Evaluating Health Insurance: A Review of the

Theoretical Foundations
John A. Nyman
Division of Health Policy and Mgt, School of Public Health, University of Minnesota,
15-219 Phillips-Wangensteen, Minneapolis, MN 55455, U.S.A.
E-mail: nyman001@umn.edu
Over the last 50 years, the theoretical basis of the value of health insurance has transformed
itself from one based primarily on a gain from risk avoidance and a welfare loss from the
additional medical care purchased by those who are insured, to one based primarily on the
welfare gain from the additional medical care purchased by those who are insured. This
transformation reflects (1) an increasing realization of the importance of health care in the
demand for insurance, and (2) an increasing recognition that insurance, even insurance that
pays off by paying for care, acts to transfer income from the healthy to the ill. This article
traces the development of the theory of the value of health insurance using the above two
themes as the basis for its organization.
The Geneva Papers (2006) 31, 720738. doi:10.1057/palgrave.gpp.2510103
Keywords: health insurance; income transfers; expected utility theory
Introduction
Private health insurance is a contract to transfer income or wealth from those who buy
insurance and remain healthy, to those who buy insurance and become ill. That is,
redistribution is the essence of the private health insurance contract.
Economists commonly evaluate economic behavior on the basis of efficiency and
have the powerful tool of marginal analysis for doing so. In analyzing economic
behavior, efficiency considerations have been shown both theoretically and
empirically to be important sources of welfare. Economists, however, have been
reluctant to venture into the evaluation of behavior based on redistribution or equity
because they do not have similarly powerful tools. In order to be able to thoroughly
evaluate economic behavior on the basis of equity, it is necessary both to make
interpersonal utility comparisons and to be able to evaluate these utilities from a social
welfare perspective. Both of these tools, however, are missing from the economists
toolbox.
1
In the case of insurance, however, economists are partially able to bridge the gap
between efficiency and equity by using expected utility theory. Instead of evaluating
the effect of insurance on the utility of those who become ill separately from those who
remain healthy, expected utility theory assumes that a single consumer can imagine
what it would be like to be both healthy and ill, and can evaluate the utility in these
two states from an ex ante perspective. The utilities from these states are then weighted
1
Arrow (1950).
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r 2006 The International Association for the Study of Insurance Economics 1018-5895/06 $30.00
www.palgrave-journals.com/gpp
by the probabilities (perceived or actual) associated with being in these states, in order
to determine the total effect of insurance on the typical consumer. So, instead of
insurance being thought of as a redistribution of income or wealth across consumers,
from a theoretical perspective, it is typically viewed as a redistribution of income or
wealth across health states for the same consumer. This allows what is in essence an
equity issue to be transformed into and analyzed as an efficiency issue.
In order to analyze insurance as an efficiency issue, however, it is still necessary to
specify the differences in the marginal utility across health states. In the earliest models
of the demand for health insurance, the transfer of income or wealth across health
states was analyzed using the assumption that utility is a single-argument, continuous
and twice differentiable function of income or wealth, and that the marginal utility of
income or wealth is declining. In these early models, health care spending was regarded
as a loss of income or wealth, and marginal utility of income increased with illness
solely because of that loss.
From this beginning, it is possible to view the evolution of the theoretical literature
on the evaluation of health insurance as the confluence of two trends. First, there is an
increasing realization that health care, and the utility that it generates, plays an
important role in determining the value of health insurance. Initially, health care is
essentially missing from the model, only entering the demand for health insurance as
the source of financial loss. In contrast, in the most current model, access to health
care, and to the utility derived from it, plays a central role in the private demand for
health insurance and in determining its value to society.
The second trend is the increasing recognition of the role of health insurance in
redistributing income from the healthy to the ill, and of the subtle way in which this
redistribution is manifested by health insurance. In initial models, health care price
and income elasticities were implicitly assumed to be the same for all consumers, both
healthy and ill, but in the most recent model, the response of a healthy person to a
change in the price of medical care is assumed to differ fundamentally from the
response of an ill person, and similarly for a change in income. In other words, from
an efficiency perspective, the price and income elasticities for a given individual
consumer are not constant, but are state dependent.
Similarly, in initial models, when health insurance paid for the care of an ill
beneficiary it was viewed as a price decrease for the insured consumer, whether ill or
healthy. However, in the most recent model, paying for care is viewed as a price
decrease that is effective for only the ill, and as such, constitutes a redistribution of
income from the healthy to the ill. As a result, the welfare implications for moral
hazard in the most recent model differ dramatically from those of initial models.
In this essay, the history of the theoretical thinking about the value of health
insurance is reviewed, using these trends as the organizing themes. For each of a series
of four articles, the central contribution is summarized and the limits of the analysiss
applicability in the real world are discussed, using the U.S. as an illustration. The
seminal work of Friedman and Savage begins this review.
2
2
Friedman and Savage (1948).
John A. Nyman
Evaluating Health Insurance
721
Friedman and Savage (1948)
While the history of the analysis of demand for insurance can be traced as far back as
Daniel Bernoullis 1738 paper which first suggested the concepts of utility and
diminishing marginal utility (in trying to derive a reason for the low willingness to pay
for the gamble associated with the St Petersburg paradox), the modern analysis of the
demand for insurance derives from Friedman and Savages famous paper.
3
According
to this analysis, utility is assumed to be increasing with income or wealth at a
decreasing rate. The consumer, faced with the prospect of losing a pre-specified
amount of income or wealth by chance, will choose to purchase insurance because
expected utility is greater with insurance than without it.
Formally, if y
1
is the original income or wealth level and a loss of (y
1
y
0
) occurs
with a probability of p because a person becomes ill and must spend that amount of
otherwise disposable income or wealth (henceforth, just income, the or wealth
will be understood) on health care, then expected utility without insurance is:
Eu
u
y puy
1
y
1
y
0
1 puy
1

puy
0
1 puy
1
:
1
If y* is the expected value of the income given this health care spending, such that the
actuarially fair premium payment is (y
1
y*), then expected utility of insurance with a
payoff that covers the entire loss is:
Eu
i
y puy
1
y
1
y
0
y
1
y
0
y
1
y

1 puy
1
y
1
y

puy

1 puy

uy

:
2
If the consumers utility function exhibits the standard concave or risk averse
functional form, then insurance produces a higher expected utility than no insurance.
A consumer who maximizes expected utility, therefore, would choose insurance over
no insurance. As the expected income levels are the same with or without this fair
insurance contract, the gain in welfare was attributed to choosing certainty in
preference to uncertainty.
4
Thus, the demand for insurance and the welfare gain
associated with it were related to the efficiency derived from certainty. In this model
and many subsequent applications of it that were intended to evaluate health
insurance, the gain from certainty, or equivalently, the gain from the avoidance of
risk, became the sole source of value to be recognized by economic theory.
In order to apply this efficiency gain to health insurance, the consequences of
becoming ill had to be limited to the loss of existing income represented by health care
spending, a loss that was analogous to the loss of existing wealth under fire and
casualty insurance. That is, spending on health care when ill was treated in the same
way as the loss of wealth that would occur if a consumers house burned down or if a
3
Bernoulli (1738), translated by Sommer, 1954; Friedman and Savage (1948).
4
Friedman and Savage (1948, p. 279).
The Geneva Papers on Risk and Insurance Issues and Practice
722
consumer had an accident that totally demolished his or her automobile. Thus, health
care was modelled as paying a certain pre-determined amount for health care if the
consumer became ill, and the gain from health insurance was limited to the certainty of
paying a premium equal to the expected cost of that spending, rather than enduring
the uncertainty of incurring this pre-determined loss or not.
This perspective ignores a number of important aspects of the health insurance
contract. First, consumers receive health care in return for their health care spending,
and this health care is often very valuable because it affects their health and lives. This
is in contrast to a fire or casualty insurance where, say, a fire simply destroys
something of value.
Second, this health care is predominantly consumed by those who are ill, that is, by
those whose health status has changed in important ways, compared to their health
status when the contract was purchased. This change in health status is associated with
the demand for additional services health care that would not otherwise have been
demanded at all. These services represent net additions to the individuals aggregate
demand for commodities. For example, without a diagnosis of coronary arterial
disease, a consumer might demand housing services and food, but with such a
diagnosis, he might demand those commodities plus a coronary bypass procedure. As
a result of this increase in demand for the health care services associated with illness,
the consumers marginal utility of income increases when the consumers health status
changes. In other words, it is not simply because health care spending reduces income
available for purchases of consumer commodities that the marginal utility of income
increases. It is instead because the change in health status increases the marginal utility
of income available to be spent on medical care itself.
5
Moreover, a transfer of income
from those with low marginal utility of income to those with a higher marginal
utility of income because of illness (even though it is expressed as the expected-utility
equivalent) results in a net welfare gain that is exactly the same as the gain typically
associated with the redistribution of income from rich to poor.
5
A literature has developed arguing both theoretically and empirically that the marginal utility of income
(or wealth) decreases with illness, especially, catastrophic illness (e.g., Evans and Viscusi (1991)), which is
seemingly contradicts the assumptions used throughout this paper that marginal utility of income (or
wealth) increases with illness. These studies, however, do not recognize that health insurance represents an
income transfer that is made to the ill when they become ill. For example, Viscusi and Evans (1990) find
that the marginal utility of income is lower when injured on the job than when healthy. This study,
however, is based on data from workers in the chemical industry in 1982, most of whom are presumed to
have health insurance. Because of this, Evans and Viscusis estimates captured the marginal utility of
income of the injured worker assuming that a health insurance income transfer was also made to cover
medical care expenses at the time of their injury. Because the consumer already has more income stemming
from the health insurance payoff, the marginal utility of income spent on consumer goods and services
can be smaller. In other words, Evans and Viscusis estimates only measured the change in the marginal
utility of income available to spend on non-health-related consumer goods and services, with and without
injury. They did not measure the change in marginal utility of income available to spend on non-health-
related consumer goods and health care, with and without injury. If workers did not have health insurance
(or make precautionary savings) and had to cover their health care expenses out of their disposable
income, it seems clear that illness or injury would generally increase the marginal utility of income or
wealth because of the value of the health care purchases, especially catastrophic ones, that would need to
be made out of their existing income or wealth.
John A. Nyman
Evaluating Health Insurance
723
Third, the assumption of a predetermined loss (that is either paid for by the
uninsured consumer or the insurer) ignores that insurance represents a contract where
income is transferred from the healthy to the ill, and that consumers with more income
are likely to purchase more health care when they become ill, compared to those with
less income. Thus, the prospect of insurance paying for care represents an effective
increase in income to the consumer, who in turn responds by purchasing more health
care because health care is a normal good.
6
Indeed, the income transfer in insurance
may permit the purchase of health care that is far beyond the consumers budget
constraint and access to this health care makes insurance very valuable.
Overlooking the effect of the income transfer on medical care consumption appears
to be due, in part, to the specification of the model. The model is conventionally
specified as a choice between certainty and uncertainty. The purchase of insurance is
interpreted as implying that consumers prefer a certain loss to an uncertain loss of the
same expected magnitude. Indeed, this or similar language is often used in health
economics texts to explain why consumers purchase insurance. This choice
specification, however, obscures the underlying transfer of income from healthy to
ill, and has distracted analysts from appreciating the role that income transfers play in
increasing medical care consumption.
Indeed, in the experimental studies associated with prospect theory,
7
where subjects
are given exactly this choice, a majority invariably prefer the uncertain loss to the
certain loss of the same expected magnitude, exactly the opposite to the conventional
explanation. In one study, a head-to-head comparison was made between (1) an
insurance policy that cost $50 and covered a 25 per cent chance of losing $200 and (2)
a choice between a $50 loss and a $200 loss that occurred 25 per cent of the times.
8
A
majority (65 per cent) of the 208 subjects preferred to purchase insurance when
confronted with the choice framed as in situation (1), but a majority (80 per cent)
preferred the uncertain option, favoring the 25 per cent chance of a $200 loss, when
confronted with the choice framed as in situation (2). Thus, not only does this
specification obscure the income transfer within insurance, but the words used to
explain the demand for insurance are exactly contradicted by experimental evidence.
In the standard theory of the consumer, the purchases that the consumers make are
typically viewed by economists as quid pro quo transactions: the consumer pays a price
in dollars and in exchange, he or she receives a good, service, contract obligation, etc.
The reason that consumers make a purchase is that the value of the commodity,
determined by the consumers maximum willingness to pay, exceeds its price and
generates a surplus for the consumer. A specification of the demand for insurance that
is consistent with the quid pro quo transaction is simply to find the difference between
equations (1) and (2):
Eu
i
y Eu
u
y puy

1 puy

puy
0
1 puy
1
: 3
6
See, for example, Fleurbaey (2004).
7
Kahneman and Tversky (1979).
8
Slovic et al. (1988).
The Geneva Papers on Risk and Insurance Issues and Practice
724
Collecting terms associated with the same states of the world yields:
Eu
i
y Eu
u
y puy

uy
0

1 puy

uy
1
:
4
Thus, under a quid pro quo specification, the net gain in utility from purchasing the
insurance contract is the utility gained from the income transferred to the consumer if
ill, net of the utility lost from paying the premium if healthy. If utility were measured
in dollar equivalents, this would be analogous to an expected consumer surplus.
9
The explanation of why consumers purchase insurance differs depending on
the specification of the model. With the conventional specification (equations 1 and 2),
the demand for insurance was interpreted as a demand for certainty, or a demand
for the avoidance of risk. As a result of this specification, risk, conceptualized
as what is avoided when equation 2 is chosen over equation 1, represented the focus
of and the important motivator in the decision to purchase insurance. That is,
insurance eliminates risk. However, if a quid pro quo specification (equation 4) had
been adopted, then the demand for insurance would have been a demand for an
income transfer in the event of illness. This would have placed the emphasis on the
income payment when ill (or when the bad state of the world occurred) in explaining
why consumers purchased insurance. A quid pro quo specification would have led
analysts to recognize the importance of the redistribution of income in insurance
contracts, and the potential effect of this increased income on increasing health care
purchases. And, by collecting utilities associated with health states, the changing
nature of the utility function in response to changes in health state would have been
easily recognized.
Pauly (1968)
As part of the debate surrounding the passage of Medicare and Medicaid in the U.S.,
Kenneth Arrow argued that if health insurance were provided at actuarially fair
premiums to consumers who maximized expected utility and who possessed risk
averse utility functions, the case in favor of insurance would be overwhelming.
10
In
his paper, Arrow held that the gain from insurance owed solely to the certainty (or risk
avoidance) that was described by Friedman and Savages (1948) model and because of
this, insurance generated a welfare gain.
9
Alternatively, if p [u(y*)u(y
1
)] is subtracted from and added to the right hand side of equation (4), then
the resulting equation,
Eu
i
y Eu
u
y puy

uy
0
puy

uy
1

1 puy

uy
1
puy

uy
1

puy
1
uy
0
uy

uy
1
;
5
suggests that the insurance contract is purchased with the premium or price regardless of health state, and
in return, the consumer obtains the entire payoff of (y
1
y
0
) in the event of illness. Again, this specification
would emphasize that consumers purchase insurance to receive an increase in income in the ill state.
10
Arrow (1963).
John A. Nyman
Evaluating Health Insurance
725
In response to this paper, Mark Pauly wrote what was to become one of the most
influential health economics papers to appear during the last third of the 20th
century.
11
This paper questioned the conclusion that a welfare gain was eminent with
health insurance because of the presence of moral hazard. Pauly recognized that if
insurance pays off by reimbursing for any health care spending that occurs and the
consumer knows this, then the insurance payoff is equivalent to changing the price of
medical care to zero. As this price change is artificial the true price is still the
marginal cost of producing the health care insurance generates a welfare loss that is
associated with the additional health care consumed when insured. Pauly noted that
this welfare loss might be so large as to swamp the gain from certainty, resulting in a
net change in utility that could well be negative.
12
Martin Feldstein embraced this model as his own, and in still another seminal paper,
presented an empirical calculation of the net welfare implications of the level of
insurance coverage in the U.S. at the time.
13
He calculated that the level of insurance
coverage in the U.S. was represented by an average coinsurance rate of about 33 per
cent including the contribution of those who were uninsured at the time. He
concluded, however, that this rate of coverage was excessive and overall produced a
very substantial welfare loss.
14
He suggested that the coinsurance rate should be
raised to 67 per cent or higher in order to reduce the welfare loss from health
insurance.
With Paulys model,
15
health care itself entered into the welfare calculations for
health insurance. In contrast to Friedman and Savage
16
who viewed the health care
associated with health insurance as simply generating a financial loss, the additional
health care in Paulys model had value. This value, however, was less than the cost of
producing this health care, and as a result, generated the oft-cited moral hazard
welfare loss associated with health insurance.
While the utility from health care now appears in this model of the demand for
health insurance, any recognition of the redistribution associated with insurance is
missing. Specifically, Paulys demand curve does not distinguish between those who
are ill and those who are healthy. The demand curve analysis assumes that consumers
would generally respond to the change in the price of health care just as they would
respond to any a change in price of any other consumer commodity. Paulys model
does not recognize that healthy and ill consumers might respond differently to a
change in the price of medical care. For example, a healthy consumer would not
consume a coronary bypass procedure, regardless of how low the price becomes,
because of the disutility associated with medical care when healthy. In contrast, a
consumer who has been diagnosed with coronary blockage may respond to the price
decrease by purchasing a bypass procedure that he would not have been able to afford
at a higher price.
11
Pauly (1968).
12
Ibid., p. 534.
13
Feldstein (1973).
14
Ibid., p. 275.
15
Pauly (1968).
16
Friedman and Savage (1948).
The Geneva Papers on Risk and Insurance Issues and Practice
726
Although Paulys model might be appropriate for certain types of discretionary
health care that do not require being ill as a precondition cosmetic surgery, drugs to
enhance sexual function, or designer prescription sunglasses it does not apply to
health care that is consumed by those who are seriously ill. Most health care spending
appears to be devoted to paying for the more serious types of health care. For example,
the Medical Expenditure Panel Survey found that the top 10 per cent of health care
spenders in the U.S. accounted for about 72 per cent of all health care spending.
17
It is
likely that almost all of this spending represents hospital procedures trauma, organ
transplants, resections of lesions, etc. for those who are seriously ill, and not the sort of
discretionary procedures that Pauly and Feldstein apparently had in mind.
Moreover, once it is recognized that the demand for specific health care procedures
differs by health state, the redistribution of income from healthy to ill must then be
brought into the model. And once this redistribution is recognized, then it must also be
recognized that at least a portion of the additional health care consumed when insured
is due to this income transfer. Thus, the problem with Paulys model is that the moral
hazard is not necessarily a response to a change in price alone. As insurance also
represents a redistribution of income, a portion of the additional health care consumed
by the insured is due to this income transfer. As a result, health insurance paying for
health care could either be modelled as a price reduction, or as the vehicle by which
income is transferred from those who are healthy to those who are ill, or a
combination of both.
Although some have claimed the contrary, to my knowledge the interpretation that
an artificial price change can be a vehicle for transferring income appears not to have
precedence in economic theory.
18
Instead, economic theory has uniformly viewed the
establishment of artificial prices as changes in incentives and sources of inefficiency.
To paraphrase the personal correspondence from a distinguished insurance
theoretician, when you have the hammer of incentive theory, every problem with an
artificial price change looks like a loose nail.
The models of Friedman and Savage
19
and Pauly
20
dominated the thinking about
the value of health insurance in the U.S. during the latter half of the 20th century and
represented the accepted paradigm through which health insurance in the U.S. was
viewed and evaluated. The dominance of this paradigm is evidenced by the number of
17
Cohen et al. (2000).
18
Some have suggested that Arrow first identified the role of the insurance price reduction in transferring
income to the ill (or to the ill state). I have not been able to find a discussion of this in his work. In his
1963 paper, Arrow adopts the Friedman and Savage (1948) view that insurance is valuable only because
of the certainty it provides. In his response to Pauly (Arrow (1968)), he adopts Paulys view that all moral
hazard is welfare decreasing, suggesting that in the presence of moral hazard, non-market controls (such
as rationing) might be adopted to force the consumer to purchase only what would have been bought in
the absence of insurance (Arrow (1968, p. 538)). In Arrow (1976), he provides for a feed-back
mechanism so that moral hazard spending is reflected in the fair insurance premium, but because the
model is a miniature general equilibrium model for a single (average) consumer rather than an expected
utility model, it does not allow for the effect of transfers from (those in) the healthy state to (those in) the
ill state.
19
Friedman and Savage (1948).
20
Pauly (1968).
John A. Nyman
Evaluating Health Insurance
727
studies that based their empirical calculations and conclusions regarding the value of
health insurance in the U.S. on these theories alone.
21
A number of these studies were
based on data from the RAND Health Insurance Experiment, which was also based
on this paradigm.
22
The dominance of this paradigm is also evidenced by the large
number of U.S. health economics texts that presented the theory of the demand for
health insurance as (1) an efficiency gain from the avoidance of risk, balanced against
(2) an efficiency loss derived from moral hazard, and therefore as consistent with these
two models.
23
Only recently have a few of these texts presented an alternative, more
comprehensive theory of the value of health insurance.
24
Subsequent to the publication of the Friedman and Savage, and Pauly papers,
25
a
number of other models appeared in the literature addressing the demand for
insurance and health insurance. A number of these made important contributions. For
example, Mossin presented the case that the demand for insurance fell with wealth.
26
With regard to the health portion of this literature, however, Richard Zeckhausers
paper is especially noteworthy.
27
While state dependent utility can be traced back to
Eisner and Stotz,
28
Zeckhauser appears to have been the first to apply state-dependent
utility to health insurance.
29
Zeckhauser also implicitly demonstrated that when insurance pays off by making a
lump sum transfer to the beneficiary, health insurance consumes more health care than
if uninsured. However, the most enduring contribution of his 1970 paper (and the
aspect that most influenced subsequent work) was, perhaps, his conceptualization of
optimal health insurance as a tradeoff between risk spreading and appropriate
incentives, as the title of his paper makes clear. This conceptualization, however, is
consistent with the welfare gain and loss described by Friedman and Savage, and
Pauly.
While Zeckhauser recognized the importance of health state on determining
behavior with insurance and thereby better captured the value of the health care,
his paper did not recognize that a portion of the incentives within standard
(coinsurance) insurance were in fact appropriate because they generated health
care purchases whose value exceeded the costs. Moreover, his model did not explicitly
include the income transfer, and without recognizing the income transfer, it is
difficult, if not impossible, to understand the welfare implications of the insurance
price reduction.
21
Pauly (1969); Zeckhauser (1970); Feldstein (1973); Friedman (1974); Feldstein and Friedman (1977);
Manning et al. (1987); Feldman and Dowd (1991); Newhouse et al. (1993); Manning and Marquis (1996);
Zweifel and Manning (2000); Cutler and Zeckhauser (2000).
22
Newhouse (1974).
23
Feldstein (1988, 1993, 1999, 2005); Folland et al. (1993, 1997, 2001, 2004); Getzen (1997, 2004);
Henderson (1999, 2002, 2005); Santerre and Neun (1991, 2000); Phelps (1992, 1997, 2003); Jacobs and
Rapoport (2004).
24
Johnson-Lans (2006); Santerre and Neun (2007).
25
Friedman and Savage (1948); Pauly (1968).
26
Mossin (1968).
27
Zeckhauser (1970).
28
Eisner and Strotz (1961).
29
Viscusi and Evans (1990).
The Geneva Papers on Risk and Insurance Issues and Practice
728
As I stated in the introduction to this paper, the intent of this somewhat
idiosyncratic review of the literature is to follow two threads through the literature: the
realization that the value of health insurance is closely related to the value of health
care, and the recognition of the income transfer in insurance and the role of the
insurance price reduction in accomplishing this transfer. By following these threads,
the theoretical basis for evaluating health insurance is expanded from (1) the risk
avoidance gain, net of (2) the moral hazard loss, to include in addition (3) the gain
from access to otherwise unaffordable care (and the simultaneous reduction of the
portion of the moral hazard welfare loss that is attributed to the income transfer), and
(4) the external benefits that this access to health care bestows on other members of
society. To remain consistent with this intent, this essay considers only 2 other models.
De Meza (1983)
The type of health insurance where a beneficiary is paid a lump-sum amount upon
diagnosis of a health condition is often referred to as contingent claims insurance. In
an important paper, de Meza considered the issue of why people purchase contingent
claims health insurance, rather than save for a rainy day (that is, build up
cautionary savings to pay for health care) or borrow when ill.
30
Even though de Meza presents a model of contingent claims health insurance (and
not conventional health insurance that pays off by paying for health care and, as a
result, by reducing the price of care), his paper makes a number of insightful
contributions to understanding conventional insurance. His model can be summarized
as follows. First, he assumes utility is state-dependent: utility depends on the spending
of disposable income on other goods when healthy, but it depends on the spending of
disposable income on both medical care and other goods when ill. Next, he makes the
standard assumption that when ill, disposable income is allocated so that the marginal
utility of spending on other goods equals the marginal utility of spending on medical
care, and then assumes that because of these additional demands, the marginal utility
of disposable income (optimally divided between medical care and other goods) when
ill exceeds the marginal utility of disposable income when healthy. In this way, he is
able to finesse the specification of a utility function when ill, but at the same time,
incorporate the realism that the value of insurance is related to the value of health care
on which the additional income generated by insurance is spent, and this health care is
generally very valuable to an ill person.
31
De Meza then establishes that medical care spending when insured is greater than
medical spending if financed by either saving or borrowing. He does so by showing
that the cost of medical care spending if financed by insurance is smaller in terms of
present consumption foregone than the cost of medical care spending if financed by
saving or spending. This is because, in order to spend an additional $1 when ill if
financed through saving, $1 of present consumption must be foregone, but in order to
30
De Meza (1983).
31
This gain is similar to utility gain from a transfer of income from rich to poor, only it is expressed in an
ex ante health insurance frame.
John A. Nyman
Evaluating Health Insurance
729
spend an additional $1 when ill financed through insurance, only a fraction of $1 of
present consumption must be forgone because not everyone becomes ill at the same
time. Thus, the consumer with insurance pays into the insurance pool only a small
portion of the amount that the consumer is paid if ill. As a result, the optimal
disposable income when ill is larger when using insurance to finance health care,
compared with using saving or borrowing to finance it, and as a result, spending on
medical care is also larger.
32
Although de Meza considers the demand for insurance compared to the demand for
cautionary savings or borrowing, rather than the more conventional comparison of
the demand for insurance compared to simply being uninsured, his model contains two
other important insights for understanding the demand for health insurance. First, he
materializes the mechanics of the insurance contract by emphasizing the fact that
any payout when ill originates in premium payments when healthy. That is, although
expected utility theory is used, the mechanics of the income transfer are made explicit
in his model.
Second, and perhaps most important, the income effect of the insurance payoff is
also modeled explicitly. That is, the reason why medical care spending is greater when
insured is because disposable income is greater due to the income transfer, and this
implies that medical care spending will be greater as well. As a result, moral hazard
the consumption of additional medical care when insuredcan occur because of an
income effect.
Subtle differences in specification can often have enormous theoretical implications.
There is, perhaps, no better illustration of this than the difference between how de
Meza and Pauly specify health care spending when healthy.
33
De Meza makes the
assumption that health care spending is $0 when healthy. This is a reasonable model
for many specific illness/treatment pairs. For example, if becoming ill is operationa-
lized as contracting appendicitis for which medical care is an appendectomy, then ill
results in medical care being consumed and healthy clearly does not.
Pauly, in a 1983 response to de Meza, took issue with the idea that there would be
any income effect at all with health insurance. Paulys argument is based on the
equally realistic assumption that health care spending when healthy would be some
small amount, say, $100. If ill, spending would be an additional $1,000, or $1,100 in
all, in Paulys example. If the probability of illness is 0.1, then the actuarially fair
premium is $200, because total spending for every 10 consumers is
(9 $100 1 $1,100) $2,000. Under a contingent claims policy where the insured
consumer was paid either $100 or $1,100, depending on whether healthy or ill,
respectively, any income effect would be negative for the healthy consumers (since they
paid $200 for the insurance premium but received only $100 in payoffs). Assuming a
certain constant propensity to spend income on medical care that does not depend on
health state, the reduction in spending by the healthy would exactly cancel the increase
32
De Mezas model further suggests that because the cost in terms of present consumption forgone is lower
with insurance than with saving, health savings accounts are less efficient than health insurance as a
vehicle for generating income when ill.
33
De Meza (1983); Pauly (1983).
The Geneva Papers on Risk and Insurance Issues and Practice
730
in spending by the ill. Thus, under these assumptions, health insurance cannot
generate any additional health care spending due to income transfers because the
income gains equal the income losses. This assumption, however, leads to the
unreasonable conclusion that the massive redistribution of income from healthy to ill
consumers, represented by the widespread application of private contingent claims
insurance, would not result in any increase in health care spending at all.
As mentioned, de Meza assumes the propensity to spend income on medical care is
zero when healthy, consistent with the absence of health care spending when healthy,
and becomes positive only when ill. This latter small change in specification leads to
the conclusion that contingent claims insurance generates additional health care
spending only among the ill. To make this assumption more realistic, it would simply
be necessary to assume that the propensity to spend income on health care is greater
when ill than when healthy.
Paulys 1983 comment also established the state of the art regarding the
understanding of moral hazard at the time. He suggested that his original discussion
34
pertained only to moral hazard for relatively minor illnesses and health care
expenditures, such as routine physicians services, prescriptions, dental care, and the
like but that [t]he relevant theory, empirical evidence and policy analysis for moral
hazard in the case of serious illness has not been developed. This is one of the most
serious omissions in the current literature.
35
Despite de Mezas insights and Paulys admission, the theory that dominated health
economics research and health policy continued to hold that (1) health insurance was
demanded because consumers preferred certain losses to uncertain ones of the same
expected magnitude, but that (2) the additional health care consumed because of
health insurance made consumers worse off. Empirical calculations of the value of
health insurance during this period continued to suggest that moral hazard so
dominated welfare calculations that health insurance at current coverage parameters
made consumers worse off.
36
As is evidenced by the RAND Health Insurance
Experiment and many other similar studies, health economics in the U.S. was
dominated by the issue of empirically determining the extent that health insurance led
to high and rising health care costs in part because of the theoretical connection
between the growth of health insurance coverage in the U.S. and the additional
(presumably inefficient) health care spending.
37
Also because of the widespread acceptance of this theory, most of health policy in
the U.S. from the implementation of cost sharing of the 1970s to the adoption of
managed care of the 1980s and 1990s to the recent interest in consumer-driven health
care and health savings accounts was based on the presumption that in an insurance-
dominated environment, too much quantity of health care was being consumed. The
portion of the costs of medical care that were attributable to the high prices of medical
care were actually seen as favorable because the high prices reduced the size of the
34
Pauly (1968).
35
Pauly (1983, p. 8283).
36
See Nyman for a review of the empirical literature. Nyman (2006).
37
Newhouse et al. (1993).
John A. Nyman
Evaluating Health Insurance
731
moral hazard effect.
38
The RAND Health Insurance Experiment made it clear that
greater cost-sharing would reduce the quantity of health care demanded.
39
As the
health of those who responded to cost-sharing by reducing health care consumption
appeared to be largely unaffected by the reduction in care the Health Insurance
Experiment also seemed to confirm the theoretical presumption that the extra health
care consumed with insurance was not very valuable.
Nyman (2003)
An alternative theory has been suggested that is based on two tenets.
40
First, a health
insurance contract is a quid pro quo transaction. That is, when consumers purchase a
health insurance contract, they are paying a premium if healthy for an income transfer
if ill, as equation (4) above illustrates.
41
Therefore, the demand for health insurance is
a demand for an income transfer if ill, rather than for risk avoidance. The premium if
healthy is the price of this contract and the net gain can be conceptualized by the
expected consumer surplus.
42
In this conceptualization, the financial loss from medical
expenditures is no longer the focus and is replaced by a change in health status.
Second, the price reduction in health insurance no longer represents a movement
along the demand curve, but is instead a vehicle for transferring income from those
who remain healthy to those who become ill. This is based on the realization that for
most health care, a change in price to zero would not entice healthy consumers to
purchase it. For example, what healthy consumer would purchase a coronary bypass
procedure simply because the price dropped to zero? As a result, for most health care,
the price reduction is effective only for those who are ill, and as such, it represents the
vehicle for transferring income to them.
It is also based on the realization that the response by an ill person to an insurance
price reduction without the income transfer would leave the consumer on their original
budget constraint. That is, if everyone who held insurance became ill and as a result,
there was no transfer of income from healthy to ill, an insurance contract would
simply represent a contract that entitled the beneficiary to pay a lower price for health
care. The cost of this lower price and the beneficiarys response to it, however, would
be entirely paid for up front by the premium, and would not move consumers off
their original budget constraint.
In comparison, with health insurance, only a portion of consumers become ill in any
given period. Thus, although the price of health care with insurance decreases, it is
only because of the transfer of income that the consumer is able to consume
38
Pauly (1995); Crew (1969).
39
Newhouse et al. (1993).
40
Nyman (1999a, b, 2003); Nyman and Maude-Griffin (2001).
41
Equation (4) is used here for illustration of the income transfer effect. The utility function used in the
model in Nyman (2003) is state-dependent, where if ill, utility is a function of health care and spending on
other goods and services, but if healthy, utility is a function of spending on other goods and services
alone.
42
A slightly different alternative specification has already been shown in equation (5), but it is generally
consistent with this description
The Geneva Papers on Risk and Insurance Issues and Practice
732
beyond his or her budget constraint when the price falls. Thus, in health insurance, the
price decrease is actually the vehicle by which income is transferred from the healthy
to the ill, and so, a portion of the response to the price decrease is due to this
income transfer.
The core implication of this theory is that moral hazard the additional health care
consumed because of the price reduction that is used to pay off the health insurance
contract is made up of a portion that is due to the income transfer and a portion that
is due to the pure price effect, that is, due to using a price reduction to transfer income.
The former is efficient and welfare increasing, and the latter is inefficient and
welfare decreasing. As a result of this, the welfare implications of health insurance are
substantially different from those of the conventional theory. Not only is the welfare
loss smaller because inefficient moral hazard represents only a portion of the total
moral hazard, but also the remaining portion of the moral hazard no longer represents
a welfare loss, but instead, a welfare gain. The substitution of a gain for a loss in the
welfare calculations causes a dramatic increase in the value of health insurance.
Intuitively, much of moral hazard represents the purchase of additional health care
that consumer would not otherwise be able to afford, and this increased access to
expensive and often life-saving health care generates an important welfare gain that
has not been recognized in previous theories.
For example, consider the example of Elizabeth who has just been diagnosed with
breast cancer. Without insurance, Elizabeth would have purchased a $20,000
procedure to excise the cancer from her breast. She would have considered purchasing
an additional $20,000 procedure to correct the disfigurement caused by the first
procedure, but this breast reconstruction would be too expensive without insurance,
given the competing claims on her resources. As a result, she would only purchase the
first procedure if uninsured.
Fortunately, Elizabeth had purchased a health insurance contract for $4,000 that
pays for all her care. With this insurance, she purchases (1) the cancer excision
procedure costing $20,000, (2) the breast reconstruction costing $20,000, and (3) an
extra 2 days in the hospital to recover costing $4,000. Moral hazard is represented by
the additional consumption of health care when insured, represented here by the
additional $24,000 in spending for the breast reconstruction and 2 extra days in the
hospital.
To determine the efficient and inefficient portions of moral hazard, it is necessary
to decompose the additional spending into the portion generated by the income
transfer and the portion generated by the pure price (substitution) effect. As
the insurer has paid $44,000 out of the insurance pool for Elizabeths care while
she has paid in only $4,000 in premiums, a transfer of $40,000 in income has
occurred. What would Elizabeth have done if instead a cashiers check for $44,000 had
been written to her upon diagnosis of breast cancer and the transfer had been a lump
sum amount?
With her original income plus this additional amount, assume that Elizabeth would
have purchased (1) the excision of the cancer and (2) the breast reconstruction, but
not (3) the extra 2 days in the hospital. If so, efficient moral hazard is represented by
(2) the $20,000 breast reconstruction, because Elizabeth could have purchased
anything of her choosing with her original income plus the additional $40,000 in
John A. Nyman
Evaluating Health Insurance
733
income (from the $44,000 cashiers check minus her $4,000 premium), but chose to
purchase the breast reconstruction. That is, her willingness to pay with the additional
$40,000 now apparently exceeds the purchase price of the breast reconstruction
procedure, $20,000, therefore, the purchase is efficient. On the other hand, the 2 extra
days in the hospital would not have been purchased, so their purchase under the policy
that pays for all care represents inefficient moral hazard and a welfare loss for the
conventional reasons.
Nyman has suggested that the welfare gain from the income transfer effect is the
dominant reason for the purchase of health insurance.
43
Indeed, it so dominates the
welfare calculations that it results in a welfare gain from moral hazard that is about
three times the costs, according to calculations based on findings from the literature.
That is, the main reason for purchasing insurance under this theory is the valuable
additional health care that is purchased, not an aversion to risk.
This theory explicitly takes account of the transfer of income from those who
remain healthy to those who become ill. It assumes that reduction in income
represented by the premium payments does not reduce the number of cancer excision
procedures among those who remain healthyan obvious point, but critical to the idea
of a differential (income) effect from the income transfer. Therefore, there is a net
increase in health care consumption because of the transfer of income from the healthy
to the ill.
The theory also explicitly takes into account the fact that for most medical
procedures, the price decrease is effective only for those who are ill. No healthy
consumer would purchase a procedure as serious and unpleasant as a breast
reconstruction or a course in chemotherapy just because the price has dropped to zero.
Therefore, the price decrease is the vehicle by which income is transferred to the ill,
and to a certain extent represents a shifting out of the (Marshallian) demand curve,
rather than a movement along the demand curve.
This theory has a number of implications that have been discussed in more detail
elsewhere.
44
First, the price of insurance under conventional theory is the loading fee,
but under the new theory, the price of insurance is the entire premium. Second, the
inefficient portion of moral hazard represents the transactions costs of a contract that
uses a price reduction to transfer a certain amount of income to a consumer who
becomes ill. Third, in contrast to an exogenous decrease in the market price, the price
decrease in health insurance must be purchased. Therefore, instead of decomposing
the exogenous price decrease into a single Hicksian income effect, the price decrease
in health insurance contains two income effects: (1) the effect of the income
transfer described earlier, and (2) the effect of having to pay a larger premium in order
to obtain an insurance contract with a lower coinsurance rate. Fourth, the financial
loss that is salient in the conventional theory is replaced by a change in health
state and a desire for additional consumption (the health care) in the ill state.
Fifth, the demand for a health insurance contract is derived from the transfer of
income to the ill state and the additional health benefits that are generated by the
43
Nyman (2003).
44
Ibid.
The Geneva Papers on Risk and Insurance Issues and Practice
734
resulting increase in health care purchases. Sixth, an important positive demand-side
externality is the benefit that others derive from an ill person being able to gain
access to the needed care, care that such persons would not otherwise have been able
to afford to purchase if they were not insured. This external benefit is a market
failure and represents the prime reason for government intervention either to subsidize
the purchase of health insurance or to provide it to all its citizens. This gain is
missing from studies that evaluate health insurance on the basis of the risk avoidance
gain, because it is assumed that with or without insurance, the needed care would
be purchased.
Conclusions
This paper holds that the redistributive nature of health insurance has been obscured
by the requirement that the demand for health insurance be modelled in expected
utility terms. As a result of embodying the demand for health insurance in the expected
behavior of a single consumer, early models of the demand for health insurance did not
adequately distinguish between the behavior of those who became ill and those who
remained healthy. And the subtle way in which the transfer of income from the healthy
to the ill is manifested in health insuranceas a price reduction that is effective only for
those who are illwas missed.
Moreover, the role of health care in the demand for health insurance also evolved
from something that generated only a welfare loss, to something that generated a net
welfare loss, to something that generated a net welfare gain. Indeed, empirical
studies suggest that the welfare gain derived from access to the additional health
care that is generated by health insurance now represents the dominant explanation
for the demand for health insurance.
45
The certainty- or risk-related benefit on which
the earliest theory was based in its entirety is now estimated to provide only a
negligible fraction of the gain from the additional health care.
46
Very little empirical work actually underpins the newest theory. Evidence is lacking
regarding the portion of moral hazard that is efficient and inefficient, and we have
little evidence that can be used to determine the welfare effects. Ideally, a randomized
trial, similar to the RAND Health Insurance Experiment, would be done to determine
these magnitudes. For example, those who do not now have insurance could be
randomized into three arms: (1) remaining uninsured, (2) becoming insured with
insurance that pays for all care, and (3) becoming insured under an equivalent
contingent claims insurance, where the consumer is paid a cashiers check upon
diagnosis in an amount equal to what the insurer would pay if the insurer simply paid
for all care. Comparison of the amount of spending in arm (3) to spending in arm (1)
would determine efficient moral hazard, and comparison of spending in arms (2) and
(3) would determine inefficient moral hazard. Clearly, there are practical, budgetary,
and ethical issues in designing such a study.
45
Nyman (2003); Miller et al. (2004); Muennig et al. (2005).
46
Miller et al. (2004).
John A. Nyman
Evaluating Health Insurance
735
In the meantime, studies could be done that would indirectly determine the relevant
magnitudes. For example, Koc has shown that moral hazard effects differ for those
who are healthy compared to those who are ill.
47
Also, Nyman and Barleen have
estimated the health benefit derived from moral hazard in the case of supplemental
health insurance in Brazil.
48
Other similar studies are underway.
In summary, this paper describes an evolution of the theory of the value of health
insurance that suggests that health insurance is much more valuable than previous
theories have held. Health care represents a substantial portion of the economies of
developed countries and of many developing countries as well. Understanding the
welfare associated with the principle mechanism for financing and gaining access to
this health care private and public health insurance would seem to be an important
undertaking, based on the size of the health care sectors alone.
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About the Author
John A. Nyman, Ph.D., is a health economist and Professor in the Division of Health
Policy and Management, School of Public Health, University of Minnesota,
Minneapolis, U.S.A. His research interests range from health insurance theory and
cost-effectiveness analysis to gambling theory, physician behavior and nursing home
policy in the U.S. He is the author of The Theory of Demand for Health Insurance
(Stanford, CA: Stanford University Press, 2003).
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