QUESTION: Why do well-functioning insurance markets require the insured population to be risk averse?

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Private insurance exists in nearly every nation, either as the primary method for distributing healthcare or as a supplemental system. For private or supplemental insurance to succeed, the people seeking coverage must haverisk aversionmeaning that the insured population has declining marginal utility. An alternative way of thinking about this population is that the people'sutilityis affected more severely by a loss than by a gain of the same magnitude. Although most individuals have behaviors and preferences that are indifferent to risk or even risk seeking, most individuals have some measure of risk aversion when it comes to health.

In a stylized and simplistic example of how private insurance markets function, imagine two states of health mapped onto a declining marginal utility curve (seeexhibit 2.4). The vertical axis represents the measure of an individual's satisfaction or economic utility, and the horizontal axis represents income or wealth. As income increases, so does utility, but it does so at a declining rate. The relationship is nonlinear. More income creates more utility, but the impact of the additional income declines as the population or individual makes more money.

Predicting Healthcare Costs

Regardless of the differences in the ways healthcare delivery systems are organized, the mechanisms for predicting general health expenditures remain remarkably similar (Lynch 1992). Governments or insurance firms, collectively referred to aspayers, exchange an individual'scontingent losses(in the eventthat the individual falls ill or needs or seeks care) for a fee. That fee may be a direct premium paid for by the consumer (as in the case of private insurance), or it may be paid for indirectly through tax revenues (as is the case with universal or social insurance coverage).

In a well-functioning system, payers first estimate the contingent losses or expenses for the covered population. The estimate incorporates the size of the eligible population, the intensity of utilization per person, and the cost of services to be provided. To determine total health expenditures, payers must project the probability that members of a predetermined target population will need or seek care. This probability represents thehealth status risk(also called thepopulation health risk). The health status risk is then paired with themedical care riskthe estimated cost of providing care in the event that an individual seeks an intervention. Multiplying the probability of needing healthcare (health status risk) with the interventional costs (medical care risk) gives rise to theexpected medical costfor an individual.

The expected medical costs can then be applied across the entire insured population to arrive at a global estimate of healthcare costs.²The process of calculating the expected medical costs is commonly known as theunderwriting methodology. It relies on large data sets and actuarial tables to determine the average health status and medical care risk for a target population.The calculation and use of predicted medical expenses typically depend on national, social, and cultural norms. The methodology may reflect the idea of solidarity among individuals, with mutual aid between the sick and well, or it may stress individual responsibility and autonomy.

After medical expenses are projected, theloading factorsthe overhead costs incurred while administering to the insured populationare considered. These administrative expenses cover such areas as auditing, clinician and facility oversight, utilization management, and, in the cases of private, investor-owned firms, profit. If the projected medical and administrative costs are unacceptably high, overhead expenses can be cut, or demand- and supply-side tools may be employed. The aggregate costs (medical plus overhead expenses) drive a total fee that must be paid out of pocket, through a supplementary insurance premium, through an employer/employee tax, or from government tax revenue.