After studying this chapter, readers should be able to
• describe the key features of insurance,
• describe the major private and public insurers,
• demonstrate how insurers set premium rates for buyers, and
• assess the implications of health reform for the health insurance
In general, businesses in the healthcare sector that do not provide products
or services directly to patients have the same operating environment as businesses in any other industry. For example, Cincinnati Milicron, a machine
tool manufacturer, and GE Medical Systems sell their products in roughly
the same way. Cincinnati Milicron sells its machines directly to manufacturers that use the machines to produce other goods, and GE Medical sells its
diagnostic equipment directly to hospitals, medical practices, and other organizations that use the equipment for diagnostic testing. The prices that the
two firms charge for their products are set in the competitive marketplace,
and it is relatively easy for buyers to distinguish among competing products.
In general, the more expensive the product is, the better the performance,
where performance can be judged on the basis of objective measures. Thus,
in some industries in the healthcare sector, and in most other sectors of the
economy, the consumer of the product or service (1) has a choice among
many suppliers, (2) can distinguish the quality of competing goods or services, (3) makes a (presumably) rational decision regarding the purchase on
the basis of quality and price, and (4) pays the full cost of the purchase.
For the most part, the provision of healthcare services takes place in
a unique way. First, often only a few providers of a particular service exist
in a given area. Next, it is difficult, if not impossible, to judge the quality
of competing services. Then, the decision about which services to purchase
is usually not made by the consumer but by a physician or some other clinician. Also, payment to the provider is not normally made by the user of
Understanding Healthcare Finance Management
the services but by a third-party payer. Finally, for most individuals, health
insurance from third-party payers is totally paid for or heavily subsidized by
employers or government agencies, so patients are mosdy insulated from the
costs of healthcare.
This highly unusual marketplace for healthcare services has a profound
effect on the supply of, and demand for, such services. In this chapter, we
discuss elements of health insurance that directly affect financial management
decisions in health services organizations.
The third-party payer system is an insurance system comprising a wide variety
of insurers of all types and sizes. Some are investor-owned, while others are
not-for-profit or government-sponsored. Some insurers require their policyholders, who may or may not be the beneficiaries of the insurance, to make
the policy payments, while other insurers collect partial or total payments
from society at large. Because insurance is the cornerstone of the third-party
payer system, an appreciation of the nature of insurance will help you better
understand the marketplace for healthcare services.1
A Simple Illustration
To better understand insurance concepts, consider a simple example. Assume
that no health insurance exists and you face only two medical outcomes in
the coming year:
Furthermore, assume that everyone else faces the same medical outcomes and “sees” the same odds and costs associated with healthcare. What
is your expected healthcare cost—E(Cost)—for the coming year? To find the
answer, we multiply the cost of each outcome by its probability of occurrence
and then sum the products:
E(Cost) = (Probability of outcome 1 x Cost of outcome 1)
+ (Probability of outcome 2 x Cost of outcome 2)
= (0.99 x $0) + (0.01 x $20,000)
= $0 + $200 = $200.
Now, assume that you, and everyone else, make $20,000 a year.
With this salary, you can easily afford the $200 “expected” healthcare cost.
The problem is, however, that no one’s actual bill will be $200. If you stay
healthy, your bill will be zero, but if you are unlucky and get sick, your bill
will be $20,000. This cost will force you, and most people who get sick, into
Now, suppose an insurance policy that pays all of your healthcare costs
for the coming year is available for $250. Would you purchase the policy,
even though it costs $50 more than your expected healthcare costs? Most
people would. In general, individuals are risk averse, so they would be willing to pay a $50 premium over their expected costs to eliminate the risk of
financial ruin. In effect, policyholders are passing to the insurer the costs
associated with the risk of getting sick.
Would an insurer be willing to offer the policy for $250? If the insurer
can sell enough policies, it can take advantage of the law of large numbers. We
know that it is impossible to predict the healthcare costs for the coming year
for any one individual with any certainty because the cost will be either $0 or
$20,000, and we will not know for sure until the year is over. For any individual, the expected cost of healthcare is $200, but the standard deviation is
a whopping $1,990, so there is significant uncertainty about each individual’s
However, if an insurance company sells a million policies, its expected
total policy payout is one million times the expected payout for each policy,
or 1 million x $200 = $200 million. Furthermore, the law of large numbers
tells us that the standard deviation of costs to an insurer with a large number
of policyholders is c/fn, where c> is the standard deviation for one individual
and n is the number of individuals insured. Thus, payout uncertainty for
the insurer, as measured by standard deviation, is only $1,990/^/1,000,000
= $1.99 per subscriber, or $1.99 million in total. Given these data, we see
that if there were no uncertainty about the $20,000 estimated medical cost
per claim, the insurer could forecast its total claims precisely. It would collect 1 million x $250 = $250 million in health insurance premiums; pay out
roughly $200 million in claims; and hence have about $50 million to cover
administrative costs, create a reserve in case realized claims are greater than
predicted by its actuaries, and make a profit. Clearly, with a standard deviation of claims of about $2 million, the $50 million “cushion” should be sufficient to carry out a successful business. The problem for real-world insurers
is their inability to forecast the cost of each claim.
Basic Characteristics of Insurance
The simple example of health insurance we just provided illustrates why individuals would seek health insurance and why insurance companies would be
Understanding Healthcare Finance Management
formed to provide such insurance. Needless to say, the concept of insurance
becomes much more complicated in the real world. Insurance is typically
defined as having four distinct characteristics:
1. Pooling of losses. The pooling, or sharing, of losses is the heart of
insurance. Pooling means that losses are spread over a large group of
individuals so that each individual realizes the average loss of the pool
(plus administrative expenses) rather than the actual loss incurred.
In addition, pooling involves the grouping of a large number of
homogeneous exposure units (people or things having the same risk
characteristics) so that the law of large numbers can apply. Thus,
pooling implies (1) the sharing of losses by the entire group and (2)
the prediction of future losses with some accuracy, based on the law of
2. Payment only for random losses. A random loss is one that is
unforeseen and unexpected and occurs as a result of chance. Insurance
is based on the premise that payments are made only for losses that are
random. We discuss the moral hazard problem, which concerns losses
that are not random, in a later section.
3. Risk transfer. An insurance plan almost always involves risk transfer.
The sole exception to the element of risk transfer is self-insurance,
which is assumption of a risk by a business (or individual) itself rather
than by an insurance company. (Self-insurance is discussed in a later
section.) Risk transfer is transfer of a risk from an insured to an insurer,
which typically is in a better financial position to bear the risk than the
insured because of the law of large numbers.
4. Indemnification. The final characteristic of insurance is indemnification
for losses—that is, the reimbursement of the insured if a loss occurs. In
the context of health insurance, indemnification occurs when the insurer
pays the insured, or the provider, in whole or in part for the expenses
related to an insured illness or injury.
One of the major problems facing insurers is adverse selection. Adverse selection occurs because individuals and businesses that are more likely to have
claims are more inclined to purchase insurance than those that are less likely
to have claims. For example, an individual without insurance who needs a
costly surgical procedure will likely seek health insurance if she can afford
it, whereas an individual who does not need surgery is much less likely to
purchase insurance. Similarly, consider the likelihood of a 20-year-old to seek
health insurance versus the likelihood of a 60-year-old. The older individual,
with much greater health risk due to age, is more likely to seek insurance.
Chapter 2: Health Insurance
If this tendency toward adverse selection goes unchecked, a disproportionate number of sick people, or those most likely to become sick, will seek
health insurance, and the insurer will experience higher-than-expected claims.
This increase in claims will trigger a premium increase, which only worsens
the problem, because the healthier members of the plan will seek insurance
from other firms at a lower cost or may totally forgo insurance. The adverseselection problem exists because of asymmetric information, which occurs
when individual buyers of health insurance know more about their health
status than do insurers.
Insurance companies attempt to control the adverse selection problem
by underwriting provisions. Underwriting refers to the selection and classification of candidates for insurance. From a health insurance perspective,
insurers can take two extreme positions regarding underwriting. First, if we
assume that insurers offer insurance in all 50 states, insurers can base premiums on national average statistics without regard to individual characteristics.
Thus, each individual (or employer) would pay the same health insurance
premium regardless of age, gender, geographic location, line of work, smoking habits, genetic disposition, and so on. The premium charged for each
individual would be sufficient in the aggregate to cover all expected outlays,
plus administrative expenses, and the insurer would still earn a profit. In this
situation, cross-subsidies clearly exist because young, healthy nonsmokers in
relatively safe jobs would pay the same premiums as older, sickly smokers in
relatively hazardous jobs. Thus, after taking administrative costs out of the
insurance premium, healthy individuals would pay premiums that exceed
their expected healthcare costs, while the sicker individuals would pay premiums that are lower than their expected costs.
At the other extreme, if no information asymmetries existed and perfect information were available, insurers could charge a premium to each
subscriber on the basis of that subscriber’s expected healthcare costs, as was
done in the illustration presented previously. Individuals who are expected to
have higher costs would be charged higher premiums, and those with lower
expected costs would be charged lower premiums. Of course, neither individuals nor insurers have perfect foresight, so charging an insured individual
on the basis of his expected healthcare costs is not feasible. However, insurers
can take into account all factors that are proven to affect health status (and
hence costs)—such as smoking habits, weight, cholesterol level, and hereditary factors—when setting insurance rates.
What approach do health insurers take in practice? When health
insurance first became popular following World War II, most insurers used
community ratings. They offered a single set of premiums, or rates, to all
members of a community without regard to age, gender, health status, and so
on. The rates represented an average of high-risk and low-risk individuals in
Understanding Healthcare Finance Management
that community. Thus, rates reflected geographic differences and sometimes
ethnic and cultural differences if the community was dominated by a single
ethnic or cultural group. Over time, some insurers (particularly commercial
insurers) started to offer experience ratings—meaning they set rates on the
basis of the claims experience of the group being insured.
For example, the Boeing Company might contract with a health
insurer to insure all of Boeing’s employees in the Seattle area. If Boeing’s
employees—who as a group tend to be younger and more educated—have
lower healthcare costs than the community in general, insurers that use
experience ratings can offer Boeing lower rates than those offered by competitors that use community ratings. As more and more employers with lowrisk employees seek health insurance based on experience ratings, the least
costly groups are skimmed from the insurance pool, and those that remain
are charged higher-than-average costs. Because the healthcare costs for those
remaining are above the community average, insurers serving that population
have no choice but to apply experience ratings, so higher premiums will be
charged to the remaining groups. The trend over time, then, has been toward
the use of experience ratings and away from the use of community ratings,
although community ratings are still used.
Another way health insurers used to protect themselves against adverse
selection was by including preexisting conditions clauses in contracts. A preexisting condition is a physical or mental condition of the insured individual
that existed before the policy was issued. A typical clause stated that preexisting conditions were not covered until the policy had been in force for a
certain period—say, one or two years. Preexisting conditions were a problem
for the health insurance industry. As we discussed earlier, one of the key
elements of insurance is randomness—that is, payouts on a policy should
be made in response to random events. If an individual had a preexisting
condition, this key feature of insurance was violated, as the insurer no longer
bore random risk but rather assumed the role of payer for the treatment of
a known condition.
Actions taken by insurers that are considered to be unfair to policyholders (including preexisting condition clauses) have been the subject of
much recent congressional legislation. First, Congress passed the Health
Insurance Portability and Accountability Act (HIPAA) in 1996. Among
other things, HIPAA established national standards regarding what provisions can be included in health insurance policies. For example, under a
group health policy, individuals cannot be denied coverage or receive limited
coverage, nor can they be required to pay more because of their health status.
Although preexisting condition clauses were not banned by HIPAA, it established limits as to what counts as a preexisting condition and to the amount
of time that must pass before coverage begins. Many of the provisions of
Chapter 2: Health Insurance
HIPAA are strengthened by the Patient Protection and Affordable Care
t ( ^CA) of 2010, which now prohibits insurers from denying coverage
because of a preexisting condition. The ACA, along with the Health Care
and Education Reconciliation Act of 2010, included a large number of provisions that have (save for a few) taken effect over the past several years to help
uninsured Americans obtain health insurance, improve healthcare quality and
access and reduce costs. These changes are described in the last section of
Insurance is based on the premise that payments are made only for random
losses, and from this premise stems the problem of moral hazard. The most
common case of moral hazard in a casualty insurance setting is the owner
who deliberately sets a failing business on fire to collect the insurance. Moral
hazard is also present in health insurance, but it typically takes a less dramatic form; few people are willing to voluntarily sustain injury or illness for
die purpose of collecting health insurance. However, undoubtedly there are
people who purposely use healthcare services that are not medically required.
For example, some people might visit a physician or a walk-in clinic for the
social value of human companionship rather than to address a medical necessity. Also, some hospital discharges might be delayed for the convenience of
the patient rather than for medical purposes. Finally, when insurance covers
the foil cost or most of the cost of healthcare services, individuals often are
quick to agree to a $1,000 MRI (magnetic resonance imaging) scan or other
high-cost procedure that may not be necessary. If the same test required
total out-of-pocket payment, individuals would think twice before agreeing
to such an expensive procedure unless they clearly understood the medical
necessity involved. All in all, when somebody else is paying the costs, patients
consume more healthcare services.
Even more insidious is the impact of insurance on individual behavior. Individuals are more likely to forgo preventive actions and embrace
unhealthy behaviors when the costs of not taking those actions will be borne
by insurers. Why stop smoking if the monetary costs associated with cancer
treatment are borne by the insurer, or why lose weight if others will pay for
the adverse health consequences likely to result?
Insurers generally attempt to protect themselves from moral hazard
claims by paying less than the foil amount of healthcare costs borne by the
insured. By making insured individuals bear some of the cost, insurers discourage them from consuming unneeded services or engaging in unhealthy
behaviors. One way of doing this is to require a deductible. Medical policies
usually contain some dollar amount that must be satisfied before benefits
are paid. Although deductibles have a positive effect on the moral hazard
Understanding Healthcare Finance Management
problem, their primary purpose is to eliminate the payment of small claims
because the administrative cost of processing the claim may be larger than the
claim itself. Although several types of deductibles exist, the most common
form is the calendar-year deductible. Here, the insured individual pays the
first $250 (or $500 or more) of medical expenses she incurs each year. Once
the deductible is met, the insurer pays all eligible medical expenses (less any
copayments) for the remainder of the year.
The primary weapon that insurers have against the moral hazard
problem is the copayment, which requires insured individuals to pay a certain percentage of eligible medical expenses—say, 20 percent—in excess of
the deductible amount. For example, assume that George Maynard, who
has employer-provided medical insurance that pays 80 percent of eligible
expenses after the $100 deductible is satisfied, incurs $10,000 in medical
expenses during the year. The insurer will pay 0.80 x ($10,000 – $100) =
0.80 x $9,900 = $7,920, so George’s responsibility is $10,000 – $7,920 =
The purposes of copayments are to reduce premiums to employers and
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