Risk Aversion and the Consumer Choice of Health Insurance Option

Abstract

T HE dominant type of health insurance contract in the United States contains a formula providing partial reimbursement to the consumer for expenditures on selected goods and services. The consumer pays a predetermined amount per period, the premium. At the beginning of the period specified in the insurance contract, the consumer is uncertain about many future developments. The occurrence of various illnesses, the amount of medical services consumed, and the out-of-pocket (direct) monetary loss cannot be perfectly foretold. When a consumer chooses health insurance from a set of alternative contracts, he may reveal information of a general nature about preferences for avoiding risk. This paper suggests a model of the choice among health insurance options which permits quantitative inference about risk aversion from revealed choices. The model is based on the theory of expected utility maximization, and more recent development in Arrow (1963), Pauly (1968), and Zeckhauser (1970). The analysis is only exploratory, since several limiting assumptions and functional representations have been adopted. The model will be seen, however, to have useful application to the Federal Health Benefits Program in which federal employees choose health insurance from a wide range of options. The premium cost to the employee for any option depends on the average experience of all those selecting the option. This program has been in existence since 1960, and has generated important information on the frequency distributions of total and direct expense for various types of consumer unit under various types of insurance. The Expected Utility Model