Key Concepts and Summary

Key Concepts and Summary

Insurance is a way of sharing risk. A group of people pay premiums for insurance against some unpleasant event, and those in the group who actually experience the unpleasant event then receive some compensation. The fundamental law of insurance is that what the average person pays in over time must be very similar to what the average person gets out. In an actuarially fair insurance policy, the premiums that a person pays to the insurance company are the same as the average amount of benefits for a person in that risk group. Moral hazard arises in insurance markets because those who are insured against a risk will have less reason to take steps to avoid the costs from that risk.

Many insurance policies have deductibles, copayments, or coinsurance. A deductible is the maximum amount that the policyholder must pay out-of-pocket before the insurance company pays the rest of the bill. A copayment is a flat fee that an insurance policy-holder must pay before receiving services. Coinsurance requires the policyholder to pay a certain percentage of costs. Deductibles, copayments, and coinsurance reduce moral hazard by requiring the insured party to bear some of the costs before collecting insurance benefits.

In a fee-for-service health financing system, medical care providers are reimbursed according to the cost of services they provide. An alternative method of organizing health care is through health maintenance organizations (HMOs), where medical care providers are reimbursed according to the number of patients they handle, and it is up to the providers to allocate resources between patients who receive more or fewer health care services. Adverse selection arises in insurance markets when insurance buyers know more about the risks they face than does the insurance company. As a result, the insurance company runs the risk that low-risk parties will avoid its insurance because it is too costly for them, while high-risk parties will embrace it because it looks like a good deal to them.

Glossary

adverse selection

when groups with inherently higher risks than the average person seek out insurance, thus straining the insurance system

coinsurance

when an insurance policyholder pays a percentage of a loss, and the insurance company pays the remaining cost

copayment

when an insurance policyholder must pay a small amount for each service, before insurance covers the rest

deductible

an amount that the insurance policyholders must pay out of their own pocket before the insurance coverage pays anything

fee-for-service

when medical care providers are paid according to the services they provide

health maintenance organization (HMO)

an organization that provides health care and is paid a fixed amount per person enrolled in the plan—regardless of how many services are provided

insurance

method of protecting a person from financial loss, whereby policy holders make regular payments to an insurance entity; the insurance firm then remunerates a group member who suffers significant financial damage from an event covered by the policy

moral hazard

when people have insurance against a certain event, they are less likely to guard against that event occurring

premium

payment made to an insurance company

risk group

a group that shares roughly the same risks of an adverse event occurring