NOTE: This article is the fourth in a series of 10 articles and is part of our Health Economics 101 course. You can find a course overview and links to all 10 course modules here:

Health Insurance and Risk Management

Health insurance plays a central role in modern health systems, functioning both as a mechanism for financing care and as a critical tool for managing financial risk associated with illness and injury. In health economics, the study of insurance is grounded in the principles of risk pooling, uncertainty, and market behavior. Yet, health insurance markets also experience specific failures, including moral hazard and adverse selection, which necessitate regulatory oversight and public policy solutions.

The Concept of Insurance in Health Economics

At its core, insurance is a financial mechanism designed to manage risk. Individuals or entities pay premiums into a collective fund, and those who experience specific losses—such as illness, hospitalization, or disability—receive compensation. In the context of health economics, insurance serves to protect individuals from the unpredictable and potentially catastrophic costs of health care.

Health is characterized by uncertainty in both timing and magnitude: individuals do not know when they will become ill or how much care they will need. This makes insurance an attractive tool for risk pooling, whereby the costs of health care are spread across a population. By pooling risks, insurance reduces the financial burden on individuals when health shocks occur and promotes more equitable access to care.

Unlike other forms of insurance (e.g., car or home), health insurance is not only a financial contract but also affects utilization behavior, pricing, and access. These features make the economics of health insurance particularly complex.

Types of Health Insurance (Public vs. Private)

Health insurance systems vary widely across countries and typically involve a combination of public and private arrangements.

Public Health Insurance

Public health insurance is financed primarily through taxation or mandatory social contributions and administered by governments or quasi-public agencies. Examples include:

  • The National Health Service (NHS) in the UK (tax-funded)
  • Medicare and Medicaid in the US (for the elderly and low-income groups)
  • Social Health Insurance models in Germany and Japan (based on employment and payroll taxes)

Public schemes often aim for universal coverage, equity, and risk-sharing across the population. They may provide a defined benefits package, control prices, and engage in purchasing from public and private providers.

Private Health Insurance

Private insurance is financed through voluntary or employer-based premiums. It includes:

  • Primary coverage (e.g., in systems like the US, where employer-sponsored plans dominate)
  • Supplementary insurance, covering services not included in the public system (e.g., dental or vision care in Canada or France)

Private insurers operate under different incentives than public payers and often face competitive pressures. While private insurance can increase choice and responsiveness, it may also exacerbate inequities if not properly regulated.

Moral Hazard and Adverse Selection

Two key concepts in the economics of insurance—moral hazard and adverse selection—represent sources of inefficiency and challenge the sustainability of insurance markets.

Moral Hazard

Moral hazard arises when insured individuals change their behavior because they are shielded from the full cost of care. Once insured, people may:

  • Use more health services than they would otherwise (e.g., visiting the emergency room for minor issues)
  • Opt for more expensive treatments or unnecessary procedures

This overuse increases total health expenditures and undermines cost containment. Policymakers and insurers often attempt to mitigate moral hazard through cost-sharing mechanisms such as co-payments, deductibles, and coinsurance. However, excessive cost-sharing can deter necessary care, especially among low-income or chronically ill patients.

Adverse Selection

Adverse selection occurs when individuals with higher health risks are more likely to purchase insurance than healthier individuals. If insurers cannot fully assess or price these risks, premiums rise, potentially driving out healthier individuals. This can create a death spiral in which the risk pool deteriorates over time.

To address adverse selection, many health systems implement:

  1. Mandates (requiring individuals to purchase insurance)
  2. Community rating (insurers must charge the same premium regardless of risk)
  3. Risk adjustment (redistributing funds among insurers based on enrollees’ risk profiles)

Insurance Market Failures and Regulation

Health insurance markets are susceptible to market failures that justify regulatory intervention:

  • Information Asymmetry: Insurers may lack accurate information about enrollees’ health status, and patients may not understand coverage terms. This can distort pricing and enrollment decisions
  • Non-Competitive Behavior: In some markets, insurers may wield market power to increase premiums or reduce coverage. Lack of transparency further reduces competition
  • Inequity and Access Gaps: Private markets may exclude high-risk individuals, impose unaffordable premiums, or provide insufficient coverage, leading to underinsurance or lack of access altogether

To address these failures, governments regulate insurance markets through:

  • Benefit mandates (requiring coverage of essential services)
  • Premium subsidies (to make coverage affordable)
  • Marketplaces or exchanges (to foster competition and transparency)
  • Public options or risk pools (to cover high-risk individuals)

Well-regulated insurance markets balance efficiency with equity, ensuring financial protection and access to care while managing incentives and costs.

Conclusion

Health insurance is a cornerstone of modern health systems and a critical tool in managing the financial risks of illness. Its design and regulation are central concerns in health economics, particularly due to the unique market failures inherent in health care. Effective insurance systems must mitigate moral hazard and adverse selection, promote risk pooling, and ensure access to essential services. Whether public or private, the success of insurance markets depends on thoughtful design, robust regulation, and ongoing evaluation.

References

  1. Arrow, K. J. (1963). Uncertainty and the Welfare Economics of Medical Care. American Economic Review, 53(5), 941–973.
  2. Pauly, M. V. (1968). The Economics of Moral Hazard: Comment. American Economic Review, 58(3), 531–537.
  3. Cutler, D. M., & Zeckhauser, R. J. (2000). The Anatomy of Health Insurance. In Handbook of Health Economics, Vol. 1A, Elsevier.
  4. Glied, S., & Smith, P. (2011). The Oxford Handbook of Health Economics. Oxford University Press.
  5. Phelps, C. E. (2017). Health Economics (6th ed.). Routledge.
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