Academic journal article Journal of Risk and Insurance

The Effects of Uncertainty on the Demand for Health Insurance

Academic journal article Journal of Risk and Insurance

The Effects of Uncertainty on the Demand for Health Insurance

Article excerpt


This article analyzes the effects of uncertainty and increases in risk aversion on the demand for health insurance using a theoretical model that highlights the interdependence between insurance and health care demand decisions. Two types of uncertainty faced by the individuals are examined. The first one is the uncertainty in the consumer's pretreatment health and the second is the uncertainty surrounding the productivity of health care. Comparative statics results are reported indicating the impact on the demand for insurance of shifts in the distributions of pretreatment health and productivity of health care in the form of first-order stochastic dominance, Rothschild-Stiglitz mean-preserving spreads, and second-order stochastic dominance. The demand for insurance increases in response to a Rothschild-Stiglitz increase in risk in the distribution of the pretreatment health provided that the health production function is in a special class and the price elasticity of health care is nondecreasing in the pretreatment health. Provided also that the demand for health care is own-price inelastic, the same conclusion is obtained when the uncertainty is about the productivity of health care.


The presence of uncertainty in the health care industry is well established. Arrow (1963) points it out in the incidence of disease and in the efficacy of treatment. Consequently, much of an individual's demand for health care is not steady, but irregular and unpredictable. This implies that the costs of health care act as a random deduction from an individual's income. Therefore, under uncertainty, risk-averse individuals demand risk-bearing goods, such as health insurance, to safeguard their income against possible shocks.

A health insurance policy is a contract between an insurer and an individual. Within the duration of this contract, the individual agrees to exchange income in the form of a premium for lower prices for certain health care services in the event of poor health. Individuals seeking to enter into such a contract are not selected at random. Individual characteristics, such as health status, may influence the decision to enter into a contract and thus create a self-selection bias. In other words, the individual may have information about the probability of poor health, which the insurer cannot observe. Thus, individuals with low expectations about their future health status may have an incentive to select more comprehensive insurance coverage. In this article, we analyze how changes in risk surrounding future health status (1) affect the demand for insurance. One focus of our inquiry is into the conditions under which the identification of low- (high-) risk consumers with smaller (greater) demand for health insurance is plausible.

In an attempt to analyze the effects of uncertainty surrounding the incidence of disease and the efficacy of treatment on the demand for health insurance, we consider two shifts in the distributions of these variables. The first is a mean-preserving spread in which the individual keeps his/her original estimate of the related variable but becomes less confident about it. The second is a second-order stochastic dominant shift in which both the uncertainty surrounding the related variable and its expected value change simultaneously. Moreover, the utility function is parameterized by an ordinal risk aversion parameter to analyze the effect of increases in risk aversion on the demand for insurance.

It is well known that health care demand is influenced by health insurance coverage; the resulting moral hazard and attempts to deal with it have been a central focus of many studies of the demand for health care. Arrow (1963) was the first to identify the moral hazard phenomenon in the health care industry. Pauly (1968) shows that the effect of moral hazard can cause insurance among some types of uncertain events to be nonoptimal even if all individuals are risk averters. …

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