This is the Healthcare Market Specialization, Healthcare Marketplace Overview. I'm Steve Parente, and this is module 3.1.3, How Does Insurance Work? Well, as you can see here, we have a lovely pool of pigs sitting in their life preservers. And it's very appropriate because the way insurance works is essentially the concept of pooling risk, or not so much pooling pigs but pooling risk. And the idea is that since we know from our prior lectures that essentially folks can be very risk averse, we have a sense that depending upon how risk averse they might be you could actually pool some of their collective risk together. And because people have different levels of risk and different problems, if they are willing to pay more money than they otherwise really need to, which meaning they're really, really more risk averse than otherwise. You can actually make insurance not just able to pay for itself but actually even profitable if you can set your premiums correctly. And so one of the things that's really kind of key about this is understanding how the bad events that can happen can go wrong. So, when we look about these pigs, mostly they're kind of happy pigs. If they get sick, they could be kind of a sad pig. But the worst case scenario is they could be a dead pig. And so one of the issues in terms of insurance, is not just basically making you, again, a happier pig because we made you better, well, we can't raise you from the dead. But we at least can help your family get moving if you happen to have an untimely death. And obviously, life insurance takes care of that consideration. Now, when we talk about the insurance market in general, this graph here showing again, a utility, a wealth curve really explains a lot of what's going on. Again, we have a straight line here showing basically people that are effectively risk neutral as our comparison. This bowed out line here showing someone that's fairly risk averse. And so if we actually think about what this line is showing, the real key thing is this line here. Notice we go from really a top of a utility 100 all the way to utility of 0. And when we draw that line and it's showing the range of our uncertainty, what that really is suggesting is that your choice set could go from anywhere from being really happy to a utility of zero. And the utility of zero, again, is our friends, the pigs, that are dead. That's your choice. And you might say, well that's really kind of sad to actually think about that. But if you are facing cancer and you don't get treatment, your outcomes are potentially going to lead to your death. And so that idea of having insurance to be able to get paid for that treatment is a sort of realistic example of what this might look like in this particular scenario. So the interesting thing here that we have is that we have a range of uncertainty from zero to one. We know some other prior information in terms of what's there, meaning that the insurance policy that we're talking about that's available to you is, let's say we're going to drop from 100 to 90. That drop is actually going to lead to a decrease in wealth from 10 to 9, which means that the minimum cost of your insurance in order to keep you pretty much where you were before is $1,000. Now you might say, well, you just took that money away from me. Well, no, you always have a probability. In this case we're basically saying you're living with a 10% probability of dying. If you actually are older, that's actually very realistic, if you're over the age of 65. So, the idea is that you really didn't have utility of 100, you really had expected utility of 90. Because you had to pay essentially, or lose some income to be able to operate where you were today. Now that's a person who's risk neutral. What about someone, again, who's kind of risk averse? Their line is different. Turns out, the value of their insurance is actually going to be something where they perceive that it's not that they're just going to lose $1,000. They're going to lose potentially $3,000. And as a result of that, in terms of where they feel their risk aversion will be, they're willing to pay $3,000 for their insurance rather than the minimum cost of the insurance. So, if you're an insurance company and you know this, guess what this means? If someone is willing to pay 3K, and the cost of insurance is only 1K, you're going to get as an insurance company, 2K profit. And that's one reason why insurance works. Now, you might say well that's awesome. There are instances though, where sometimes you have a losing proposition. These again, are probabilities. We're not quite sure exactly you can predict exactly what costs are going to be. So that profit might be great one year, and it could all disappear the following year. So what else to talk about on this graph. I mean one thing just to put it into operation is, let's say an insurance company comes along and says we're going to offer you this great policy, and it's going to be $1500. And it's going to cover you for catastrophic care if something really goes wrong. I guess the question then is, what's the profit margin that plan's hoping to make from that? Well we know from again the 9 to $10,000 that the cost of insurance is really $1,000. So it's likely that that health plan would be making $500 on that person. More likely than not, sometimes they put that money if they're a non-profit into their reserves, so that if there's an off year and they didn't predict exactly what was going to happen, they are able to be covered in the future market. So this is essentially the ultimate design of how an insurance policy works. This is true insurance insurance in the sense of health insurance of really saving your life, not so much giving you extra care or copays for drugs. The consequences, again, for your range of uncertainty is 0 to 100, meaning that really dead or alive, it's a life saving treatment that'll take you to the next side. This concludes our module on insurance.
