Evaluating Health Insurance: A Review of the Theoretical Foundations
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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: [email protected]
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, 720–738. 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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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 vi
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