
1.2.1 Diverse Beginnings of Health Insurance . . . . . .
1.2.2 Policy and the Growth of Health Insurance. . . .
1.2.3 Professionalizing Health Insurance . . . . . . . . . .
1.3 The Health Insurance Literatures . . . . . . . . . . . . . . . . .
1.3.1 Health Insurance Policy . . . . . . . . . . . . . . . . . .
1.3.2 Health Economics . . . . . . . . . . . . . . . . . . . . . . .
1.3.3 Risk Management and Insurance . . . . . . . . . . . .
1.3.4 Health Services Research . . . . . . . . . . . . . . . . .
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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3
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2 Insuring Health Capital . . . . . . . . . . . . . . . . . . .
2.1 The Economic Value of Health . . . . . . . . . .
2.1.1 Consuming and Investing in Health .
2.1.2 Health Investments . . . . . . . . . . . . . .
2.1.3 The Health Capital Model . . . . . . . . .
2.2 Risk Aversion and Health Risks . . . . . . . . . .
2.2.1 Changes in Health Capital. . . . . . . . .
2.2.2 Valuing Health Capital . . . . . . . . . . .
2.2.3 Health Risk Aversion . . . . . . . . . . . .
2.2.4 Health Insurance Choices . . . . . . . . .

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ix


x

Contents

2.3 Financial Intermediation of Healthcare Spending .
2.3.1 Insuring Health Indirectly . . . . . . . . . . . . .
2.3.2 Monetizing the Value of Health . . . . . . . .
2.3.3 Challenges in Monetizing Health Capital .
2.3.4 Health Insurance Pricing . . . . . . . . . . . . . .
2.3.5 Scale and Scope in Third-Party Payment .
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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44
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3 The Scope of Health Insurance . . . . . . . . . . . . . . . . .
3.1 Measuring the Degree of Protection . . . . . . . . . . .
3.1.1 Defining Quantity . . . . . . . . . . . . . . . . . . .
3.1.2 Measuring Quality. . . . . . . . . . . . . . . . . . .
3.1.3 Determining Prices . . . . . . . . . . . . . . . . . .
3.2 Optimizing Health Insurance . . . . . . . . . . . . . . . .
3.2.1 Health Insurance Trade-offs . . . . . . . . . . .
3.2.2 Optimal Health Insurance as a Benchmark
3.2.3 Determining the Optimal Policy . . . . . . . .
3.3 Constraints on the Scope of Insurance . . . . . . . . .
3.3.1 Insurer Constraints . . . . . . . . . . . . . . . . . .
3.3.2 Asymmetry of Information . . . . . . . . . . . .
3.3.3 Moral Hazard . . . . . . . . . . . . . . . . . . . . . .
3.3.4 Adverse Selection . . . . . . . . . . . . . . . . . . .
3.3.5 Other Economic Externalities . . . . . . . . . .
3.3.6 Irrationality of Consumers and Producers .
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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4 Demand for Health Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . .
4.1 Health Insurance Demand Functions. . . . . . . . . . . . . . . . . . . .
4.1.1 The Demand Side of Markets . . . . . . . . . . . . . . . . . . .
4.1.2 Demand as a Function of Price . . . . . . . . . . . . . . . . . .
4.1.3 Constrained Willingness to Pay . . . . . . . . . . . . . . . . . .
4.1.4 Diminishing Marginal Benefit of Health Insurance . . .
4.1.5 Different Types of Demand Functions . . . . . . . . . . . . .
4.2 Individual Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
4.2.1 Direct Purchase of Insurance . . . . . . . . . . . . . . . . . . . .
4.2.2 Explaining Individual Demand . . . . . . . . . . . . . . . . . .
4.2.3 The Services Individuals Purchase . . . . . . . . . . . . . . .
4.3 Group Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
4.3.1 Employer-Provided Coverage . . . . . . . . . . . . . . . . . . .
4.3.2 Explaining Employer-Provided Coverage . . . . . . . . . .
4.3.3 Social Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
4.3.4 Explaining Social Insurance . . . . . . . . . . . . . . . . . . . .
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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87
87
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113

Part II

Health Insurance Markets


Contents

xi

5 Producing Health Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5.1 Health Insurance Supply Functions . . . . . . . . . . . . . . . . . . . . .
5.1.1 The Supply Side of Markets . . . . . . . . . . . . . . . . . . . .
5.1.2 Supply as a Function of Price . . . . . . . . . . . . . . . . . . .
5.1.3 Production of Health Insurance . . . . . . . . . . . . . . . . . .
5.1.4 Bundling Versus Disintermediation . . . . . . . . . . . . . . .
5.2 Health Insurance Companies. . . . . . . . . . . . . . . . . . . . . . . . . .
5.2.1 Organizational Forms . . . . . . . . . . . . . . . . . . . . . . . . .
5.2.2 Markets for Health Insurance Companies . . . . . . . . . .
5.2.3 Diversity of Health Insurance Companies . . . . . . . . . .
5.2.4 Competition and Partnerships . . . . . . . . . . . . . . . . . . .
5.3 Healthcare Providers as Insurers . . . . . . . . . . . . . . . . . . . . . . .
5.3.1 Providers’ Provision of Financial Intermediation . . . . .
5.3.2 Direct Contracting Versus Third-Party Payment . . . . .
5.3.3 Features and Drawbacks of Provider-Supplied
Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5.4 Employers and Governments . . . . . . . . . . . . . . . . . . . . . . . . .
5.4.1 Health Insurance as an Instrumental Good . . . . . . . . .
5.4.2 Self-insurance by Governments and Employers . . . . .
5.4.3 Features and Drawbacks of Self-insurance . . . . . . . . .
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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6 Matching Supply and Demand . . . . . . . . . . . . . . . . . .
6.1 Equilibrium Health Insurance . . . . . . . . . . . . . . . .
6.1.1 Economics of Equilibrium . . . . . . . . . . . . .
6.1.2 Optimality Under Equilibrium . . . . . . . . . .
6.1.3 Health Insurance Subsidies and Taxes. . . .
6.2 Health Insurance Choices . . . . . . . . . . . . . . . . . . .
6.2.1 Individual Choices . . . . . . . . . . . . . . . . . .
6.2.2 Employer Choices . . . . . . . . . . . . . . . . . . .
6.2.3 Government Choices . . . . . . . . . . . . . . . . .

6.3 The Uninsured . . . . . . . . . . . . . . . . . . . . . . . . . . .
6.3.1 Defining the Uninsured . . . . . . . . . . . . . . .
6.3.2 Explaining the Uninsured . . . . . . . . . . . . .
6.3.3 Alternatives to Health Insurance . . . . . . . .
6.3.4 Consequences of Uninsurance . . . . . . . . . .
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Part III

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175
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177

Health Insurance Policy

7 Group Purchasing . . . . . . . . . . . . . . . . . . . . . . . . . . . .
7.1 Group Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . .
7.1.1 Actuarially Fair Group Insurance . . . . . . .
7.1.2 The Role of Community Rating . . . . . . . .
7.1.3 Taxation and Regulation Considerations . .


xii

Contents

7.2 Outsourcing Versus Insourcing Decisions . . . . . . . . . . .

7.2.1 Provider-Based Insourcing . . . . . . . . . . . . . . . .
7.2.2 Employers and Outsourcing . . . . . . . . . . . . . . .
7.2.3 Governments, Outsourcing, and Insourcing . . . .
7.2.4 Healthcare Reimbursement as a Public Good . .
7.3 Growth in Public Group Insurance . . . . . . . . . . . . . . . .
7.3.1 New Public Programs—Pre-ACA . . . . . . . . . . .
7.3.2 Non Policy-Based Shifts to Public Insurance . .
7.3.3 New Public Programs—The ACA. . . . . . . . . . .
7.3.4 Public Group Insurance Internationally . . . . . . .
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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8 The Role of Government . . . . . . . . . . . . . . . . . . . . . . . . . .
8.1 Second-Best Health Insurance . . . . . . . . . . . . . . . . . . .
8.1.1 Beneficent Social Planner . . . . . . . . . . . . . . . . .
8.1.2 Feasibility and Second-Best Solutions . . . . . . . .
8.1.3 Addressing Market Failures . . . . . . . . . . . . . . . .
8.2 Features and Limitations of Public Policy . . . . . . . . . .
8.2.1 Policy and Regulatory Tools . . . . . . . . . . . . . . .
8.2.2 Measuring Crowd Out and Deadweight Loss . .
8.3 Health Insurance Policy Options . . . . . . . . . . . . . . . . . .
8.3.1 Universal Coverage . . . . . . . . . . . . . . . . . . . . . .
8.3.2 Single Payer Approaches. . . . . . . . . . . . . . . . . .
8.3.3 A Range of Policy Options . . . . . . . . . . . . . . . .
8.4 The Meaning of Public Health Insurance . . . . . . . . . . .
8.4.1 Federal Group Purchasing . . . . . . . . . . . . . . . . .
8.4.2 Diversity and Homogenization . . . . . . . . . . . . .
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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9 Public Policy Choices . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
9.1 The Economics of Value . . . . . . . . . . . . . . . . . . . . . . .
9.1.1 Defining Value . . . . . . . . . . . . . . . . . . . . . . . . .
9.1.2 Variation in the Value of Health Insurance . . . .
9.1.3 Improving Value . . . . . . . . . . . . . . . . . . . . . . . .
9.2 Expansion and Reduction . . . . . . . . . . . . . . . . . . . . . . .
9.2.1 Defining Expansion and Reduction . . . . . . . . . .
9.2.2 Value Through Expansion and Reduction . . . . .
9.3 Ongoing Health Insurance Challenges . . . . . . . . . . . . .
9.3.1 Analytic Challenges . . . . . . . . . . . . . . . . . . . . .
9.3.2 The Limits of Health Insurance . . . . . . . . . . . . .
9.3.3 Public Choices . . . . . . . . . . . . . . . . . . . . . . . . .

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Contents

9.4 The Future of Health Insurance . . . . . .
9.4.1 The Risk Management Menu . .
9.4.2 Health Insurance as an Entrée . .
9.4.3 Unpicked Fruit . . . . . . . . . . . . .
9.4.4 Better Meals, Better Lives . . . . .
References . . . . . . . . . . . . . . . . . . . . . . . . . . .

xiii

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Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263

Part I

The Importance of Health Insurance


Chapter 1

Defining Health Insurance

1.1
1.1.1

Healthcare Finance
Defining Healthcare Finance

Health insurance has become central to American life. Healthcare is an enormous
industry in the United States, comprising nearly 20 % of the economy. Most of the
payments for healthcare services flow through a health insurer, meaning that health
insurers manage trillions of dollars in funds for healthcare spending (Keehan et al.
2015). Health insurance is also a major part of the U.S. political system, rating as a
top issue in elections by voters across the political spectrum (Newport 2016). In
addition, health insurance has an intensely personal aspect given the highly personal nature of health. Health insurers that deny payment for treatments are derided
as “greedy” (Moynihan 2009). Conversely, many health insurers advertise the
benefits of their products, which allow people to “live fearlessly” in the words of
one major health insurer (McClung 2014).
Despite the role that health insurance plays in the economy, the healthcare
system and the political system, it is also a deeply misunderstood product. At its
core, health insurance is a “pass-through” entity akin to a gas station. Just as most
people rely on a gas station to store gas and then sell it to them on demand, most
people may relate to health insurance as a card in their wallet to be used any time

they have a demand (or need) for healthcare. Health insurance is also related to
healthcare in the same way that a mortgage is related to a person’s house—people
derive satisfaction from living in their house, not paying the mortgage. In the same
way, people derive satisfaction from being healthy, not paying their health insurance premiums. And yet, health insurance allows people to afford the cost of
treatments they could never pay for on their own, just as mortgages allow people to
live in houses they could never afford to pay for all at once.
The easiest way to define health insurance is to look at the health insurance plans
that individuals use to pay for care. For example, many people in the United States
© Springer International Publishing Switzerland 2016
R.D. Lieberthal, What Is Health Insurance (Good) For?,
DOI 10.1007/978-3-319-43796-5_1

3


4

1 Defining Health Insurance

receive health insurance through their employer, or through a spouse’s or parent’s
employer. In 2011, more than half (55.1 %) of individuals were covered by private,
employer-provided health insurance, making employer-provided health insurance
the most common source of health insurance coverage in the country
(DeNavas-Walt et al. 2012). Others receive coverage from public (government-run)
social insurance programs such as Medicare and Medicaid. “In 2013, Medicare
covered 52.3 million people: 43.5 million aged 65 and older, and 8.8 million
disabled” (The Boards of Trustees, Federal Hospital Insurance and Federal
Supplementary Medical Insurance Trust Funds 2014). “Medicaid provided health
care assistance for an estimated 58.9 million people on average in 2013. An estimated total of 72.5 million people, or about one of every five persons in the U.S.,
were enrolled in Medicaid for at least one month in 2013” (CMS Office of the

Actuary 2014).1 There is also a third group of people who purchase insurance
directly from a private health insurance company on the “nongroup” market.
Use of the terms “public” versus “private” health insurance to distinguish
between types of health insurance can be useful but also misleading. Insurance
provided by a government program is considered “public” in the same way that
government-run schools are “public schools.” Conversely, insurance purchased
from a private health insurance company and employer-provided insurance are
considered forms of “private” health insurance. This distinguishes the household
and employers’ purchase of health insurance from the public (governmental) purchase. Under this definition of health insurance, private sources accounted for
63.9 % of coverage for those with insurance, and public plans cover the other
36.1 % of the insured population (DeNavas-Walt et al. 2012). This taxonomy can
also be misleading because there are several forms of governmental subsidy of, and
intervention in, “private” health insurance. Conversely, many “public” health
insurance programs are administered by private health insurance companies or
healthcare providers (e.g., physicians and hospitals).
Examination of health insurance as a form of healthcare financing often focuses
on the flow of funds through health insurers. For example, employer-provided
health insurance is considered important in large part because of the scale of
employer-provided health insurance. Health insurance is often the most costly part
of an employer’s labor cost next to salaries (cash wages). As a result, employers
face a trade-off between the employees’ demand for health insurance benefits, the
demand for other forms of cash and noncash compensation, and the desired profit
level or cost of services provided. Different types of employers may choose to
devote different amounts to health insurance. For example, health benefits were on
average 8 % of the cost of employee compensation for private employers and 12 %
1

Note that these numbers do not include children enrolled in the Children’s Health Insurance
Program (CHIP) for children in households with income above Medicaid eligibility levels. In
addition, many individuals are eligible for both Medicare and Medicaid, so-called “dual eligible”

individuals. Finally, the count of Medicaid enrollees is an average because of the fact that individuals can obtain Medicaid coverage and then lose such coverage due to failure to re-enroll or
lose of eligibility.


1.1 Healthcare Finance

5

of the cost of employee compensation for state and local governments on average as
of September of 2015 (Bureau of Labor Statistics 2015).
When public health insurance is examined as a form of healthcare financing, the
focus also turns to the flow of funds through government budgets. Government at
all levels has a large demand for health insurance, with plans that include Medicare
and Medicaid, as well as coverage for current members of the military, their
families, and veterans’ coverage. The cost of health insurance makes the cost of
these programs a major public policy concern. Health insurance is one of the top
three highest costing programs for many governments at the federal, state, and local
level. For example, 24 % of the federal government budget is spent on Medicare,
Medicaid, the Children’s Health Insurance Program (CHIP), and Affordable Care
Act health insurance exchange (marketplace) subsidies (The Center on Budget and
Policy Priorities 2015). This proportion of government spending equals the amount
spent on Social Security and yet still does not include the amounts spent on government benefits paid to employees of the government. In this sense, federal
financial policy is in many ways a debate about federal health insurance policy.
Examining the cost of employer and government-provided insurance is complicated because both groups act as consumers and producers of health insurance
services. Both employers and the government purchase health insurance services.
Since many employers and governments are also suppliers of health insurance, they
could be considered as health insurers. For example, many employers run
“self-insured” health plans where the employer is responsible for risk management,
while a health insurance company is responsible for administration (third-party
payment). Similarly, federal and state governments often choose to contract out

(outsource) some or all health insurance functions to health insurance companies
while providing other health insurance services directly. For example, the federal
government is “at risk” under the “traditional” Medicare program—it is responsible
for the cost of healthcare rather than passing on the risk to a insurance company,2
however, it outsources the management of Medicare payments to large health
insurance companies that act as servicers for the Medicare program.
This book explores the tension caused by the trade-off between control,
responsibility, and efficiency when a third party finances healthcare costs such as
when individuals have the majority of their healthcare paid for by a health insurer.
Employers, governments, health insurance companies, and healthcare providers are
constantly exposed to this tension because risk is shared, and managed, by these
different entities. Taking on risk management or third-party payment creates tension
by giving an organization more control over healthcare payments in order to take on
more risk. Conversely, outsourcing a health insurance service reduces risk, but it
lessens control. Splitting up responsibility for healthcare finance among a number
of insurers may increase efficiency through gains to specialization or reduce

“Traditional Medicare” is the program as it was originally conceived. Many Medicare beneficiaries are now enrolled in managed care plans run by private insurance companies (“Medicare
Advantage” plans) where the health insurance company is “at risk” for individuals’ cost of care.

2


6

1 Defining Health Insurance

efficiency since outsourcing requires some oversight function. One of the main
purposes of this book is to highlight these trade-offs, and facilitate better choices
that can improve health insurance functioning.

1.1.2

Demand and Supply of Healthcare Finance

From a flow of funds perspective, health insurance is currently the “third-party
payer” for the majority of healthcare in the United States. In 2013, 12 % of payments for healthcare were considered “out-of-pocket”, meaning they came directly
from a consumer and went directly to a provider, according to the Centers for
Medicare and Medicaid Services (CMS). The remaining 88 % was paid by a third
party (i.e., by a source other than the individual treated or by someone in his or her
household). In addition, the share of out-of-pocket payments is projected to shrink
slightly to 10.0 % in 2024 (CMS). The importance of health insurance is not limited
to the United States: most other developed countries also use a form of national
health insurance or a national health system to pay for the majority of care: “The 25
wealthiest nations all now have some form of universal coverage (apart from the
USA, where political opposition remains strong, despite a recent supportive
Supreme Court decision)” (Rodin and de Ferranti 2012).3
Measuring healthcare finance through out-of-pocket payment is important
because it touches upon one of the rationales that may motivate people to obtain
health insurance, which is to reduce or eliminate the financial burden that is
associated with healthcare costs. In this sense, health insurance is said to be an
“indirectly demanded” good. In other words, most people do not place an intrinsic
value on health insurance, but rather value it in the instrumental sense that it frees
up financial resources to spend on other consumption and allows them to manage
the risk associated with large healthcare bills. Most people could never afford costly
surgeries or cancer treatments, and many people are unable to pay the out-of-pocket
costs for many brand name drugs. Indirect demand does not mean that there is
anything “inferior” about health insurance. The observation is, in fact, true for
healthcare itself—people do not directly demand healthcare, but rather health, and
healthcare is simply a means to an end (Grossman 1972).

Health insurance is also important from the point of view of providers and
individuals because most healthcare providers and facilities accept health insurance
for the payment of healthcare costs. It is difficult to generalize about an industry as
diverse as healthcare, which can range from single physician practices to large,
integrated health systems. The fact that 88 % of payments for healthcare are from
third-party payment sources shows the ubiquity of healthcare insurance-financed
3

The international perspective, while important, is not the focus of this book. While this book will
consider health insurance in countries outside the U.S., it will focus on the U.S. health insurance
system. It serves to highlight the types of health insurance arrangements that may be useful for the
U.S. to consider, such as in Chap. 7.


1.1 Healthcare Finance

7

care at the macroeconomic level. In addition, the increasing intensity and sophistication of medical technology increases the amount of the economy devoted to
healthcare and may increase the demand for health insurance to pay for higher cost
technologies. Weisbrod (1991), highlighted this phenomenon in a seminal study:
“One mechanism through which technological change could foster increased
expenditures on health care would be through its effect on the health care insurance
system” (Weisbrod 1991).
However, there is substantial heterogeneity at the microeconomic level in terms
of whether a particular individual will be able to gain access to a specific provider
or a specific healthcare service or to obtain such services at a particular level of
quality. These questions about the “narrowness” of provider networks and the
“quality” of health plans are crucial to disentangling the potential effects of health
insurance on health. Answering these questions is a major emphasis of “health

services research (HSR),” which is explored further in this chapter. It is also a
somewhat intangible feature of health insurance that is important when group
purchasers consider the characteristics of different health insurance plans and
trade-offs among such characteristics in Chap. 7. For now, it suffices to point out
that in the United States, health insurance is not a homogeneous service but rather a
class of services that are provided to different groups of people by different
organizations.
Health insurance provides a major service in terms of “risk management” for
health related risks by virtue of the fact that it is a third-party payer. Risk and risk
management will be the subject of Chap. 2. A good way to summarize the risk
management function of health insurance is to consider the fact that third-party
payment can be the basis for risk management, but third-party payment alone is not
a sufficient condition for saying that a health insurer delivers risk management. To
take an extreme example, a health insurer that pays all, or many, of the claims
related to an unforeseeable injury, such as falling down a flight of stairs, is also
providing risk management. Conversely, there are other instances in which
third-party payment does not result in any risk management. For example, if a
health insurer pooled people’s money to pay for an annual wellness visit and
negotiated the price for such visits with a group of providers, there would be no risk
management services at all. The insurer would simply be responsible for collecting
the money, disbursing it as a third-party payer, and negotiating a favorable rate with
providers. There is no risk involved if everyone is getting an annual wellness visit.
The only “financing” element would be indirect payment of the third-party intermediating between the patient receiving the wellness visit and the physician paid to
provide it.
This book explores health insurance as generally situated between these two
extreme examples. Many forms of healthcare are risky because the probability that
they occur is neither zero nor one. In addition, many forms of healthcare spending
relate to healthcare risks that are partly within a person’s control. In other words,
healthcare spending is often related to conditions where individual behavior can
mitigate, if not eliminate, the risk, such as diabetes. It is also possible in theory for a

health insurer to provide risk management without any third-party payment—an


8

1 Defining Health Insurance

organization could calculate the risks a person is subject to, calculate the expected
healthcare costs, and direct that person about how best to protect themselves against
those risks through a combination of prevention, precautionary savings, and
insurance. Such advisory roles are more common in other types of financial services
than in healthcare; most health risks management is bundled with some kind of
third-party payment system. We will investigate why this might be by next
examining the subjectivity of healthcare finance.

1.1.3

The Subjectivity of Healthcare Finance

Health insurance is distinguished from other lines of insurance because it covers
health capital. Health capital is an economic way of viewing health as a valuable
asset that people possess. Health insurance covers health capital in the sense that
health insurance payouts are based on a person’s health state. A person who suffers
an injury or illness, or who is in poor health, receives benefits from a health insurer
based on his or her state of health. As a result, “writing” health insurance involves
answering questions such as, “What is a human life worth?” (also known as the
“value of life” literature) and “What is the value of returning an individual to full
health?”4 These questions may seem philosophical while insurance is a more
objective financial product. Indeed, traditional models of insurance are financial
because they conceive the effects of insurance as using money to make individuals

whole for the risks that they face. Insurance is based on “monetizing” the value of
losses suffered by individuals, so health insurance is based on putting a dollar value
on a person’s health, as well as on any health losses or gains he or she experiences.
The challenge in writing health insurance is that the value of health capital is
highly subjective and personal. The use and origin of the term “health capital” is
itself at the core of the economics of health insurance, and is the subject of Chap. 2
of this book. It is certainly a common sense notion that the value of human life is
subjective. However, the subjectivity of value is not a strict impediment to economic analysis—for example, two different people may place different values on an
item such as a diamond ring. The reason that the subjectivity of health capital is
challenging for economic analysis is that there is no market for human life. Health
cannot be bought and sold like other products such as a diamond ring. As a result,
economists and insurers cannot use the “market value” or “replacement value” of
human life to price insurance the way other lines of insurance do.
From a policy point of view, it is also the case that the United States has a
particularly individualistic set of policies with respect to health insurance. In most
other developed countries, health insurance is universal, compulsory, or provided to

“Writing” insurance refers to the process of assessing risk, creating an insurance contract, selling
that contract to individuals or organizations, and settling claims arising from the insurance
contract.

4


1.1 Healthcare Finance

9

all individuals by the government. Furthermore, healthcare is considered a basic
human right in many countries such as Italy, where this right is written into the

constitution, and where the country’s constitutional commitment to healthcare as a
basic right has one of the highest “intensity scores” in the world (Kinney and Clark
2004). In the United States, health insurance coverage is much more diverse, and
still not fully compulsory.5 An individualistic approach to health insurance is also
somewhat at odds with the public, group nature of health insurance—if health is an
individual concern, then how can an insurer pool individuals together for the
purposes of writing health insurance?
Health insurers address the subjectivity of health mainly by focusing on the
pragmatic fact that health insurance pays for healthcare. Payment for healthcare
allows health insurance to be a common service akin to other lines of insurance,
such as automobile insurance or homeowner’s insurance. Individuals may place an
idiosyncratic or personal valuation on their own health, but the healthcare products
and services people use to restore and maintain their health are defined as a commodity. For example, a flu shot is a healthcare commodity. A visit with a physician
is also a type of healthcare commodity. Most health insurance plans are set up on a
“benefits” basis, to pay for such well-defined services, whether a physician
encounter, a day of hospitalization, or a 30-day supply of a specific drug. Insurance
can also be set up on an “indemnity” basis, where the insured individual receives a
cash payment in exchange for a given loss. Life insurance is set up in this way.
Currently, indemnity based health insurance plans are rare, confined to lines of
insurance such as “critical illness” insurance where an individual gets a defined
cash payment upon a diagnosis such as cancer (Pokorski 1997). To the extent that
health insurance can take the existence, and pricing, of these goods and services as
given, it can elide the more philosophical questions of value that arise in the health
capital literature. Health insurance simply pays for, and manages the risk of, costly
healthcare goods and services.
This straightforward definition of health insurance as paying for healthcare can
become difficult because the definition of healthcare is also, in some sense, subjective. For example, even the “commodity” service of a 15 min visit with a
physician is not a standardized product. Defining what is and is not “covered” by
health insurance has often been defined through the expertise of physicians and
other providers. For example, a health insurer will pay for a 15 min visit with a

physician if that individual has a “medical need” and the physician has a medical
degree and a license to practice medicine. However, we can see that there are issues
of both subjectivity and control that arise from such a policy. For example, how
should an insurance company define the “necessity” of the office visit in the first
place?

5

The Affordable Care Act changed this aspect of the health insurance system by introducing
several health insurance mandates for individuals and employers. However, even this mandate
does not apply to all individuals.


10

1 Defining Health Insurance

The issue of insurer control arises because a health insurer that writes a policy
based on physician expertise leaves itself open to essentially unlimited exposure
arising from physician discretion. This can be seen in the history of health insurance, where “usual and customary” charges for care gave way to more defined,
“managed care,” payment models because of the cost control issues involved in
health insurance, followed by “backlashes” where controls on health insurance
costs based on a reduction in choice are removed in response to pressure from
consumers and healthcare producers (Mechanic 2004). As a result, the ability to
define the scope of services is itself a health insurance function related to, but
distinct from, the risk management function that insurers perform. In addition, these
two services—defining the scope of services and paying for care—may be performed by a single insurer or split between multiple health insurers depending on
the market where health insurance is provided. Thus, an understanding of health
insurance requires an understanding of traditional insurance models, what constitutes healthcare, and how insurers define and measure healthcare services and the
effectiveness of healthcare.

The subjectivity of health capital relates to a more general dilemma in insurance
of the asymmetric nature of information in insurance markets. In general, insurance
markets feature “asymmetric information” in the sense that the person who seeks
insurance and the insurer know different information about the probability of a loss.
An individual seeking automobile insurance may know how good of a driver he or
she is, and an automobile insurer may not reveal how likely individuals with similar
characteristics are to incur insured losses.
Health insurance markets feature a similar asymmetric information situation. The
asymmetry is compounded by the fact that much of the value that people place on
their own health is subjective and internal. Differences in information are important
for health insurance because, if a person makes a claim for healthcare in order to be
restored to a particular level of health, then the health insurer must rely, to some
extent, on that individual’s self-reported health state. We will see that information
asymmetry leads to concerns about the problems of “adverse selection,” especially
in Chap. 3.
Of course, providers of health insurance and providers of healthcare have
information that they may not share with consumers, giving them a different type of
informational advantage compared to consumers. Health insurers have expertise in
the average cost of care for populations and in the design of health plans, and this
expertise is beyond the grasp of most individuals. Providers have expertise in the
clinical nature of healthcare, particularly in what treatments are appropriate and
might work best for a particular individual. Again, this leads to an informational
advantage both because of the time costs of learning such information (consumers
could in theory learn about medicine, but it would take time) and because of truly
private information that a provider may be unwilling or unable to share, such as his
or her honest assessment of how well a treatment is likely to work. That naturally
leads to the question of whether health insurance is the best way to finance many
forms of healthcare.

1.1 Healthcare Finance

1.1.4

11

Alternative Forms of Healthcare Finance

Health insurance is ultimately a third party, intermediating between an individual
seeking care and the provider who must be paid for delivering that care. As a result,
health insurance has a “loading cost” above and beyond the cost of claims, which is
the cost to design and administer the insurance plan. All health insurance producers
incur some cost for the production of health insurance. This cost must be paid by
someone, which is generally whoever “pays for” the insurance. The third-party
nature of health insurance also leads to a time cost in terms of healthcare finance,
introducing a lag between when healthcare services are provided and when they are
reimbursed. This is part of the “finance” system provided by healthcare. Again, any
producer of insurance, must generate, apply, and validate a set of rules in order to run
the insurance plan; indeed, the creation of this “rulebook” is a major part of the value
created by health insurers. Individuals may seek to avoid this cost in order to reduce
the overall cost of healthcare and spend their money on other forms of consumption.
One other aspect of health insurance that many individuals may wish to avoid is
its publicness. Health insurance is “public” in the original sense of the word of
being common or of the people: “Of or pertaining to the people as a whole; that
belongs to, or concerns, the community or nation; common, national, popular”
(Murray 1933). Some forms of health insurance are also public in the sense that
they are run or financed by the government. Other forms of health insurance are
public in the sense that they are run or financed by an employer, who then has a
financial stake in the health of its employees. This publicness of health insurance
conflicts with the essential nature of health as a private asset, perhaps the most

private asset anyone possesses. This is not to deny that health does not have public
consequences—quite the contrary, a person’s health is of some concern to his or her
family and friends, employer, and to society (also known in economics as an
“externality” or “spill over”). Rather, it is the case that, once health insurance is
involved, the insured will be forced to surrender some control over his or her health
and healthcare in order to utilize the insurance policy.
Alternatives to health insurance include personal finance activities. An individual could accrue savings in order to pay for future healthcare costs that he or she
might incur. Such “precautionary savings” are a key aspect of the literature on
insurance (Kazarosian 1997). Another alternative for individuals is preventative
activity. Again, prevention—along with mitigation of risks such as health risks—is
a classical part of the insurance literature, since such prevention could be seen as
one of the main alternatives to purchasing insurance or as a complement to
insurance, making the decision of purchase of health insurance and prevention one
that is best modeled jointly (i.e., as a contemporaneous decision) (Nordquist and
Wu 1976). Additional options would include loans to finance healthcare costs that a
person cannot afford using his or her current savings. One theme of the book is that
the main advantage of personal finance activities is their generally lower cost than
health insurance, while their main disadvantage is that negative health shocks
generally correlate with negative income shocks. In other words, spells of poor


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1 Defining Health Insurance

health not only increase demand for healthcare, but they also limit an individual’s
ability to earn income to pay for healthcare.
Public health activities are an attractive alternative to health insurance since they
can achieve the outcomes of improved health at a relatively low cost per person.
Public health interventions, such as improved sanitation, can achieve positive outcomes in terms of health for a large population at a relatively low average cost per

person because public health programs often have so-called “economies of scale”
with high fixed costs but low variable costs, or “economies of scope” where the same
program can be delivered to a wide variety of individuals at the same price. For
example, while water treatment plants are costly to create and maintain, the cost is
small for adding one extra household to a sewer system. In addition, the properties of
clean water are essentially the same for all individuals regardless of their personal
characteristics. Additionally, public health interventions have the advantage that
they do not rely on the individual willingness or ability to pay for health. The main
disadvantages of public health are that it cannot be tailored to an individual’s health
in the same way that healthcare can be, and therefore may be less efficient, and the
“deadweight loss” of taxes used to finance public health programs.
The other reason to consider alternatives to health insurance is that many of the
improvements in human health in the United States and other developed and
developing countries have come from interventions outside the healthcare system.
Victor Fuch’s classic study “Who Shall Live” examined, and pointed to, the role of
cultural and other factors in terms of the health of populations. For example, those
in Utah were healthier than those in Nevada due to religious practice (Fuchs 1974).
Public health is often more responsible than medical interventions for major
reductions in mortality and morbidity than healthcare on average. In contrast,
healthcare may be more effective on the margin—a person suffering an acute
episode such as a heart attack can be saved and brought back to health, when in the
past he or she would have died (Weisfeldt and Zieman 2007).
Healthcare is therefore best considered as a high effectiveness, high cost for
improving health. Identifying the individuals who benefit from healthcare at the
margin is a costly process. Health insurance is designed to address health risks on a
case-by-case, or person-by-person, basis by financing healthcare. Thus, health
insurance is an important product that can address health risks, as well as the cost of
healthcare, in concert with many other complementary goods—self-care, prevention,
mitigation, and public health programs. This complementarity will be important for
designing policies to promote the optimal health insurance policies as a larger effort

to protect and improve human health that are the subject of Part III of this book.

1.2

The Growth of Health Insurance

Having defined health insurance, we next investigate one of the most salient features of health insurance—its growth over time. Health insurance has grown in both
absolute and relative terms. In other words, health insurance is now a large and


1.2 The Growth of Health Insurance

13

important part of a healthcare industry. In addition, health insurers finance a much
larger proportion of healthcare than they did one hundred or even fifty years ago.
This section explores the growth in health insurance in order to describe the context
for the current use of health insurance and future improvements to the health
insurance system.

1.2.1

Diverse Beginnings of Health Insurance

Health insurance as we know it today originates partly in other lines of insurance.
Early forms of health insurance include “accident and disability policies” sold by
insurance companies. Accident and disability policies were introduced in the late
1800s to pay for costs related to these hazards to human life and health. Related
insurance policies included nursing care policies that paid for the cost of nurses to
care for individuals in their homes (Bluhm 2007, p. 1). These markets later liberalized in the 1920s and 1930s, as coverage was extended to medical costs and

eventually sold separately from disability income (DI) policies (Bluhm 2007, p. 2).
These forms of health insurance foreshadow the modern health insurance company.
“Cooperative societies” were an alternative to insurance companies that provided a large amount of what we would call insurance today outside of the formal
insurance sector. These cooperative societies, also known as “mutual aid societies,”
were an extremely popular form of insurance. “By 1920, over a third of the adult
male population received sickness, accidents, or death benefits through association
in cooperative societies” (Gottlieb 2007). These societies were less formal, community level risk sharing arrangements formed by individuals with similar professions. Gottlieb (2007), further elaborates on how these societies were able to
function in the absence of the actuarial pricing that is generally considered the
foundation of insurer viability. “Cooperative societies developed strict disciplinary
rules to deal with informational asymmetries. To mitigate adverse selection problems, prospective members had to undergo medical examinations as well as
‘character investigations.’” (Gottlieb 2007)
The early history of health insurance also includes employer-provided group
health insurance called “industrial sickness funds” that was provided to individuals
working for the same company. “Such funds, organized by workers through their
employer or union, provided the rudiments of health insurance, principally consisting of paid sick leave, to a large minority of the industrial workforce of the late
nineteenth and early twentieth centuries” (Murray 2007, p. xi). These funds were
thus industry specific in the same way as cooperative societies and benefitted from
the backing of the sponsoring institution. These early funds faced some of the
problems that cooperative societies faced in terms of financial viability, and they
also used medical examinations in order to qualify individuals for their plans. “To
mitigate the problems of moral hazard and adverse selection, sickness funds
imposed a variety of tests such as waiting periods for applicants and claimants and
the certification by a physician of a member’s claim” (Murray 2007, p. 13).


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1 Defining Health Insurance

Many industrial sickness funds can be traced back to early railroad and other

industry specific funds. For example, railroad funds were the largest group of
sickness funds identified in a 1908 survey by the U.S. Commission of Labor—there
were 31 such funds with 262,747 members (Murray 2007, p. 79). Occupation was
also an important rating class for individual health insurance. “Companies classify
the insurable occupations into groups of about the same average claim cost and
have a scale of premium rates applicable to the various classes (Dickerson 1963,
p. 467). Occupation rating also led to difficulties given that certain professions were
so risky as to be considered “uninsurable”. “Certain occupations are considered
uninsurable for individual insurance. Such occupations as test pilot, steeplejack,
sandhog, and the like are beyond the purview of ordinary policy forms” (Dickerson
1963, pp. 466–467). These industrial sickness funds are the foundation for the
preponderance of employer-provided health insurance in the modern U.S. health
insurance system.
Healthcare providers were also key in the early development of health insurance.
Baylor Hospital in Dallas developed one of the first forms of “prepaid hospital
coverage.” Baylor University Hospital enrolled schoolteachers in this plan. “The
1250 schoolteachers were encouraged to prepay their hospital care at Baylor for 50
cents a month. In return, they were offered twenty-one days of semiprivate care
(including the use of the operating room and various ancillary services—anesthetic,
lab tests) in a twelve-month period” (Fein 1986, p. 11; Kimball 1934). We can see
in this setup one of the early features of what is now called “managed care”: a
defined quantity of benefits from a specific provider in exchanged for a fixed per
member per month (PMPM) payment. The use of healthcare services rather than a
cash payment for illness is also known as the “service basis” for health insurance.
The use of a specified provider also means that there is an important dimension in
terms of the quality of the health insurance coverage, since all care would be
delivered by Baylor University Hospital, meaning that the schoolteachers were
accepting Baylor’s definition of the quality and scope of care.
The fact that the Baylor plan delivered hospital benefits to those who became
sick and restricted services to a specific hospital led to controversy in the 1930s

about whether the hospitals were selling a form of prepaid services or were in fact a
health insurance company that was unduly restricting the choices of members (Law
1974, p. 7). The prepaid plan was certainly a form of health insurance in the sense
that it financed healthcare for the members of the plan. In addition, the Baylor
Hospital model was later developed into the “Blue Cross” plans for hospitalization
coverage as states set up laws to enable hospital service plans in the 1930s and
1940s (Law 1974, p. 8). In 1933, the “Blue Cross Plan (was) organized in Newark,
New Jersey. This, the first Blue Cross plan covering hospital services, (was) organized by the Hospital Association of Newark, New Jersey” (National Information
Center on Health Services Research and Health Care Technology (NICHSR) 2013).
Thus, not only was the prepaid plan a form of health insurance, but it was part of the
genesis of one of the most important types of health insurance companies, the Blue
Cross and Blue Shield companies.