Risk-Sharing: The Importance of Health Expenditure Shocks

We set up a model with uninsurable idiosyncratic risk in the tradition of Bewley and Aiyagari. In addition to labor income shocks we also model health expenditure shocks and a health insurance market that allows imperfect insurance against expenditure shocks, calibrated to U.S. data on health expenditures and patient co-payments. We then study the potential welfare gains of improving health risk-sharing. Specifically, we compute the welfare gain of providing perfect insurance for health expenditures, i.e., giving every agent the average health expenditure in every period. One can view this as an upper bound on the welfare gain that health insurance policy could achieve. We compute the transition dynamics towards the new steady state and find that eliminating health expenditure risk increases welfare substantially, by more than 2 percent, measured as consumption equivalent. About two thirds of the gain comes from better risk-sharing in the new steady state, the rest from reducing precautionary savings along the transition path.