1 Terminology
Historically, health insurance was relatively simple. Individuals paid a monthly fee to an insurance company (sometimes little more than a union) in exchange for financial protection if they needed medical care. The insurer would then pay the costs of that care. We will return to the history of health insurance in Chapter 2.1.
The basic financial logic was straightforward: not everyone would need care at the same time. Some enrollees would use little or no care, while others would need a great deal. If premiums were set appropriately, the excess revenue from low-utilization patients would cover the losses from high-utilization patients. This basic idea extends to modern-day insurance products as well and is made possible through the concept of a risk premium, which we discuss in Chapter 4.2.
As health care has become more expensive, insurance products have grown increasingly complex. Today, even health economists can find the terminology and mechanics confusing. Much of the system only becomes clear when you experience it yourself—for example, learning that some providers do not accept insurance (a common issue in dentistry, optometry, and mental health) or discovering how costs differ between in-network and out-of-network providers. If those terms sound unfamiliar, you are in the right place. The purpose of this chapter is to introduce the basic terminology of health insurance and explain how the pieces fit together in a typical plan.
1.1 Insuring health?
First, let’s clarify the purpose of health insurance, since the name itself can be misleading. It does not insure health any more than life insurance insures life. Rather, health insurance protects against the financial risk of adverse health events. There is evidence that insurance can improve health—for example, by ensuring access to care—but this is a byproduct rather than the explicit purpose of insurance.
1.2 How Insurers Shape Coverage
Insurers do more than collect premiums and pay claims. Because health care is expensive, they design plans that manage where patients receive care and what services are covered. These coverage rules fall into two major areas: managed care and benefit design.
1.2.1 Managed Care
One common feature of modern insurance is managed care (Definition 1.1). “Management” in this context means that the insurer directs enrollees toward certain providers over others, usually reflecting the prices negotiated with those providers.
For example, suppose there are two large hospital systems in a market, and an insurer has negotiated lower payments with Hospital A. If Hospital A offers adequate quality and a wide range of services, the insurer wants enrollees to use it rather than Hospital B. To achieve this, the insurer might lower the patient’s out-of-pocket payment if care is received at Hospital A.
This arrangement resembles a Preferred Provider Organization (PPO), in which the insurer still covers some costs at Hospital B but at a less generous rate. Alternatively, the insurer might refuse to pay for care at Hospital B altogether. This is the logic of a Health Maintenance Organization (HMO), where coverage is limited to a defined set of providers. In both cases, the insurer uses financial incentives to steer patients toward preferred providers.
PPOs and HMOs are the most common forms of managed care insurance products in the United States.
Definition 1.1 (Managed Care) A health insurance product that attempts to manage utilization of health care among its enrollees, often by assigning providers (physicians, hospitals, etc.) into tiers based on negotiated prices.
1.2.1.1 Networks
A central tool of managed care is the construction of a provider network (Definition 1.2). Insurers negotiate agreements with certain hospitals, physicians, and other providers, designating them as “preferred” sources of care. Providers included in these agreements are considered in-network, meaning the insurer will cover care received from them, subject to the rules of the plan. By contrast, out-of-network providers have no such agreement, and patients are usually responsible for the full bill if they choose to use them.
The financial consequences of going out-of-network can be severe. Because out-of-network bills are based on the provider’s charges (essentially a sticker price) rather than the negotiated allowed amounts, patients may face costs many times higher than in-network rates (see Section 1.4). For example, an in-network MRI might leave a patient with a $200 co-insurance bill, while the same scan out-of-network could cost the patient over $2,000.
Definition 1.2 (Insurance Networks) A set of providers for which the insurer has agreed to pay some portion of care received, conditional on other terms of the insurance contract. The most common network-based insurance products are Preferred Provider Organizations (PPOs) and Health Maintenance Organizations (HMOs). PPOs often use a tiered structure, where patients pay less at higher-tier providers, while HMOs typically make a sharper distinction between in-network and out-of-network coverage.
Networks and managed care are closely linked. By deciding which providers are in-network and under what terms, insurers influence where patients seek care. The possibility of exclusion from a network—or assignment to a less favorable tier—also gives insurers bargaining power when negotiating prices with providers.
1.2.2 Benefit Design
Beyond steering patients to certain providers, insurers also decide what services are covered and how costs are divided between the insurer and the enrollee. This is referred to as the plan’s benefit design.
Benefit design has two main components:
1. Covered services — the types of care included in the plan (e.g., hospital visits, prescription drugs, mental health services). Some services may be excluded or subject to limitations.
2. Premium and cost-sharing rules — the financial terms that specify how much patients must contribute when using care. These include the deductible, co-payments, and co-insurance.
These design choices shape patient access to care and the overall generosity of the plan. We now turn to the patient side of the story: how these rules translate into what people actually pay.
1.3 How Patients Pay for Coverage
From the patient’s perspective, the most visible features of an insurance product are the payments they are responsible for. These include the premium—the fixed monthly amount paid for coverage—and the various forms of cost-sharing that apply when care is received.
1.3.1 Premiums
A premium is the fixed amount an enrollee pays each month for health insurance coverage, regardless of whether any care is received. In employer-sponsored plans (the most common form of private insurance), this cost is typically shared between the employee and the employer.
Premiums have risen steadily over time, as shown in Figure 1.1. Several factors contribute: advances in medical technology and pharmaceuticals, greater demand for care due to an aging population and rising rates of chronic disease, and the administrative and regulatory costs of running insurance plans. Together, these pressures have made premiums an increasing financial burden for households and employers alike.
1.3.2 Cost-Sharing
While premiums must be paid every month, cost-sharing refers to what patients pay when they actually use health care. Cost-sharing provisions determine the out-of-pocket expenses a patient faces once they receive care. The three most common forms are the deductible (Definition 1.3), co-insurance (Definition 1.4), and co-payment (Definition 1.5).
Figure Figure 1.2 shows that over time, insurers have relied more heavily on high deductibles and co-insurance, while the use of co-payments has declined.
Definition 1.3 (Deductible) The amount a patient must pay out-of-pocket before the insurer pays anything. For example, with a $2,000 deductible, a patient must first cover $2,000 in health care costs each year before insurance begins contributing. Once this threshold is reached, the deductible is considered “met.”
Definition 1.4 (Co-insurance) A percentage of costs the patient pays after meeting the deductible. For example, with a 20% co-insurance rate, a patient who has already met the deductible and then receives a $5,000 hospital bill would pay $1,000 (20%), while the insurer pays the remaining 80%. Co-insurance is common for larger, less predictable services such as hospital stays or emergency visits.
Definition 1.5 (Co-payment) A fixed dollar amount the patient pays for a specific service after meeting the deductible. Co-payments are more common for lower-cost, predictable services such as physician office visits or prescription drugs. For instance, a plan might require a $20 co-pay for a doctor’s visit, with the insurer covering the remainder.
Note that co-insurance and co-payments can coexist within the same plan. Office visits may involve a co-payment, while hospital services may involve co-insurance. Importantly, monthly premiums are not considered cost-sharing, because they are owed whether or not any health care is used. Cost-sharing applies only to expenses incurred when care is actually received.
1.4 An Aside on Prices
To understand why out-of-pocket costs can vary so much, it is important to distinguish between different notions of price in health care. In most markets, prices are relatively transparent. In health care, by contrast, there is typically both a charge and an allowed amount.
The charge is like a suggested retail price—it reflects what the provider would like to be paid. The allowed amount is the negotiated rate that the provider and insurer have agreed upon.
If there is no such agreement (e.g., the provider is out-of-network), patients are asked to pay the full charge. Charges can exceed allowed amounts by thousands of dollars, making the distinction more than semantic. We will return to this issue in greater detail in the chapter on hospital pricing and bargaining.