The Economic and Behavioral Architecture of Health Insurance Design

How health insurers design their policies to avoid health care utilization and payment

Health insurance is rightfully in the news right now. Most American’s feel and understand that the systems of health insurance in the United States are in desperate need of overhaul. Health care in America is expensive and the administrative burden, resulting from business practices, on individuals, practices, and employers contributes to the cost and feelings of displeasure.

A few weeks ago, I wrote an article about some of the underlying economics issues in health care services that make it unique when compared to other industries. Getting treatment for cancer is fundamentally different than getting your air conditioner replaced or frozen pipe fixed. While the latter are inconveniences and can also be expensive, the former is a life or death situation. Because of this, most people are willing to pay any price to stay alive or improve their quality of life. Economists classify products and services that exhibit these characteristics as those with inelastic demand—or, simply, demand that remains consistent regardless of price. You will opt to get that emergency surgery to remove your appendix and pay the $10,000 through a combination of insurance and out-of-pocket expense because you MUST have it. This effect, naturally, creates upward pressure on prices.

Importantly, not all health care services or products have inelastic demand. There are services that are low-value and that solve problems that could probably be otherwise ignored or managed without medical intervention. There are also instances of services that are wasteful or unnecessary provided anyways due to provider profit motive or other factors. And, there is fraud and other abuses of the system that contribute to higher health care costs on the whole.

If you ask the insurance companies, they will tell you that they are there to ensure that care is appropriate, medically necessary, and provided based on the current best practices. They will also say that they serve to prevent fraud, waste, and abuse and to monitor quality in their provider networks. At a high level, they will tell you that they serve to effectively mitigate the growth of health care expenditures for their customers (i.e., the government and employers.) To do this, insurers have designed their policies, products, and procedures carefully.

Health insurance design in the United States represents a complex interplay of economic incentives, risk management, and market dynamics. Understanding the various components of health insurance plans and their economic purposes requires examining both their historical context and theoretical underpinnings.

This article is meant to be informative. I am in no way defending these practices or suggesting that they do not cause harm. The design elements of insurance products create incentives and those incentives can often be averse to good health or services. But, in some cases they certainly might prevent unnecessary or low-value service utilization, while in other cases they can create challenging barriers and ethical dilemmas for patients with significant illness.

This article will explore the purpose and the impact of insurance product design, insurance company networks, and prior authorizations. Basically, everything you probably don’t want to know about products that you rely on when you and your family might need it.

Historical Context and the State of Health Insurance in the United States

The modern American health insurance system emerged largely as an accident of history. During World War II, wage controls prevented employers from competing for workers through higher salaries. In response, companies began offering health insurance as a benefit to attract employees. This practice was further cemented when the Internal Revenue Service ruled that employer-provided health insurance would be tax-exempt, effectively creating a substantial subsidy for employer-sponsored coverage. This, along with a few other notable events and later other laws such as those that created Medicare and Medicaid insurance, contributed to the mix of health insurance options. Since then, many more types of insurance, health care providers, and laws have shaped the systems we experience today.

That’s right, it might shock you to know that most of what we witness was not systematically designed and centrally planned. The organizations, systems, processes, and terminology were started for one reason, then morphed into something new over time, and have since become institutionalized via state and federal policy.

This government-driven institutionalization stems from either well-meaning policies to improve health, reduce medical cost burden, and otherwise provide a health safety net, or from intentional lobbying efforts undertaken by the organizations and financial beneficiaries of the systems. The latter is a concept called regulatory capture (Here is an interesting article that discusses concepts of regulatory capture in American healthcare.)

The American version of health care is marked by layers of for-profit, government, and non-profit elements all seeking laws and regulations that support their own self-interests. These interests are sometimes excellent patient care, while other times they are solely based around profit, costs, and growth.

The Theory and Challenges of Risk Pools

Whether it is employer or government based, insurance products are designed around the concept of a risk pool. Risk pools are based on the idea that individuals pay into the risk pool with a relatively small amount of money (the premium) with the hope that most people will not use the money thus allowing the risk of financial harm from infrequent events for any one individual to be proactively prevented. Nobody wants to get sick, hospitalized, and left with a $10,000 or $100,000 bill. That $10,000 or $100,000 bill is a catastrophic event that risk pooling seeks to prevent. If you paid into the risk pool as an individual and happen to be unlucky enough to receive a $100,000 hospital bill, the risk pool has your back.

However, risk pools are designed for infrequent events. They work very well when the risk of a covered event for any one individual is very low, but not zero. It can’t be too close zero because if it were then individuals would decide not to form a risk pool in the first place. Thus, risk pools are useful for events that people expect might happen to them, but that are sufficiently infrequent that the premiums can be low enough to make sense. If everyone was guaranteed to use the risk pool each year, then premiums would increase accordingly. If everyone was guaranteed to use the risk pool at exactly the same amount as their premiums, then we would call it a prepayment and not a risk pool.

At their core, health insurance companies operate on the principle of risk pooling – spreading the financial risk of health care needs across a large group of individuals. However, several fundamental challenges complicate this seemingly straightforward concept when applied to health care:

Adverse Selection

Risk pooling requires a balanced distribution of healthy and less healthy individuals to function effectively. When insurance is voluntary, those who know they are likely to need medical care are more likely to purchase insurance, while healthier individuals might choose to forgo coverage. This phenomenon, known as adverse selection, can create a "death spiral" where premiums increase as the risk pool becomes increasingly composed of higher-risk individuals. This is one reason why the Patient Protection and Affordable Care Act sought to make health insurance participation mandatory for all Americans in order to combat this phenomenon. Similarly, all Americans pay into Medicare through payroll taxes their entire life in order to fund health insurance coverage in retirement.

This premium cost death spiral can also occur from other market factors that drive up prices of health services (e.g., market consolidation, more demand than supply, workforce shortages, new technologies) and from an increase in utilization resulting from a sicker, or less healthy population. We see many of these factors in the U.S. health insurance market.

Moral Hazard

Insurance companies and risk pools must also contend with moral hazard – the tendency for insured individuals to use more healthcare services because they bear less of the direct cost¹. This increase in utilization can drive up overall healthcare costs and, consequently, premiums. This phenomenon is a core reason for the insurance product design components like cost-sharing and deductibles.

A New, Third Challenge

The classical risk pool economic theories discuss moral hazard and adverse selection, but the modern U.S. concept of health insurance has created a new challenge in the quest to minimize premiums while ensuring protections against catastrophic events. That challenge is what I will call “the payment processing role” challenge. Health insurance, we now expect, in America also covers routine, non-catastrophic costs. Annual physicals, physician’s visits for prescription refills, medications, durable medical equipment, and much more. A large percentage of spending from health insurance risk pools results from non-catastrophic, routine services. Thus, these costs are factored into premiums (e.g., resulting in higher premiums) and curtailed via components of insurance design.

Cost Sharing Components and Their Economic Purposes

In order to combat moral hazard and the “payment processor role challenge” of modern health insurance, companies design their policies using core product strategies to manage the utilization and cost of health services in the risk pool. These strategies are outlined below:

Deductibles

Deductibles serve multiple economic purposes in insurance design. First, they create so-called "skin in the game" by requiring consumers to pay the first portion of their healthcare costs out-of-pocket. This mechanism helps address moral hazard by encouraging consumers to be more selective in their healthcare utilization, particularly for discretionary or routine services.

Deductibles, in theory, can serve to reduce administrative costs by eliminating the processing of small claims that individuals can reasonably self-insure against. However, as is the case in American health care, the prices for services are already so high, that Americans have a difficult time with the “self-insurance” or out-of-pocket payment components.

Deductibles, in theory, are supposed to keep premiums lower by focusing insurance coverage on larger, more catastrophic expenses. This is a key protection of the risk pool premiums against that “payment processor” function and is an attempt to make the health insurance product truly function as a risk pool rather than a prepayment.

This approach works in practice, but it is not enough to quell rising household healthcare costs given the backdrop of very high prices in the American care delivery market.

Copayments

Copayments represent fixed amounts that patients pay for specific services. Their primary economic purpose is to create price signals that influence consumer behavior without imposing excessive financial burden. For example, higher copayments for emergency room visits compared to urgent care centers encourage appropriate utilization of different levels of care.

Copayments also serve to reduce moral hazard by requiring some cost sharing at the point of service, but in a more predictable way than percentage-based coinsurance. This predictability helps consumers make informed decisions about seeking care while still maintaining access to necessary services.

Coinsurance

Coinsurance requires patients to pay a percentage of the total cost of services, creating a direct connection between the cost of care and the patient's financial responsibility. This mechanism serves several economic purposes:

1. It makes patients more price-sensitive consumers of healthcare services, potentially encouraging them to seek lower-cost providers or treatment options. However, this theoretical effect only works when prices are both transparent and the value of the service can be assessed. More on that in this article.

2. It helps control utilization of high-cost services by requiring meaningful patient contribution while still providing substantial insurance protection.

3. It creates an incentive for patients to question the necessity of expensive tests or procedures, potentially reducing unnecessary care. The extent to which this works depends on the elasticity of demand. For those absolutely necessary, often emergency, inelastic services, co-insurance just serves to increase patient cost. For services that may be unnecessary or low-value, co-insurance may have an effect. Also, in many cases patients are not “deciding,” but rather taking advice from a physician who has actually decided that a test is necessary.

Medical Coverage Policy and Prior Authorization

Ah, yes, the dreaded prior authorization. Little did you know that insurance payment-avoidance starts well before the prior authorization process. Prior authorizations are used by insurers to “ensure medical necessity” of the service or product prior to remitting payment. Insurers, both government and private, issue medical payment policy to detail their requirements for coverage. These requirements often involve which diagnoses are eligible for the service, other treatments that must be attempted first, and other criteria by which they will remit payment. On one hand, there are procedures that probably should not be performed until other less invasive or cheaper options are tried. On the other hand, the insurance company should not be practicing medicine or shaping clinical practice given their obvious profit incentives to not pay.

This is a challenging balance and the answer to the bad experiences with prior authorizations is equally complex. The answer probably lies in creating an independent body to recommend medical policies and treatment algorithms for health insurance rather than insurers creating their own. This is part of the impetus for the federally-funded Patient Centered Outcomes Research Institute and the United States Preventive Services Task Force.

If an independent standards-setting body, rather than health insurers, were responsible for outlining treatment algorithms based on clinical-evidence and cost-effectiveness, then the need to prevent unnecessary or wrong services while ensuring the patient’s best interest could be balanced. The United Kingdom has a system like this called the National Institute for Health and Care Excellence (NICE).

Network Design: Managing Provider Networks and Cost

Health insurers and risk-pool managers also use provider networks to minimize the payouts from their risk pools. Narrow networks have emerged as a crucial tool for insurers to control costs and maintain quality (or, so they say). By limiting the network of providers, insurers can:

1. Negotiate better rates with providers in exchange for higher patient volume

2. Select providers based on quality metrics and cost-effectiveness

3. Limit physical patient access (fewer providers = increased waitlists and distances)

However, narrow networks also raise concerns about access to care and the potential for inadequate provider coverage, requiring careful balance between cost control and healthcare access. Network access and timeliness of care standards are regulatory tools, especially used in Medicaid, that attempt to ensure adequate access to in-network providers. They do not work very well because access to care is challenging to measure and enforce. Thus, many Medicaid insurance enrollees suffer from poor access to care.

Claims Processing Operations

Related to network design are insurer practices around claims payment. Insurers first attempt to limit the utilization of health services through the aforementioned strategies. But, once a covered service has occurred insurers often seek to delay payment to providers in order to increase the probability that a claim will not be resubmitted or to make money off of the interest generated by the money in the risk pool. This is the use of administrative burden and intentionally slow payment processes as a business strategy. This is similar to the reason why Paypal takes three days to transfer your money to your bank. They want to make interest off of your money sitting in their own account.

Market Dynamics and Selection Effects

Adverse Selection and Market Stability

Adverse selection remains one of the most significant challenges in health insurance markets. When individuals have more information about their health status than insurers, those expecting high healthcare needs are more likely to purchase coverage. This information asymmetry can lead to:

1. Higher premiums as insurers try to account for a riskier pool

2. Market instability as healthy individuals drop coverage

3. Potential market failure if premiums become unaffordable

However, the U.S. health system is likely more affected by other factors that increase the prices and demand for health services and products. A sicker population with high rates of obesity and chronic illness results in more health care utilization and therefore more cost. Market consolidation of hospitals creates higher prices for risk pools when there is no competition for network contracts. These trends can have the same effects as outlined above.

Cream-Skimming and Risk Selection

Insurers may attempt to attract healthier enrollees through benefit design, a practice known as “cream-skimming.” This can occur through:

1. Benefit packages that appeal to healthier individuals

2. Marketing strategies targeted at lower-risk populations

3. Network and cost-sharing design that may discourage higher-risk individuals

While regulations limit overt discrimination, subtle forms of risk selection continue to influence market dynamics. For example, Medicare Advantage health plans can offer certain non-medical benefits such as gym memberships. While on the surface this seems like a positive health benefit to encourage healthy behaviors in the risk pool, but it also may attract people who are already using the gym to the health plan. This allows the health plan to attract less risky individuals who are likely healthier.

Conclusion

The various components of health insurance design serve complex and interrelated economic purposes. Cost-sharing mechanisms like deductibles, copayments, and coinsurance help address moral hazard and create price sensitivity while maintaining protection against catastrophic costs. Network design allows insurers to manage costs, though it requires careful balance with access concerns that are difficult to regulate. Understanding these mechanisms and their economic purposes is crucial for policymakers, insurers, and consumers as the health care system continues to evolve.

The challenge remains striking the right balance between controlling costs, maintaining access to care, and ensuring market stability. As health care costs continue to rise and new delivery models emerge, the importance of well-designed insurance mechanisms becomes increasingly critical to the sustainability of the healthcare system.

In the American health system, the for-profit components and the practices listed in this article beg the following question: if this system is so concerning to Americans as indicated by the recent events, why are universal health care policies like Medicare For All not more popular. I cover some of this in another article here.

1. So, this is a core economic theory associated with health insurance risk pools and I am certain that this type of behavior does occur, but the extent to which it occurs is unclear. I generally believe that most people do not enjoy receiving health services in their spare time, so I think this effect is often over stated.