Private Insurance System Concerns

As compared to public insurance systems, private systems face a unique set of market problems that have occupied a central position in health economics research. These ethical and efficiency problems that arise in market transactions plague national insurance systems to a much lesser degree and involve different solutions. This article first considers the reasons why private insurance systems exist in their current forms; next, it examines the ways in which private and public systems attempt to solve market failures; finally, it ends with a discussion of regulations related to perceived problems in the private market.

Healthcare appears in some ways a very well-suited market for private insurance transactions, as it involves high and unpredictable costs for a large segment of the population. However, numerous problems can potentially lead to classic market failures or otherwise societally unacceptable outcomes in a private health insurance system. The efficiency related problems of such a system include adverse selection due to a lack of perfect information and moral hazard due to price responsiveness in the demand for medical care. There are also several ethical questions that surround the affordability of insurance for the poor and high premiums for the sick, which lead to private-system regulations that borrow features of a public system. As expected, private systems maintain a delicate balance between ethical and efficiency concerns: various practices adopted by private insurance markets in response to adverse selection and moral hazard problems have heightened ethical concerns, while government policies adopted within private systems designed to alleviate ethical concerns have sometimes had market failure consequences.

Purely public systems, described in other articles in terms of the history of health insurance in developed countries (John Murray) and a comparison between such insurance systems (Victor Rodwin), are distinct from the largely private system that exists in the US (see the article by Tim Jost on the history of health insurance in the US). Yet, as a thought exercise, one could imagine a private market, that under certain conditions recreates the essential elements of social insurance for healthcare, providing cradle-to-grave mandatory insurance that is financed by progressive taxation.

A Private-System Equivalent Of Standard Public Insurance

Even with private insurers selling health insurance, it is theoretically possible that all policies offered are based on lifetime contracts, purchased at birth and priced uniformly. What leads such a scenario to be infeasible? For one, there is no mechanism in the private market to retain the feature of equity present in a public system through progressive taxation based financing. Even if lifetime policies were available, parents would have to purchase them for their children based on private funds. As long as there was an unequal distribution of incomes, there would be some level of uninsurance.

Even among families whose lifetime expected incomes could pay for lifetime insurance policies for their children, liquidity constraints and borrowing market imperfections would preclude them from paying for a policy that covers a long timeframe and thus would prevent the system from being considered universal and mandatory. One could design a lifetime policy with periodic payments, as is done for long-term care (see the article by Tamara Konetzka) and life insurance. A version of this long-term policy proposal was first considered by Cochrane. For several reasons including lack of contract enforceability, long-term insurance contracts are not available. Requiring periodic payments incentivizes the customers to not delay purchase until their health deteriorates and creates incentives on the part of insurers to reinterpret or rescind sales to those whose health has deteriorated since the initial contract was established. This leads to selection issues, which are one main form of difficulty experienced by a private system.

Government regulations are another reason that long-term policies do not exist in health insurance. Some regulations in current-day private systems attempt to create an equitable financing system by providing subsidies and supplemental public systems that pay for those with lower incomes. In other ways, community rating and guaranteedissue-type regulations redistribute wealth from the healthy to the sick and could actually have regressive elements, as age and health status are correlated negatively, whereas age and income are correlated positively. Because of the risk of insurance companies refusing to cover those who experience a negative health shock after years of being continuously covered (revision of risk), regulations such as guaranteed renewability, protection of preexisting conditions coverage, and portability laws have arisen to protect consumers. These regulations address equity problems but could themselves lead to efficiency concerns. For example, guaranteed issue and community rating without a strong mandate for purchasing coverage could lead to worsened adverse selection and instability in insurance markets, as has occurred in the individual health insurance market in New York in the past two decades. The availability of publicly financed health insurance for low-income families could lead to reductions in the private provision of health insurance, as has been pointed out in the case of Medicaid expansions in the US.

Some solutions to problems affiliated with a private health insurance system come from the private market itself rather than from regulation. The fact that employer groups are the main organizing form of health insurance provision in the US helps mitigate problems with adverse selection, especially among large employers who provide stable pools for insurers. Private insurance plans also impose a guarantee issue period in a plan year; enrollees must select coverage within a certain window of time within the US or else forgo coverage for that entire plan year. If employees were able to select coverage at any point in the year, the system would suffer from greater adverse selection.

A Model Of A Pure Private Health Insurance System Absent Market Problems

In addition to considering the reasons why a private system replica of the standard public insurance model does not exist, it is important to consider why problems arise in a private system for health insurance. In theory, private markets could solve the risk inherent in medical care demand provided the correct conditions exist. Suppose that health insurance is available each year to risk-averse individuals who face identical risks and are inelastic in their demand for medical care. In such a setting, optimal risk protection would be full insurance, and the price of insurance would be above or at an actuarially fair price, depending on the degree of customer risk aversion, loading costs, and degree of competition among sellers of insurance.

Problems Of Imperfect Information

The world described above does not match reality in many ways. For one, individuals are not identical in their risk profiles, and insurance sellers cannot easily discern this information. At any price, insurers would find that those whose probability of needing coverage is higher than the population average would be more likely to buy insurance, causing insurers to experience ‘adverse selection death spirals.’ Seminal work addressed the problems of asymmetric information in insurance markets. Other economists developed insurance models to consider the equilibria that could exist in health insurance markets where hidden information is held by two groups of insurance customers; they concluded that the information imperfection could lead to loss of welfare. If insurers are allowed to offer different insurance contracts, a separating equilibrium could occur in which the group with the lower but unverifiable risk gets partial insurance and the high-risk group gets full insurance. The high-risk group thus imposes an externality on the low-risk group. If insurers are only able to offer one insurance contract, the market could fail to exist altogether because of the unsustainability of a pooling equilibrium.

The importance of the insights from seminal authors writing on information problems in economics in general was recognized when in 2001 Joseph Stiglitz and two other economists jointly received the Nobel Prize in Economics. However, this early work left the reader with a rather pessimistic view of possible solutions to the information problem in the health insurance market. A large literature since then has discussed the conditions under which equilibria may exist, including cases in which consumers differed in risk aversion as well as in risk probabilities. Most recently, researchers have introduced the possibility that there could be advantageous selection in insurance markets whereby those who are lower risk or more risk averse purchase more insurance than those who are higher risk. This literature has shown that advantageous selection exists in the case of Medicare supplemental plans in the US. However, other empirical investigations have also found evidence in favor of adverse selection.

Private Market Solutions To Adverse Selection Problems

As Arrow noted several decades ago, private markets may be able to solve information failures by finding ways to convey information to sellers. In the US, health insurance is provided by employers as the predominant form of insurance to nonelderly individuals. This results in more stable insurance markets than those available for individuals, because insurers understand that health is not the primary reason for the formation of employer groups. Thereby, both the fact that employment is a signal of one’s health and the fact that the heterogeneity of the production function is a signal that a firm was not just formed for the purpose of purchasing health insurance enable insurers to be less on guard regarding adverse selection.

Health Insurance Tied To The Workplace: How Does This Affect Job Mobility?

An issue related to the labor market that public systems need not consider is the relationship between the labor market and health insurance. In the US, it is plausible that because of the important role played by employers, those who value health insurance may not leave their job for one that pays higher wages but does not pay for health insurance. One way in which private markets lessen this problem is by ‘portability’ laws that make it easier for someone to change jobs and obtain insurance without serving new waiting periods.

Insurer Practices To Guard Against Adverse Selection

Insurers are aware of their information disadvantage and attempt to gather as much information as possible on their customers’ health profiles. Insurers aim to base their prices on the information gathered, and they sometimes refuse outright to sell a policy to someone with past health problems in a practice known as ‘red lining.’ Another insurer practice used to guard against adverse selection is the refusal to cover preexisting conditions, defined as conditions that were diagnosed or treated in the past so many years or months, for the first so many years or months of a policy.

Although in one way these practices can be seen as necessary for the functioning of insurance markets, these practices are often also seen as unfair because they cause those who are unhealthy to pay more for health insurance. As a result, the US private insurance system has undergone several changes to address the concern that insurer practices guarding against adverse selection lead to inequities that society does not find fully acceptable. The latest set of such changes is being made through the Affordable Care Act, but there is long history in the US of regulating terms of sale.

The ability of insurers to place preexisting condition exclusions and other antiadverse selection restrictions on policies sold in the American individual and small group insurance markets has been regulated heavily by states since the early 1990s. The most progressive state in this topic, New York, has since 1992 prohibited insurers from charging different premiums, differentiating plan characteristics, or denying the sale of insurance based on any health or demographic factors, except to allow slightly different prices according to whether one lives in the northern or southern part of the state. This approach is known as pure community rating, and it is supplemented by guaranteed issue, guaranteed renewability, and limitations on preexisting conditions exclusions. Most other states have taken what is known as a modified community rating approach to the pricing restrictions, in which they allow some adjustments for age or gender. Although these practices are most prevalent in the individual and small-group markets, laws of this nature have been strengthened and applied to all health insurance markets by the federal US government through the Health Insurance Portability and Accountability Act of 1996 and further through the Affordable Care Act of 2010.

Long-Term Contracts For Insurance

As described when delineating the private market replica of the public system, even if insurance markets do not suffer from information problems, they may still have efficiency problems in the real world because of the relatively short term of insurance contracts. If all insurance was to be sold on a long-term basis (e.g., if it was purchased by parents on behalf of children at the point of conception or birth), adverse selection problems would be mitigated because there would be relatively little known information about the health of the customer at this point in their life. Time consistent health insurance asks why insurance contracts offered in the current market are 1 year in length at most, which causes difficulties in purchasing insurance the year after an illness manifests itself. The lack of long-term insurance contracts is suboptimal because it makes it impossible for people to insure against reclassification risk. That is, risk-averse individuals may want to protect themselves not just against the unpredictable costs of insurance in the next year, but also against the unpredictability in risk-rated premiums in the future that could result from unpredictability in health. Early research in the field acknowledged that the current lack of long-term contracts is rooted in several logistical issues, including the lack of court enforcement, the likelihood of contracts being reinterpreted after illness occurs, and regulation. The literature concluded that regulation is the main impediment to the existence of such markets.

Reclassification Risk

Even though long-term health insurance contracts do not exist, many policies are written with a clause called guaranteed renewability, which means that the policy will be available the next year, too. Of course, the risk protection offered depends on the extent to which insurers can change an individual’s premiums if their health status changes. Recent work has addressed the value of guaranteed renewability clauses in allowing individuals who purchase insurance to be protected against the risk that they might become worse health risks over time.

Portability And Preexisting Condition Exclusions

Even if insurance policies are written to have a within-policy guarantee of issue through a guaranteed renewability clause, this may not be enough protection against reclassification risk in employment-based insurance systems such as the one in the US. That is, once an individual who has been insured through the policy of one employer decides to switch jobs, the insurer of the next employer may treat him or her as a new entrant. Any reclassification risk the customer had enjoyed may disappear. This is especially the case if the new form of employment is self-employment, in which case the new insurer may be the individual market. A closely related practice is preexisting condition exclusion. Those who are switching between insurers lose their risk protection because of clauses that reassess their premiums based on current health status and because policies can exclude coverage for preexisting conditions.

Moral Hazard

In another departure from the quintessential perfectly competitive insurance market, real-world healthcare demand is not insensitive to price. This behavior, known as moral hazard, simply means that we consume more when we are faced with lower prices; we react to economic incentives. Although full insurance would be the optimal insurance contract if demand for care were completely price inelastic, insurers use cost sharing to reduce the inefficient overuse (use beyond the point at which marginal benefit equals marginal cost to society) of medical care by those who are insured. The most compelling data on the price responsiveness of medical care consumption come from the RAND Health Insurance Experiment, which placed individuals randomly into plans with different cost-sharing structures and discovered that individuals adjusted their healthcare use accordingly.

In the standard economic model, moral hazard is a source of inefficiency, as it creates dead weight loss. In the optimal design of an insurance contract, one must weigh the benefits of risk protection against the costs of inducing moral hazard and dead weight loss. As RAND researchers have pointed out, the optimal contract will depend on risk aversion parameters as well as the elasticity of demand for different forms of medical care. Other work pointed out that there is an interesting parallel between optimal cost sharing to avoid moral hazard and the optimal taxation rules set out by Ramsey. In optimal taxation, we attempt to avoid the dead weight loss of induced behavioral changes by taxing inelastic behaviors more. By analogy, cost sharing could be lower in inelastically demanded care, implying that insurance would lower their prices to a greater extent without inducing moral hazard. This works especially well if services that are inelastically demanded are also the ones in which we most value risk protection.

An alternative view of moral hazard holds that in the face of income constraints it is not all welfare reducing. Writers have raised the concern that moral hazard may act to transfer income from those who are healthy to those who are sick in ways that we could consider efficient. This would happen to the extent that income constraints cause insured individuals to respond by using coverage and to the extent that society as a whole would want an individual to purchase care even when the out-of-pocket cost of doing so is lower than the price paid by society.

Public System Solutions To Moral Hazard Problems

Although in theory adverse selection concerns are mitigated in public systems that offer a single mandatory and free insurance option through taxpayer-based financing, the risk of moral hazard after becoming insured is possibly as high in such systems as it is in private systems. A pure public system might not have as much ability as a private system to pursue solutions that rest on cost sharing. Private systems rely on many forms of cost sharing in the form of fixed or variable copays and (increasingly) high deductibles. Insurance plan formularies for medication place higher-cost drugs with more competitors into high cost-sharing tiers. Although the tiering of inpatient-service cost sharing is not prevalent, private systems are not prevented from such tiering and may decide to develop such systems in the future to mitigate cost growth.

In contrast, it is generally believed that public systems use nonprice methods to ration care (in the economic sense of the word). For example, one may have to be on a waiting list for services that are considered non essential. Researchers have compared waiting times for elective surgery in 12 Organization for Economics Cooperation and Development nations and found that mean wait times more than 3 months are quite common. These delays typically result from the fact that hospitals are paid according to a global budget and use wait times to adjust supply to demand in the absence of a pricing system. The use of a global budget with either a cap or a target is a tool by which public systems institute a nonmarket reimbursement scheme that would control costs. In a target setting, there is a fixed quota of services with fixed fees but there are some additional (lower) fees provided for producing above the quota. The cap system establishes a total budget for a set period and reimbursements rates are calculated ex post depending on the quantity of services that were provided. Fan et al. provide a theoretical explanation for why a cap is more effective than a target at controlling the quality of services provided. Regardless of the specific type, global budgets are similar in spirit to the provision of capitated reimbursements to providers under managed care within a private insurance system, also global budgets apply at the population level, whereas capitation in managed care usually applies at the individual patient level.

An additional way by which public systems counteract moral hazard on the supply side is by using cost effectiveness in decisions to cover one type of medical technology over the other, when close substitutes are available. Public systems use a ratio of expected benefits to expected costs to prioritize decisions such as whether to place a certain drug on the national formulary, whereas within a private system a formulary usually uses differences in out of pocket costs to steer consumers toward certain medications. Within private systems, managedcare organizations also tend to use this type of information to some degree, but its use is much more widespread in public systems.

Moral hazard is also tempered within public systems by the fact that often only basic care is covered by the public system whereas more expensive treatments, and perhaps treatments with more price-elastic demand, are covered by private and voluntary supplemental systems. Often the supplemental system will also cover cost sharing imposed by the public system. The literature noted that in France, private payments account for a quarter of national spending. They show that within a mixed system, supplemental coverage may increase spending for the public system as well. Even if a supplemental plan were to only cover services not provided by the public system, that coverage could stimulate the additional use of public covered services, too, through complementarities. Robust evidence of spillover effects from supplemental private coverage to the public system has been shown to exist in the case of Medicare and Medigap plans in the US as well.

Moral hazard also affects the supply side in both private and public insurance systems. Some of this can be interpreted as supplier-induced demand, where information asymmetry allows providers to misrepresent the benefits of healthcare (Arrow) even more if that care is paid for by insurance companies rather than the patient; other forms of moral hazard can be seen in rises in technology adoption due to the reduced cost sharing introduced by insurance. The advent of Medicare in the US introduced a vast array of medical technology; this may be viewed as a dynamic response to moral hazard incentives.

As mentioned earlier, both private and public systems have used managed care type arrangements (capitation or global budgets) to counteract moral hazard. Another way that public and private systems can reduce moral hazard on the part of suppliers is by extending the Ramsey rule related insight on optimal patient cost sharing to optimal provider reimbursement setting. Researchers have presented a theory of optimal pricing for regulators, who can consider using principles of Ramsey pricing to reduce oversupply in settings where physicians can extend demand. This suggests that regulators should consider setting lower reimbursements for procedures with more demand inducement possibilities.

The above discussion has focused on ex post moral hazard, the behavior of consumers and providers after they are covered by insurance. Ex ante moral hazard refers to a dynamic form of response that occurs at the individual level when one knows that consequences of risky health behaviors may be mitigated by insurance coverage. In fact, public systems face greater risk of ex ante moral hazard because of their inability to price according to health status, regardless of whether those health conditions result from health behavior choices that provided instantaneous gratification at the expense of worse health later in life. Once again, the waiting times for elective procedures may be seen as partially counteracting this form of moral hazard, as does the banning of direct to consumer ads to consumers. Seeing attractive images associated with lifestyle drugs may increase awareness and demand among consumers to these drugs. Aside from the US, only one country (New Zealand) allows the advertising of medications to consumers.

Coverage For Those Who Are Unable To Pay For Private Insurance

The largest social issue faced by private systems is probably the question of payment. For many reasons, a private market may not reach universal coverage. This is not an outcome predicted by insurance theory, where there should be an insurance policy by which everyone is fully insured. Assuming no moral hazard and no asymmetric information, the market should provide an opportunity for risk-averse insurance buyers and risk-neutral sellers to find mutually beneficial policies that reflect at least the actuarial price of coverage.

This textbook model assumes that the risks faced do not exceed available resources; relaxing just this one assumption leads to a world in which individuals will go uninsured and presumably less than fully insure, incurring debt or receiving inadequate care when they fall ill. Additional reasons for lack of insurance also include myopia and other threats to rationality. Insurance involves payment now for problems that could occur in the future, and theories of limited rationality suggest there will be under investment in such expenses leading to ex post regret when someone is injured while uninsured. The literature on health insurance affordability considers approximately one-fourth to three-fourth of uninsured adults to be able to afford insurance, using various measures of affordability.

Other reasons for uninsurance have to do with whether free care is provided as the ‘outside good.’ The US provision that hospitals shall provide stabilizing care regardless of pay, the availability of charity care, and other public provisions could influence an individual’s decision to remain uninsured, avoiding the payment of insurance premiums. It could also be that due to regulations or market institutional reasons, an individual may not find the policy described by the textbook model where price is relevant to that individual’s risk profile and coverage provided is relevant to the risk events they face. For example, young adults may not find prices that reflect their low statistical probability of illness because policies are based on community rates and do not vary by age, or because insurance laws mandate that the policy include coverage for types of care that young customers are unlikely to use.

When the available policy is too expensive for an individual because of their level of income, because of imperfect rationality, because of the availability of charity care, or because of the lack of a full spectrum of insurance policy options, uninsurance results and becomes a societal problem leading to concerns of equity and to financial and psychological stress rooted in inadequate access to healthcare. A private insurance system must then decide whether certain populations will be placed into a public system as well as the means by which such care will be paid. In reality, such a public system may include substantial out of pocket costs, as in the case of the US Medicare.


Public and private systems that aim to insure individuals against the uncertain need for medical care face different issues. Specifically, private systems are much more likely than public systems to suffer from adverse selection and equity concerns. Both sectors risk moral hazards but take different approaches to solving them. This article starts with the question of why a private system does not mimic a standard public insurance system and achieve universal coverage through equitable methods of financing. Issues such as affordability, selection, moral hazard, and legal contract enforceability lead to private systems providing coverage on terms that are often viewed as socially unacceptable. Both regulations and private market solutions exist to counteract these problems. However, regulations could themselves exacerbate efficiency problems in the private market, leading to a delicate balance between intended and unintended consequences, and between risk pooling and moral hazard.


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