ii. Problems of risk and uncertainty

If we are going to buy health care in a free market, then we have to have enough money to pay for it. But health care is expensive and we cannot predict when we are going to be ill. What makes this worse is that postponing buying health care is often risky. So we face the problems of risk and uncertainty.

The market response to this problem is to develop an insurance market to remove the uncertainty and risk from health care spending. We pay an agreed amount of money per year whether we need health care or not. But then, when we need care, the insurer pays the bills, however large they are.

So a free market in health care requires an effective health care insurance market. Unfortunately, the health care insurance market itself is often not efficient. Moral hazard and Adverse selection both cause significant market failure.

Moral hazard

Having insurance can change the way in which we act. Imagine you are in a cinema and the film is just about to start. Then you remember that you have left your bicycle unlocked. What do you do? If you have comprehensive insurance which will compensate you against any loss you are much more likely to carry on watching the film. Your attitudes have been changed by the fact that you have got insurance - this is what economists call moral hazard. Moral hazard can affect any insurance market but is a particularly serious problem for health care insurance. Consumers who are insured have an incentive to over-consume health care - to demand operations and treatments which they would not choose if they were directly paying for them. They may also not bother to follow a healthy lifestyle or to get preventative check-ups. As a result when they do fall ill, the cost of treatment is higher than it would otherwise have been.

Doctors too are affected by moral hazard. They know that the costs of treatment are covered by insurance so the temptation is to over-treat and over-prescribe medicines for their patients. Moral hazard thus leads to an inefficiently large quantity of resources being allocated to health care.

Adverse selection

A company selling health care insurance has to estimate the level of risk accurately . This is difficult because they will not have complete information on the risk status of the person they are insuring. One solution is to set the premium at an average risk level. But this makes the policy expensive for low risk customers who therefore may choose not to buy the insurance. This process whereby the best risks select themselves out of the insured group is called adverse selection.

Insurance companies know that this is likely to happen so they offer different premiums according to the level of risk and the person's experience of ill health. This is why most companies will offer non-smokers a lower premium than smokers. Offering low insurance premiums to low risk groups, often called 'cream skimming' or 'cherry picking', means high premiums have to be charged to high risk groups such as the elderly or chronically sick.

So in a free market, health care insurance is likely to be too expensive for many people, and especially for those most in need of health care.