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In the previous segment, we discussed deductibles and coinsurance.

In this segment, we will focus on

premiums but do so from the point of view of the insurer.

That is, we will discuss how premiums are priced.

To begin our discussion of pricing,

we will consider the case of insurance contracts that are actuarially fair.

An actuarially fair insurance contract is one where the premium paid by

the consumer will equal

the expected benefit paid back to the consumer in a case of a loss.

Consider PM to be the price of medical care and M to be the quantity of medical care.

Therefore, PM times M represents the expected healthcare expenditures.

The expected benefits to the individual will depend on the coinsurance rate, C,

such that the expected benefit E of B will equal one minus C,

that is the portion covered by insurance,

times the expected medical care expenditures PM time

M. This equation is easy to understand from an accounting perspective.

If my expected medical care spending in the coming year

is $2000 and I have a coinsurance rate of 20 percent,

my expected benefit from the contract would be

80 percent times $2000 dollars, which is $1600.

But these equations embeds the economic problem of moral hazard.

As we've seen in the previous segment, C,

the coinsurance rate and M,

the medical care consumption are interdependent.

When the coinsurance rate decreases,

medical care consumption increases.

When the coinsurance rate is high,

people are exposed to risk,

financial risk they were hoping to eliminate by purchasing insurance.

On the other hand, when the coinsurance rate is low,

moral hazard is stronger and people over utilize medical care.

So the insurance company is charging us for risk bearing activities,

that is, the lessening of financial risk.

But when we pay for insurance,

there is another service the insurance company is

providing and that is processing claims.

The insurance company will load this cost to the premium they charge us.

This element is called the loading fee.

The loading fee represents an additional charge to cover

the operation of the insurance company which include salaries for employees,

rent for office space,

and all other costs of running a business.

Think of the loading fee as the percentage of

the expected payout that is required for the insurer to stay in business.

We can now write the expression for premiums as one plus L, the loading fee,

times the expected benefit to the individual which is one minus C,

times PM, times M. So,

what affects the size of the loading fee L?

Wages and facilities an obvious reason,

so is the complexity of insurance contracts.

The more sophisticated the insurer is,

the higher the human capital has to attract and that would raise the loading fee.

Some elements lower the loading fee.

Two in particular, deductibles and portfolio earnings.

As we showed in the previous segment,

high deductibles lower the use of

routine medical care and therefore lower the claim processing volume,

which would lower the loading fee.

Similarly, insurers collect premiums in the beginning of

the year or the month but pay out claims during the course of that period.

This time discrepancy allows insurers to generate portfolio earnings.

Mostly during investments,

these money generating activities would allow insurers to lower the loading fee.

When the loading fee increases,

premiums increase and insurance coverage becomes more expensive.

Faced with higher premiums,

people would alter their insurance generosity to keep it affordable.

That is, people with buy insurance with higher coinsurance rate.

So, a higher loading fee would lead to

higher coinsurance rates which in turn reduce medical care consumption.

On the other hand, lower loading fee would result in

lower coinsurance rates and worsening of moral hazard.

One last component is missing in order to give us

a full picture of the pricing of insurance premiums.

This factor is tax subsidies embedded in employer-based insurance.

Based on the IRS tax code,

employer payment for health insurance are not taxed as income

to the employee but remain a legitimate deduction for the employer.

As a result, this makes health insurance cheaper for the employee.

Here is a simple example.

Sarah and Roy both work as interior designers.

Sarah works for a large architecture company

that offers employer-based health insurance to its employees,

while Roy works in a small business which does not offer such coverage.

Let's assume that both of them earn $5000 dollars per month before taxes.

Sarah receives her health insurance from her employer.

So, her premium of $1000 dollar is deducted from her salary.

Due to that, her taxable income is $4000 dollars.

Since Roy is not offered insurance,

his taxable income is $5000.

Assuming both pay 30% income tax,

Sara's net income would be $2800,

and Roy's net income would be $3500 dollars.

But Roy still does not have health insurance,

he will have to purchase insurance himself.

Let's assume that his health insurance premium is also $1000 dollars, same as Sara's.

After buying health insurance,

Roy's net income is reduced to $2500 dollars Sara has a higher net income than Roy.

Why is that? The cost of Sarah's insurance is lower due to a tax shield.

Instead of paying $1500 dollars in taxes like Roy,

she only pays $1200.

In other words, her premium was really one minus t times 1000,

where 't' is the tax rate,

in this case, 30 percent.

That is, her premium was subsidized and was $700 dollars instead of $1000.

So consider our revised formula.

The new premium includes one minus t,

to account for the tax shield embedded in the employer based insurance system.

Focus on the term one minus t times one plus L. To some clever manipulation,

this term can be rewritten as one plus L minus t times

one plus L. The term in the square brackets is called the effective loading fee,

and it's lower than L. The bigger the tax rate,

the lower is the effective loading fee.

Interestingly, if t is larger than L, for example,

if the tax rate is 30 percent but the loading fee is

only 20 percent the effective loading fee would be negative.

Why don't you pause the video and plug these numbers

in L minus tee times one plus L to convince yourself?