Insurance and Risk Finance 640

1
Insurance and RiskFinance 640

• Class 13
• November 8, 2004

2
Automobile Insurance Review Questions

• Why might a person rationally buy liability
  limits with greater than his or her limits for
  underinsured motorist coverage? (p. 273)
• In view of moral hazard, explain why it might be
  optimal for a person to have a lower deductible
  for other-than-collision coverage than collision
  coverage? (p. 273)

3
Automobile Insurance Review Questions(cont.)

• Explain why insurers have an the incentive to
  sell coverage voluntarily to a driver as long as
  the price that can be charged is greater than or
  equal to the fair premium? (P. 274)
• Why does this imply that residual markets usually
  will lose money?

4
HO 3 Policy - Revisited
5
Universal Life Cash Value Formula

• Interest credited for the policy period (Cash
  value at beginning of period premium payment
  mortality cost expense cost) x Interest rate
• Cash value at end of period
• Cash value at beginning of period
• Premium payment at beginning of period
• Mortality charge at beginning of period
• Expense charge at beginning of period
• Interest credited at end of period

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Universal Life Policy Question p. 329
7
Net Single Premium Question Term Life, Question
6, p. 330

• What is the net single premium for 1,000 face
  amount three-year policy for a 50 year old male,
  assuming an interest rate of 5?
• (1000)(.00671)/1.05 (1000)(6502/896662)/1.052
  (1,000)(7038/896662)/1.053
• 6.39 6.58 6.78
• 19.75

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Overview Major Types of Employee Benefits

• Medical Insurance
• Retirement Plan
• Life Insurance
• Short-term Disability
• Long-term Disability
• Dental Insurance

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Description Major Types of Employee Benefits
10
Who Pays the Cost of Benefits?

• In the long run, employees pay the cost
• contributory plans - directly
• noncontributory plans - indirectly
• In short run, return to owners is likely to
  decrease if benefit costs increase

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Flexibility in Choice of Benefits

• Extent of employee choice varies
• No choice lt--------------gt cafeteria (flexible
  benefit) plans
• Advantage of flexibility
• greater matching with employee needs
• Disadvantages of flexibility
• potential adverse selection
• administrative costs

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Why Firms Provide Employee Benefits

• Alternative to employee benefits
• pay higher cash wages and let employees purchase
  benefits on their own
• Explanations for employee provision of benefits
• Taxes
• Cost savings with group insurance
• Productivity effects
• Regulation

13
Income Tax Advantages of Employee Benefits

• Qualified plan gt has preferential tax treatment
• Tax treatment of qualified plans
• Employers perspective
• Same as cash wages, I.e., the cost of employee
  benefits are deductible expenses
• Employees perspective
• Benefits are either not subject to income taxes
  or income taxes are deferred
• Benefits purchased individually would not receive
  the same tax treatment

14
Example of Income Tax Advantages

• Assume
• Cost of Helens medical expense insurance
  4,000 if purchased individually or by employer
• Helens income tax rate 20
• Which compensation package would Helen prefer
• 1 Salary 40,000 and no medical insurance
• 2 Salary 36,000 and medical insurance

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Example of Income Tax Advantages

• After-tax cost to employer is the same for 1 and
  2
• Helens after-tax income after obtaining medical
  expense insurance
• 1 40,000 x 0.8 - 4,000 28,000
• 2 36,000 x 0.8 28,800
• Difference 800 income tax paid on 4,000

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Cost Savings with Group Insurance

• Lower insurer administrative costs with group
  insurance
• marketing costs
• underwriting costs (see below)
• billing costs
• premium collection costs
• Lower search costs for employees
• Reduced adverse selection
• group insurance limits choice of coverage
• gt less adverse selection if insurer does not
  classify
• gt group insurance lowers need for individual
  underwriting

17
Productivity Effects of Employee Benefits

• Idea Employee benefits increase productivity
• How?
• Improve health of employees
• Reduce turnover
• Especially important with retirement plans (see
  Ch. 17)

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Regulatory Restrictions on Employee Benefits

• Regulations are numerous and complex
• Some general types of regulations
• Benefits offered
• Management of plans
• Information provided employees
• Examples
• Proposals to require employers to offer child day
  care
• Manage plans in the best interest of
  beneficiaries
• Inform employees about changes in plans

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Group Medical Expense Coverage

• Most people in US obtain medical expense
  insurance through employers
• Traditional fee-for-service plans
• Employer provides coverage
• deductibles and coinsurance
• Employer either self insures or purchases
  insurance
• insurers
• Blue Cross/Blue Shield organizations
• Employees choose service provider
• Provider charges fee to employee or insurer

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Background on Health Care Market

• Three major players
• Providers
• Consumers
• Employers / Insurers
• Providers often can influence demand
• Providers better informed
• Consumers do not pay marginal cost due to
  insurance

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Moral Hazard Problems

• Two types
• Ex ante moral hazard - incentive to take care
• Group insurance gt premium does reflect
  individual expected claim cost
• Ex post moral hazard - once sick, incentive for
  excessive utilization
• utilize to the point that cost of care gt benefit
• why? - with insurance, consumer does not pay the
  full cost
• result excessive quality

22
Excessive Utilization and Fee-for Service

• Fee-for-service plans aggravate excessive
  utilization problem b/c of the separation of
• Provision of insurance
• Provision of care
• Reducing excessive utilization
• Increase deductibles and coinsurance
• Managed care
• insurer monitor use
• limit choice in service providers
• Preferred provider organizations

23
Health Maintenance Organizations (HMOs)

• Main features
• Reduces excessive utilization with contracts
  between providers and insurers
• Providers compensation depends on utilization
• Extreme form service providers also provide
  insurance
• Employees choice of providers is restricted
• choose primary care physician (acts as a
  gatekeeper for other services)

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HMO Backlash

• Critics
• HMOs have too little incentives for quality care
• Factors limiting problem
• too little care can lead to greater costs later
• malpractice claims
• competition

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Provisions/Issues in Group Medical Plans

• Dependent coverage
• usually requires an additional employee
  contribution
• Premiums within a plan usually vary less than
  expected claim costs vary
• cross-subsidies
• group plans can still be beneficial to low risk
• Mandated benefits
• e.g., mental health services

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Provisions/Issues in Group Medical Plans

• Portability
• Pre-existing conditions clauses
• why? - reduce adverse selection
• problems
• discourages job changes
• exposes those who switch jobs to less coverage
• COBRA
• 1996 legislation
• can still have pre-existing conditions clause for
  12 months
• but coverage under a prior employers plan counts

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Provisions/Issues in Group Medical Plans

• Renewability
• Individual coverage typically is guaranteed
  renewable
• gt those who learn about illnesses continue to
  get insurance on the same terms as those who
  dont
• Group coverage typically is not guaranteed
  renewable
• Why the difference?
• Switching costs higher for individuals
• gt less likely to get those with good experience
  switching insurers

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Health Care Cost Inflation

• Health care costs increased substantially during
  the 1980s and early 1990s

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Why Have Health Care Costs Increased?

• Excessive utilization
• Increased demand for quality care
• Technological advances
• Increased proportion of elderly people
• Other factors
• Uninsured people obtain care via expensive means
• Increased number of malpractice suits
• defensive medicine

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The Uninsured

• About 14 of people uninsured
• most for short periods of time
• Why so many uninsured?
• High cost of care
• Other sources of indemnity

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Health Care Reform

• Inevitable tradeoffs
• Fewer uninsured gt higher total health care
  costs
• Lower health care cost gt lower quality
• Possible policy objectives
• Reduce excessive utilization
• Minimum level of quality to all
• All insured

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Possible Approaches to Reform

• Nationalization
• Government specifies for all
• insurance coverage
• quality of care
• expenditure
• Little or no choice for individuals
• gt little support in US

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Possible Approaches to Reform

• Universal insurance
• Mandatory employer provision
• Play-or-pay
• Would reduce
• uninsured
• cost shifting from uninsured to insured
• inefficient provision of service
• However
• worker wages would decrease
• moral hazard would increase

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Possible Approaches to Reform

• Selective Intervention
• Deal with specific problems
• But not major change in system
• Examples
• COBRA
• legislation on pre-existing conditions

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Possible Approaches to Reform

• Changes in Tax Law
• Lower tax benefit for employer provided insurance
• reduce insurance coverage
• gt reduce excessive utilization
• Medical savings accounts (MSAs)
• insurance for large medical expenses
• small expenses (e.g., lt 3,000 per year) paid
  from MSA
• MSA receives preferential tax treatment