ELSEVIER Journal of Health Economics 16 (1997) 543—562 -- - -

Adverse selection and the purchase of Medigap

insurance by the elderly
Susan L. Ettner
Drpartmrtit o) Health Care Polic y, Hard a rd Medical School, 25 Shattut’k Street, Part el B, 1 st flo‹›i,
Bosl‹›n, MA 02115, USA

Received 1 November 1995: revised I August 1996

Abstract

This study uses data on 8561 elderly respondents from the 1991 Medicare Current
Beneficiary Survey to examine adverse selection in the supplemental private insurance
market. Logit models of supplemental insurance choices provided modest but mixed
evidence of self-selection on the basis of observable health status. Wealth had a strong
influence on coverage. Two part models of Medicare utilization and expenditures showed
that beneficiaries with individually purchased policies had higher total, part B and
physician expenditures than those with employer-provided policies, even ‹ifter
controlling for observ- able differences, suggesting adverse selection. Results were
similar for basic and more comprehensive policies. O 1997 Elsevier Science B.V.

JEL c’l‹J.s.sific’ ation.‘ 11 1 ; G22; D8

Ke1'wr› rd.s: InDurance; Adverse selection; Medicare: Medigap; Utilization; Expenditures

1. Introduction

Adverse selection in insurance markets is a topic of longstanding interest in the

economics literature (Pauly, 1974; Rothschild and Stiglitz, 1976; Wilson, 1977)
and more recently has become a major source of concern for experts interested in
health care reform (Newhouse, 1994). Capitated systems create incentives for

’ Correspt›nding author. Tel.: 617-432-4031 : fax: 617-432-(1173; e-mail: ettnerH hcp.med.harvard.edu

(I167-6296/97/$ 17.00 1997 Elsevier Sciencc B.V. All rights rescrx cd.
PIN SO 1 fs 7 - 6 2 9619 7) 00 0 1 1 - 8
544 S.L. Ettner/ Journal of Health Economics 16 11997) 543—562

insurers and plans to attract healthy patients and avoid patients who are expensive
to treat ’. If substantial selection occurs, certain plans will become increasingly
profitable, while others will raise their premiums (Price and Mays, 1985) and
eventually become insolvent, reducing the number of plans available to con-
sumers. Furthermore, selection creates incentives for plans to compete for prof-
itable patients in ways that are wasteful.
The ability of insurers to " cream-skim " is related to the degree to which
patients self-select into different plans, based on health and the propensity to
utilize services. Individual utilization patterns are highly correlated over time
(Eggers, 1981; McCall and Wai, 1983; Anderson and Knickman, 1984), particu-
larly for older adults (Eichner et a1., 1995) and despite some regression to the
mean (McClure, 1982; Welch, 1985), the impact of adverse selection on plans
tends to increase over time (Price and Mays, 1985). To explore the implications
of selection into insurance plans, one would like to distinguish the extent to which
utilization differences between persons with more and less generous insurance
coverage are due to adverse selection vs. pure insurance effects. Previous research
has shown that patients with certain readily identifiable characteristics (such as
age) that affect utilization are also more likely to have generous insurance
coverage. However, this research cannot measure the full extent of risk selection,
because observable characteristics typically do not explain much of the variation
in utilization patterns across patients.
In a review of the literature, Pauly (1986) concluded that there is little direct
evidence on whether adverse selection is an important problem in health insurance.
One market that has been studied with inconclusive results is Medicare supple-
mental insurance. 95% of the elderly are covered by Medicare Part A (hospital)
insurance and of these, about 95% have part B (physician) coverage as well.
Although Medicare benefits are fairly comprehensive, substantial copayments and
deductibles are required, prescription drugs are excluded from coverage, and long-
term care benefits are limited. For these reasons, many elderly purchase supplemental
private insurance, known as Medigap (Short and Vistnes, 1992). In earlier work, the
hypothesis that the purchase of Medigap insurance is exogenous could not be rejected
(Lillard and Rogowski, 1995); however, the power of this test may have been low
due to weak identification of the instrumental variables model. Analysis of the
AHEAD database by Hurd and McGarry (1995) showed that Medicare utilization
differed according to whether the beneficiary had supple- mental insurance. They
argued that these differences probably reflect moral hazard rather than adverse
selection, because Medigap coverage was not significantly

The most common ways of selecting low-risk patients are to locate in certain areas, provide
services that are attractive to low-risk patients, market differentially to low-risk patients, exclude pre-
existing conditions from coverage and discourage use by high-risk patients. Luft (1995) describes some
of these techniques in greater detail.
 S.L. Ettner/ Journal of Health Economic’s 16 ( 1997? 543-562 545

related to a comprehensive set of health proxies, but was determined primarily

by the respondent’s wealth. However, due to data limitations, they were unable
to explore the existence of unobservable differences in the propensity to use
services (e.g. due to heterogeneous preferences) between respondents with and
without Medigap.
This study examines the extent to which Medicare patients self-select into
supplemental insurance on the basis of both observable and unobservable
charac- teristics, using linked Medicare claims and survey data from the 1991
Medicare Current Beneficiary Survey (MCBS). I first explore adverse
selection associated with observables, by estimating logit models of the choice
of supplemental insurance among Medicare beneficiaries and the choice of
more vs. less compre- hensive coverage among respondents who have private
insurance policies.
I then examine the evidence of adverse selection based on unobservables,
by comparing the resource use of Medicare beneficiaries by the source of
supplemen- tal insurance coverage. Some of the elderly covered by Medigap
obtain their policies through employers, while others purchase them directly
from the insurer or associations such as the AARP. Persons covered through an
employer are less likely to be self-selected than those who purchase coverage
directly (Vistnes and Banthin, 1995). Under the assumption that such coverage
is exogenous, then the extent to which adverse selection occurs in the Medigap
market can be identified by comparing the resource use of persons with
employer-provided and individu- ally purchased policies. Furthermore, any
biases from the failure of this and other assumptions of the model are likely to
lead to conservative estimates of the adverse selection effect, as discussed later
in the paper. Observable ways other than insurance source in which persons with
access to employer-provided Medigap insurance differ from other Medicare
beneficiaries, such as greater income, are controlled through the use of
regression analysis. This method is also used by Long (1994), who finds
evidence of adverse selection in the market for Medigap policies covering
prescription drugs.

2. Methods

2.I. Stuff design

Table 1 illustrates the study design when there is only one type of Medigap
plan and exogenous characteristics have been controlled. Suppose that there
are two groups of respondents: those with low and high propensities to use
services. Within each of these groups, some respondents have the option to
obtain Medigap coverage through their employers, while others must purchase
coverage individu- ally if they want it. Assume for the moment that the
insurance effect of Medigap is the same regardless of the source of coverage,
that the option to obtain employer- provlded coverage is exogenous, and that
all persons who are able to obtain such
546 S.L. Ettner/ Journal of Health Economics 16 (19971 543—562

Table 1
Study design
Availability of Individual has high
Individual has low
employer-based propensity to
propensity to
Medigap coverage use services use services
Not Available Group A Group B
Available Group C Group D

coverage do so. Under adverse selection, however, only persons with a high
propensity to use services purchase individual coverage. Thus, groups B, C and D
have coverage and group A does not.
Adverse selection is defined here as the difference in average use between
group B and groups C and D combined. Because all three groups are insured,
higher average use among those with individual coverage can be attributed to self-
selection under the assumptions of the model. Moral hazard would ideally be
measured as the difference between two groups with equivalent propensities to use
services, one with and the other without coverage. For example, the use of group
C relative to group A would yield an estimate of moral hazard for persons with a
low propensity to use services °. It is not possible to identify which persons are in
group C, so instead, moral hazard is estimated as the difference in average use
between groups C + D vs. group A. Although this analysis is likely to yield an
overestimate of the moral hazard effect, due to the inclusion of high-propensity
individuals in the comparison, it should be a more accurate estimate than a simple
comparison of persons with and without insurance when adverse selection is not
controlled (i.e. B + C + D vs. A), which includes an even higher proportion of high-
propensity individuals.
The sensitivity of the model to the assumptions made above are explored in
analyses described in a later section. Most of the potential biases with this
methodology seem likely to underestimate adverse selection. For example, al-
though Table 1 assumes only one type of Medigap policy, in reality, there are
numerous choices. If employer-provided Medigap is more comprehensive than
individually purchased policies and benefit design is not fully controlled, then
utilization will be relatively higher for the employer-covered group, reducing the
difference attributed to adverse selection. Biases from other uncontrolled differ-
ences between respondents with and without access to employer-provided insur-
ance will be conservative (non-conservative) if they are associated with higher
(lower) use among the employer group relative to the individually covered group.
Finally, employer-provided coverage may not be exogenous. High-risk workers
may self-select into jobs that provide better retirement medical benefits, or

2
This estimate is likely to be lower than the estimated moral hazard for a population with a high
propensity to use services.
 S.L. Ettner/ Journal of Heulth Economic.i IN 119971 543—562 547

healthier workers may choose not to be covered by the group Medigap policy if it
is not fully subsidized by the employer. In this case, utilization will be higher for
the employer group (C + D) and lower for the uncovered group (A), biasing the
moral hazard effect upward but the adverse selection effect downward.

2.2. Data

The design of the MCBS has been described in detail in Adler (1994).
Beginning in Fall 1991, the MCBS was administered to a random sample of the
Medicare population, including oversamples of persons 85 and older and disabled
beneficiaries under 65. The MCBS is well suited for examining the extent to
which elderly self-select into supplemental insurance and the effect of this
selection on resource use, because it contains detailed information on the respon-
dent’s Medicare utilization, expenditures, insurance coverage, health status, func-
tioning, demographic characteristics, income, and education. Table 2 gives defini-
tions and weighted summary statistics for all variables used in the study.
The sample size for the non-institutionalized population was 8 561 after exclud-
ing beneficiaries who qualified for Medicare on the basis of ESRD or disability.
lived in Puerto Rico, were not covered by parts A and B for the full year, died, or
participated in group health plans. Sensitivity analyses were performed to deter-
mine the robustness of the results when including part-year respondents and
weighting the regressions by the number of months in the sample.

2.3. Logit m‹›del.s of insurance choice

A multinomial logit (MNL) model is used to estimate the choice between

Medicaid participation, employer-provided private supplemental insurance, and
individually purchased private supplemental insurance (ve. no supplemental insur-
ance) ’. Dichotomous logit models are used to estimate the probability of choosing
more (vs. less) comprehensive coverage among the two subsamples of respondents
with employer-provided and individually purchased private insurance. For ease of
interpreting the logit results, the tables show the average relative risk and
significance level associated with each regressor. For discrete regressors, the
relative risk is the predicted probability of the choice when the regressor ot
interest is set equal to one, divided by the probability when the value is reset to
zero; continuous regressors are respectively set equal to the sample mean plus one
standard deviation, and the sample mean only.
Insurance choices are specified to depend on the respondent’s demographic
characteristics (sex, race, Hispanic ethnicity, marital status, number of children.

" Housman tests of the IIA assumptions were negative and hence unintormative, but similar results
wcre obtained using nested logit models that allowed for employer and individual Medigap policies to
be closer substitutes than the other alternatives.
548 S.L. Ettner/ Journal of Health Economics l6 (1997) 543—562

and education), wealth (proxied by income and home ownership), and health
(proxied by age and its square, self-assessed health, functional limitations,
activi- ties of daily living, instrumental activities of daily living, smoker status,
and

Table 2
Data definitions and weighted summary statistics
Regressor Mean (std. dev.) Definition
BASIC 0.36 = 1 if has only Medigap policy that does not cover prescription
drugs and nursing home services
BASIC + 0.44 = 1 if has Medigap policy that covers either prescription drugs,
nursing home services or both
ADVERSE 0.29 = 1 if obtained basic Medigap policy but no enhanced coverage
through a non-employer source
ADVERSE + 0.19 = 1 if obtained enhanced Medigap policy through a non-employer
source
MEDICAID 0.07 = I if has Medicaid coverage
MEDNEED 0.83 = 1 if lives in a state with a medically needy program
FEMALE 0.60 = 1 if female
BLACK 0.08 = 1 if black
OTHER 0.02 = I if other non-white race
HISPANIC 0.03 = 1 if Hispanic
SINGLE 0.10 = 1 if divorced/separated/never married
WIDOWED 0.35 = 1 if widowed
HIGH SCHOOL 0.44 = 1 if completed high school but not college
COLLEGE 0.12 = 1 if completed college
HOMEOWNER 0.98 = l if respondent or spouse owns own home
SMOKES 0.15 = 1 if currently smokes
RESP 0.12 = 1 if reports having a respiratory condition
ENDO 0.14 = l if reports having an endocrine condition
MENTAL 0.03 = 1 if reports having a mental condition
CARDIO 0.GS = I if reports having a cardiovascular condition
NEURO 0.12 = 1 if reports having a neurological condition
CANCER 0.29 = 1 if reports having cancer
MUSC 0.55 = 1 if reports having a musculoskeletal condition
AGE 74.22 (6.68) Respondent’s age
SAH 3.23 (1.19) Self assessed health, on 1 —5 scale (5 = best)
LIMITS 0.89 (1.33) Number of functional limitations
ADL 0.82 (1.38) Number of Activities of Daily Living
IADL 0.68 (1. 18) Number of Instrumental Activities of Daily Living
CHILDREN 2.67 (2.17) Number of children
INCOME $ i g,4s0 Continuous income measure, constructed from taking midpoints
($12,422) of interval data
STANDARD $392 ($90) State SSI income standard, 1991
PRICEA $35 ($7) Monthly AARP premium in respondent’s state for Medigap policy
A (most basic), 1992
PRICEJ $126 ($14) Monthly AARP premium in respondent’s state for Medigap policy
J (most comprehensive), 1992
RATIO 0.28 (0.03) Ratio of policy A premium to policy J premium
COL 104 (10) ACCRA composite state cost-of-living index, 1992
 S.L. Eitner/ Journal oy iieulth Economics 16 (7997) 543—562 549

Table 2 (continued)
Outcome Mean (std.dev.) Definition
TOTAL $2,715 ($6,904) Total 1991 Medicare reimbursement
PART A $1,577 ($5,338) Medicare 1991 Part A reimbursement
PART B $1,138 ($2,116) Medicare 1991 Part B reimbursement
IP CHARG $2,617 ($10,360) Medicare 1991 inpatient charges
IP REIMB $1,394 ($4,881) Medicare 1991 inpatient reimbursement
IP DAYS 2.03 (7.25) Medicare 1991 inpatient days
OP CHARG $596 ($1,682) Medicare 1991 outpatient charges
OP REIMB $195 ($607) Medicare 1991 outpatient reimbursement
MD $1,976 ($3,717) Medicare 1991 physician charges
CHARG $943 ($1,803) Medicare 1991 physician reimbursement
MD REIMB 5.50 (5.93) Medicare 1991 physician visits
MD VISIT

Notes: N —— 8561. Default category for dichotomous variables is coded to 0. Regressors also include
indicators for income in the open interval (OINC) and missing data for education (MEDUC), inc‹›me
(MINC), Medigap prices (MPRICE) and state cost of living (MCOL).

indicators for whether the patient reports ever having been diagnosed with
medical conditions affecting each of seven different body systems). Functional
limitations include difficulty with lifting 10 pounds, reaching over head,
stooping/kneeling, walking 2—3 blocks, and writing. Activities of daily living
include difficulty with bathing, getting in and out of chairs, dressing, eating,
toiletting, and walking. Instrumental activities of daily living include difficulty
with money management, heavy and light housework, preparing meals, shopping,
and using the telephone. The MNL model also controls for the following state-
level variables: the presence of a Medicaid medically needy program
(Congressional Research Ser- vice, 1993); the SSI income standard, which in
most cases is the same as the Medicaid standard (Committee on Ways and
Means, 1993); the price of the most comprehensive Medigap policy (personal
communication. American Association of Retired Persons, 1992); a cost-of-living
index (American Chamber of Com- merce Researchers Association, 1992); and
indicators for missing state-level data. The models of Medigap generosity include
similar state-level variables, but control for the relative price of the least vs. most
comprehensive Medigap policy instead
of the price of the most comprehensive policy and cost-of-living index.

2.4. Two›-part models of resource use

The measures of resource use examined in this study include utilization,

reimbursement and charges. The latter two are broken down as inpatient. outpa-
tient, and physician, and reimbursement is also divided into parts A and B.
Utilization measures include the number of inpatient-covered days and physician
office visits. Charges are studied separately from reimbursement in the main
analyses because better-insured patients may visit more expensive providers, an
550 S.L. Ettner/1ournal of Health Economics 16 11997) 543—562

effect that would be reflected in charges but not Medicare payments per se.
Charges and utilization are also better proxies than payments for total resource
use, because they include supplemental insurance and out-of-pocket payments. All
of these outcomes were constructed from claims data, so they exclude services that
were paid for entirely out-of-pocket or by supplemental insurance. The advantage
is that claims data should be more accurate than self-reports.
Each outcome was estimated with a two-part model (Duan et al., 1983) of the
form E[Y) - p/ Y > O)E[Y Y > 0). The first equation is specified as a probit
regression and the second equation is a least squares regression, using the
conditional sample of persons with positive values for the outcome. The results
reported in the tables are the unconditional marginal effects bE( Y)/dX k and the
corresponding approximate standard errors, derived from a Taylor series expan-
sion. The results were robust to the use of sample weights, so the regression
analyses presented here are unweighted.
The explanatory variables are private insurance indicators and dual beneficiary
status (MEDICAID), in addition to the same individual-level demographic, socioe-
conomic and clinical characteristics used in the logit models. If Medicaid-eligibles
do not obtain coverage until they are actually in need of services, then the
estimated effect of Medicaid will include unmeasured case mix as well as pure
subsidy effects. Furthermore, because the healthiest Medicaid-eligibles will remain
in the comparison group (A), the impact of adverse selection and moral hazard
may be overstated. For this reason, I also rerun the regressions using a proxy for
potential Medicaid eligibility instead of the indicator for actual participation 4.
The regressors of primary interest are the private insurance indicators. For up to
five plans, the survey asks about the type of plan (public vs. private), policyholder
relationship, annualized premium, source of coverage, and benefits (whether
nursing home services and prescription drugs are covered). Although nursing
home and drug subsidies will not directly affect the outcomes studied here, it is
likely that they are correlated with unknown Medigap provisions, such as de-
ductibles and copayments, that do affect these outcomes (Wolfe and Goddeeris,
1991). For simplicity, I call policies that do not cover prescription drugs or nursing
home services basic Medigap ; those covering prescription drugs, nursing home
services, or both are designated as enhanced Medigap
Corresponding to the study design described earlier, four dichotomous variables
are constructed from the Medigap information: whether the respondent obtained
(1) basic coverage only, from any source (BASIC), (2) enhanced coverage from
any source (BASIC + ), (3) any basic but no enhanced coverage through a source
other than a current or former employer (of the respondent or respondent’s spouse)

4
Potential Medicaid eligibility was determined by comparing household income to the SSI income
standards in the respondent’s state of residence. Actual Medicaid participants who were predicted to be
ineligible were first included and then excluded from the eligible group.
 S.L. Ettner/ Journal of Health Economic.s lb 119971 543—562

(ADVERSE), and (4) any enhanced coverage through a non-employer source

(ADVERSE + ). With these definitions, the coefficients on BASIC and BASIC +
respectively measure the moral hazard effects of basic and enhanced Medigap
policies, and the coefficients on ADVERSE and ADVERSE + respectively mea-
sure the effects of self-selection into basic and enhanced Medigap policies.
Additional analyses were performed to examine the assumptions of the model
and the sensitivity of the findings. Descriptive evidence is presented on
differences in benefits by source of coverage, although the information available
on plan generosity was limited. The implications of omitted variable bias
associated with the factors most likely to be important—imperfectly measured
health and wealth
—were explored by determining observable differences between the two groups
and then comparing regression results with and without the health and wealth
controls. To examine how selection into employer-provided policies might affect
the results, the models were re-estimated three ways. First, respondents thought to
be self-selected into employer-provided insurance were included as pan of the
adversely selected group. Second, selection into employer-provided and individu-
ally purchased Medigap were controlled separately. Third. respondents thought to
have self-selected into employer-provided insurance were excluded from the
sample altogether. In each case, the subsample of respondents who selt-selected
into employer-provided Medigap coverage was alternately defined as those paying
any premiums and those paying over $50 per month

3. Results

3.I. Generosity of Medigap policies and out-of-pocket Premiums hv sourc e

Table 3 gives weighted frequencies and mean out-of-pocket premiums for all
private supplemental insurance policies held by the sample respondents, by
covered benefits and source of coverage (employer provided vs. individual).
Because this sample is not the same as a random sample of all Medigap policies
offered by insurers or employers, the results should be interpreted with caution.
Medigap policies obtained through an employer appear to be more comprehensive
than those purchased individually. Although there was little difference by Medigap
source in the proportion of policies that covered both nursing home and drug
coverage (9% vs. 49c), and a lower proportion of the employer-provided policies
included nursing home coverage only (4% vs. l 8%), the much higher rates o1
prescription drug coverage among employer-provided policies (56% vs. 15%) led
to correspondingly lower rates of basic coverage (319r vs. 63%). Thus, it the

The same cutoff was used regardless of the type ‹if polic y, sint‘e the out-of-pocket premiums
differed little by benefit design for employer-based coverage.
552 S.L. Ettner/ Journal of Health Economics 16 (1997) 543—562

Table 3
Covered benefits and annualized out-of-pocket premiums, by source of Medigap policy
Type of plan Source: current or former employer Source: all other
of respondent or respondent’s spouse
Basic coverage only N — 1075 N —— 2800
319• 63%
$475 ($618) $775 ($688)
Prescription drug benefits N —— 1965 N —— 665
56' o 15 to
$505 ($2119) $1004 ($915)
Nursing home benefits N — 124 N —— 797
4% l89r
$557 ($585) $1126 ($3718)
Prescription drug and nursing N —— 320 N = 201
home benefits 99c 49c
$536 ($885) $1396 ($2753)
Total number of plans 3484 4463

Notes: rows respectively show the number of plans, column percentage, and mean annualized out-of-
pocket premium (standard deviations in parentheses). All figures are weighted. The total number of
plans is greater than the number of respondents with Medigap because some respondents have multiple
policies. Sample is not necessarily representative of Medigap policies nationwide. The difference in
frequencies by the source of coverage was significant at p < 0.01 in a chi-squared test. For all policy
types except those covering nursing home benefits only, differences in mean annualized out-of-pocket
premiums by source of coverage were significant at y < 0.01 in F-tests.

greater observable generosity of the employer-provided policies is indicative

of unobservable differences, then the failure to control perfectly for benefit
design should bias the estimated adverse selection effect downward.
Employers were clearly subsidizing the plans offered to their employees,
although the average out-of-pocket premiums for employer-provided policies were
still substantial 6. The generous plans were subsidized to a greater degree than
basic plans, although this result is unlikely to hold for multiple plans offered
by the same employer. The average out-of-pocket premium paid for employer-
pro- vided policies that cover both prescription drug and nursing home benefits
was only 38% of the average premium for similar, individually purchased
policies. In contrast, among basic policies, the average premium for an
employer-provided policy was 61% of the premium for individually purchased
policies.

3.2. Selection into supplemental insurance

Table 4 shows a subset of the results from the MNL model of supplemental
insurance choice. Both reported and unreported findings are consistent with earlier

In results not shown here, the high mean was primarily due to a modest number of employees with
high premiums.
 S.L. Ettner,I Journal of Health Economic.1 lâ 119971 54.1—5h2

Table 4
Relative risks and p-values from multinomial logit model of supplemental insurance
Regressor Medicaid only
Employer Medigap Individual Medigap
N —— 618)
‹ N - 2680 N —— 4088)
MEDNEED
1.38 ( p —— . 0.73 (p — .01) 0.95 (p — .60)
STANDARD 07) 0.82 (p —— .(10) 0.98 (p —— .80)
PRICEJ
1.60 t p —— 0.72 (p —— .00) 0.77 ( p — .DD)
COL .OD) 1.23 ( p 1.95 (p —- .()ñ) 0.86 (p - .29)
HIGH SCHOOL — . 16) 0.60 ( p 1.64 (p —— .00) 1.5 I (p — .00)
COLLEGE —— .03) 1.59 (y =.00) 1.13 ( p —— .42)
HOMEOWNER 0.61 p — .OD) 1,27 (p —— 38) 1.08 ( p — .73)
INCOME 0.73 ( p —— . 2.53 (p -— .HO) 2.04 (y =.00)
AGE 32) 0.66 ( p — . 0.85 (p —— .00) 1.f)4 (p — .38)
AGE'
12) 0. i2 (p — 0.90 ( - .01) 0.90 ( =.01)
SAH
LIMITS
0 ) 1.07 ( p — . 1.12 (y .t)1) 1.11 ( y .01)
35) 0.89 (y - .04) (1.91 ( p — .07)
ADL
0.96 ( p —— . 1.10 (y .09) 1.07 (y =.20)
IADL
49) 0.95 (p —— .25) 0.96 (J› =.31)
SMOKES
0.96 ( p — .50) 0.62 (y =.to) 0.f›7 ( p —— .Oil)
RESP
ENDO
1.1 2 ( › —— . i 12(p — ss) i n1 p —— ssi
13) 1).95 (y =.62) 0.94 ( p =.58)
MENTAL
1.18 ( = .02) 1.19 (y — .39) 0.90 (y› =.59)
CARDIO
0.97 ( p — .56) 1.47 ( y — .tJ0) 1.4() ( p —— .(1(1)
NEURO
0.91 ( p —— .56) 0.90(y=.38) (L95 ( › .63)
CANCER
0.97 ( p — .87) 1.05 (y =.38) 1.17 ( p — .05)
MUSC
1 .04 ( p —— . 1.23 (y =.IN l) 1.32 ( p — .v 11
77)
I .23 ( p = .44)
1 .51 ( p = .0tl)
1.05 ( p — .74)
1.00 ( p —— .
99)
1 ,4G ( y = .00)

Nc›tes: N —— 8561. Omitted category is no supplemental insurance. Regression also controls t‘or a
constant and FEMALE, BLACK, OTHER, HISPANIC, SINGLE, WIDOWED, CHILDREN, MPR ICE,
MCOL, MEDUC, MINC and OINC. Joint significance t›f health regressors is p = 0.HO and jt›int
significance of wealth regressors is P —— 0.00.

work showing that elderly who have private supplemental insurance are generally
younger, wealthier, better educated, female, white, and in better self-assessed
health (Rice and McCall, 1985; Garfinkel and Corder, 1985; Christensen et al..
1987; Wolfe and Goddeeris, 199 l ; Hurd and McGarry, 1995; Shea and Stewart,
1995; Vistnes and Banthin, 1995). One interpretation of the wealth effects in the
demand for private insurance is that they result from public programs that serve as
catastrophic coverage for the poor (Pauly, 1990; Wolfe and Goddeeris, 1991).
Poor persons know that they can qualify for Medicaid, should they need it, so they
do not bother purchasing private insurance.
In contrast to the respondents with Medigap coverage, the Medicaid patients
tended to be poorer and less well-educated than respondents without any supple-
mental insurance. Other economic factors also appeared to play a role in insurance
choices. Elderly living in states with higher SSI income standards or Medicaid
medical need programs were significantly less likely to have private supplemental
insurance and more likely to participate in Medicaid. Furthermore, controlling for
554 S.L. Ettner/ Journal of Health Economics 16 (1997) 543—562

the cost of living, respondents living in states with higher Medigap premiums
were significantly less likely to have Medigap insurance from any source.
There was evidence of selection into supplemental insurance on the basis of
observable health status, although the results were a bit mixed. The health proxies
were highly significant in a joint test ( p —— 0.00), even excluding age.
Confirming earlier findings (Davidson et a1., 1992; Hurd and McGarry, 1995;
Vistnes and Banthin, 1995), current smokers and respondents who reported their
own health to be poorer were less likely to have Medigap policies from any
source. These results suggest favorable selection, yet persons who reported ever
having been diagnosed with a cardiovascular or musculoskeletal condition were
significantly more likely to have supplemental insurance, indicating adverse
selection. However, the smok- ing effect might be explained by occupational
choice or selective marketing on the part of insurers, while self-assessed health
may possibly be picking up unmeasured socioeconomic status effects (Ettner,
1996).
The logit results were strikingly similar for employer-provided and
individually purchased policies, except that income and education were more
strongly corre- lated with employer-provided policies (and in a logit analysis not
shown here, were highly significant predictors of the source of coverage among
respondents with any Medigap). Thus, to the extent that income is an imperfect
proxy for overall wealth and medical services are normal goods, moral hazard
should be biased upward and adverse selection downward in the two-part model
analyses. Apart from age, there were no significant differences by source of
coverage in the degree of observable health-related selection into supplemental
insurance.

3.3. Selection into enhanced coverage

Table 5 shows the estimates from logit models of the choice of enhanced vs.
basic coverage among two subsamples: those with employer-provided and those
with individually purchased Medigap policies. As before, wealth appears to be
one of the most important driving forces in the insurance decision: among both
samples of respondents with Medigap coverage, higher-income and better-
educated respondents purchased more comprehensive policies. This finding casts
doubt on the earlier hypothesis that the influence of wealth on the decision to
obtain any private supplemental insurance is due solely to the presence of a "
safety net " , since the option of going onto Medicaid should not affect the
conditional choice of Medigap plan. Respondents living in states in which the
price of the most basic Medigap policy is high relative to the price of the most
comprehensive policy were also more likely to have comprehensive coverage.
There was less evidence of health-based selection in the choice of policy type
than there was for the choice of any supplemental insurance. Cardiovascular
conditions were still significant predictors of better insurance coverage among the
group with employer-provided Medigap. However, the other health measures
were no longer individually significant; even as a group, they were jointly
significant
 S.L. Enner/ Journal of Health ñCt9DOfflffS lb I9971 543—5ñ2

Table S
Relative risks and p-values from logit models of enhanced medigap coverage
Regressor Respondents with any Respondents with
individual Medigap employer Medigap only
N —— 4,088) N —— 2.680)
PRATIO 1.43 ( p —— . OU ) 1.18 ( /› = .04)
HIGH SCHOOL 1.03 ( p — .5II) 1.07 ( y› = .02)
COLLEGE 1.19 ( = .01) 1.05 ( y› = .2fi)
HOMEOWNER 1.19 ( p — .33) (1.98 ( y› = .86)
INCOME 1.16 ( p —— .OO) 1.07 ( ji = .00)
AGE 0.95 ( p — .04) 0.93 ( /i = .00)
AGE' 11.97 ( p —— .2?) 1.01 ( J› = .29)
SAH 1.02 ( p —— .53) 0.98 ( y› — .30)
LIMITS 0.99 ( p — .69) 1.I 7 .92)
ADL 1.02 ( y = .44) 0.99 ( /7 - .61 )
IADL 0.99 ( y — .66) 1.01 ( /› = .50)
SMOKES 1.00 ( p —— .97) 1 .01 ( /› = .84)
RESP 0.92 ( = .19) 1.0U ( y› = .94)
ENDO 0.98 ( y .71) 1.03 ( j› .47)
MENTAL 1.11 p —— .39) 1.1 l ( ¿› = .11)
CARDIO 1.07 ( p —— .11) 1 .17 ( /i = .00)
NEURO 1.12 ( = .06) 1.07 ( J› = .08)
CANCER 1.01 ( y = .9(I) 1.02 ( /, = .51)
MUSC 1.07 ( p —— .11) 1.04 ( /› — .20)
% with Y = 1 389a 7IV
Jt›int significance of ().13 I).()t)
health regressors
Joint significance of 0.00 0.01
wealth regressors

Notes: in both models, omitted category is basic coverage only. Regressions also control for a constant
and FEMALE, BLACK, OTHER, HISPANIC, SINGLE. WIDOWF.D, CHILDREN, MPRICE,
MEDUC, MINC and OINC.

only among the sample with employer-provided Medigap. These results confirm
the Browne and Doerpinghaus (1994) finding that self-assessed health status is
not significantly associated with the choice of high vs. low option plans by
Medicare beneficiaries who purchase non-group Medigap insurance.

3.4. Moral hazard and selection effects on resource use

Table 6 shows the two-part model estimates of the moral hazard and selection
effects. As expected, the magnitude of the insurance effect of enhanced Medigap
coverage was always larger than that of basic coverage. Comprehensive insurance
had a consistently positive impact on all measures of charges, reimbursement and
utilization and the effects were significant for total, part B, outpatient and
physician reimbursement, outpatient and physician charges, and physician visits.
In contrast, the impact of basic coverage was significant only for physician visits.
556 S.L. Ettner/ Journal of Heolth Economics 16 (1997) 543—562

The results also provide evidence of adverse selection in the market for
Medigap. Respondents who purchased a basic Medigap policy through a source
other than an employer incurred an additional $516 in Medicare payments, above

Table 6
Two-part model marginal effects: moral hazard and adverse selection
Outcome dOutcome/ 8Outcome/ dOutcome/ fiOutcome/
3BASIC 6 BASIC + OADVERSE OADVERSE +
TOTAL 281 (304) 760 (264)‘ 516 (246)‘ 446 (222)b
PART A 89 (240) 383 (211) 353 (205) 174 (182)
PART B 159 (91) 377 (79)a 184 (74)• 181 (67)a
IP CHARGES — 452 (482) 338 (427) 655 (403) 445 (366)
IP REIMB 94 (222) 358 (196) 302 (185) 159 (168)
IP DAYS — 0.19 (0.32) 0.28 (0.29) 0.46 (0.27) 0.20 (0.25)
OP CHARGES 143 (78) 231 (67)“ 113 (61) 33 (55)
OP REIMB 50 (29) 68 (25)‘ 32 (22) 30 (20)
MD CHARGES 227 (I 59) 643 (138)' 317 (12 )a 27s (1l8)•
MD REIMB 115 (78) 313 (68)" 150 (63)“ 149 (57)"
MD VISITS 0.8 i (0.25)a i .61 (0.22)a o.66 (0.21l• 0.35 (0.19)
Notes: N —- 8561. Approximate standard errors in parentheses. All regressions also control for a
constant term and MEDICAID, FEMALE, BLACK, OTHER, HISPANIC, SINGLE, WIDOWED,
CHILDREN, HIGH SCHOOL, COLLEGE, MEDUCATION, HOMEOWNER, INCOME, MINCOME,
OINCOME, AGE, AGE, SAH, LIMITS, ADL, IADL, SMOKES, RESP, ENDO, MENTAL,
CARDIO, NEURO, CANCER, and MUSC.

(a) Moral hazard effects on reimbursement, omitting adverse selection controls

Outcome fiOutcome/ d BASIC dOutcome/ 8BASIC +
TOTAL 674 (240)‘ 992 (243)‘
PART A 362 (191) 486 (194)‘
PART B 299 (72) d 47 I ( 3)a
IP REIMB 328 (179) 450 (180)“
OP REIMB 76 (z3)a 4 (23)a
MD REIMB 229 (62)• 390 (62)a
Note: specification is the same as in Table 6, but omits ADVERSE and ADVERSE + .

(b) Adverse selection effects on reimbursement, omitting health controls

Outcome fiOutcome/ dADVERSE dOutcome/ dADVERSE +
d
TOTAL 734 (260) 530 (234)‘
PART A 527 (223) b 345 (199)
PART B 255 (78)a 205 (7 i )a
IP REIMB 451 (199) b 337 (183)
OP REIMB 47 (23)‘ 33 (21)
MD REIMB 210 (67)a i7o (so)•
Note: specification is the same as in Table 6, but omits AGE, AGE 2, SAH, LIMITS, ADL, IADL,
SMOKES, RESP, ENDO, MENTAL, CARDIO, NEURO, CANCER, and MUSC
 S.L. Enner/ Journal of Health Economics 16 f /997? 543-562 5fi7

Table 6 (continued)
(c) Adverse selection effects on reimbursement, omitting wealth controls
Outcome fiOutcome dADVERSE 8Outcome/ JADVERSE +
b
TOTAL 504 (246) 443 (221)'
PART A 348 (205) 180 (181)
PART B 181 (74)‘ 186 (67)"
IP REIMB 294 (184) 166 ( 168)
OP REIMB 32 (22) 32 (20)
MD REIMB 147 (63)‘ 152 (57)"

"Significant at 19r level.

b
signilicant at 5% level.
Note: specification is the same as in Table 6, but omits HOMEOWNER, INCOME. MINCOME. and
OINCOME.

and beyond the pure insurance effects of the coverage. The increase in resource
use associated with enhanced Medigap policies was similar, at $446. The failure
to find a greater degree of adverse selection in the market lor enhanced than basic
Medigap is consistent with the insignificance of the health measures in determin-
ing the type of plan chosen. For both basic and enhanced policies, the selection
effect showed up primarily with physician services. Effects on inpatient and
outpatient services were positive but not statistically significant. The result that
adverse selection was less evident for inpatient services is consistent with the
hypothesis that it is easier to acquire a taste ' for physician visits than for hospital
stays.
3.5. Moral haggard effects without controlling for add er. e .selection
For the reasons discussed in the methods section, the analysis presented here is
likely to overestimate the moral hazard effect, but to a lesser degree than if
adverse selection were not explicitly taken into account. To determine the addi-
tional bias when adverse selection is ignored, the reimbursement models were re-
estimated without controlling for ADVERSE and ADVERSE + . The results,
found in Table 6(a), show that without accounting for the source of the Medigap
coverage, the estimated insurance effects are much larger and more significant.
For example, the estimated effect of basic Medigap insurance on total Medicare
reimbursement more than doubled and increased greatly in significance when
adverse selection was not controlled. These results corroborate similar findings by
Wolfe and Goddeeris (1991) and suggest that studies treating Medigap insurance
as exogenous could seriously overstate its impact on resource use.
3.6. Adverse selection effects withf)ttt ‹’ontrolliR for health and wealth
Table 6(b) and 6(c) show the estimates when the reimbursement models of
Table 6 were rerun, selectively omitting first the health and then the wealth
controls. Because poor health increases expenditures, if sicker patients self-select
558 S.L. Ettner/ Journal of Health Economics 16 f 1997) 543—562

into individually purchased supplemental insurance, then the adverse selection effect
should increase in magnitude when these controls are omitted. We do see consistent
increases in the adverse selection effect associated with Medigap coverage when
comparing Table 6 and 6(b). As one example, the impact of ADVERSE on total
Medicare reimbursement increased from $516 to $734 and became significant at
the 1% level. Thus despite the mixed signs on the health proxies in the insurance
choice model, it appears that on net, insurers are attracting poor risks. These results
imply that better health controls might reduce the estimated adverse selection
effects. The magnitude changes were not that large, however, given the fairly
comprehensive health controls used. One way to think about this result is that if
observable health risks were used to adjust premiums on top of demographic and
socioeconomic characteristics, one would be able to eliminate only about one third of
the initial adverse selection effect ($218/$734). Because persons with employer-
provided insurance were found to be wealthier than those with individually purchased
policies and wealthier persons were found to use more medical care, omitting the
wealth proxies should reduce the adverse selection effect. The results in Table 6(c)
follow this pattern for basic but not enhanced coverage, supporting the argument that
better controls for wealth would increase the measured adverse selection into basic
coverage. However, in both
cases the magnitude changes were very small.

3.7. Selection into employer-provided Medigap

The results of the sensitivity analyses depended on which employer group was
defined as self-selected. When defined as respondents who paid any premiums,
the results were mixed, but generally showed a slightly reduced significance of
both the adverse selection and moral hazard effects. When defined as those paying
over
$50 per month, however, the magnitude of the adverse selection effects generally
increased, while the moral hazard effects decreased slightly for basic insurance.
As a result of the larger coefficients, the significance of the selection effects
increased except when the self-selected employee group was excluded from the
sample altogether (because the estimates were less precise). Separate indicators
for self-selection into employer-provided coverage were statistically insignificant
re- gardless of how they were defined.

3.8. Other sensitivity analyses

The results were also robust to the other sensitivity analyses described in the
methods section. Inclusion of the part-year subsample slightly increased the
magnitude of the moral hazard effect of a basic policy and somewhat decreased
the magnitude and significance of the adverse selection effects, but the overall
conclusions were similar. Use of an indicator for potential Medicaid eligibility
reduced the magnitude of the moral hazard effects, although not enough to revise
 S.L. Ettner/ Journal of Heulth Economic's 16 1997? 543—5h2

the conclusions about the significance of enhanced policies, and left the adverse
selection estimates virtually the same.

4. Discussion

Using a national sample of elderly Medicare beneficiaries, I find evidence that

respondents who purchase private supplemental insurance use more physician
services and have higher Medicare total and part B reimbursement, even after
controlling for pure insurance effects. The selection effects were modest in size
but of sufficient magnitude to cause concern about potential failure in the market
for supplemental insurance. Furthermore, the estimates found in this study are
likely to represent lower bounds on the true extent of adverse selection in this
market, for reasons discussed earlier.
As Pauly (1986) and Marquis (1992) point out, adverse selection is likely to be
less in the market for Medigap plans than in other insurance markets. Because
Medicare is the primary payer, most of the increase in utilization and expenditures
due to pure insurance effects is actually borne by the public sector, not by the
private insurer. This cost shifting onto Medicare implies that Medigap policies are
underpriced and capture more of the low-risk market than would otherwise be the
case, thereby attenuating the adverse selection. The effects of moral hazard on
total reimbursement ($281 and $760 for basic and enhanced coverage
respectively) indicate the extent of this subsidization of moral hazard, since they
are estimates of the additional outlays of the Medicare program resulting from the
purchase of supplemental plans. One policy option that might be considered is the
imposition of taxes on Medigap policies to reflect the externality on the Medicare
program. The estimates of adverse selection in insurance markets found in this
study are contingent on the characteristics of the insurance being studied (in this
case, policies that supplement virtually universal insurance coverage offering
compre- hensive benefits), as well as the covered population (the elderly). The
results therefore may not generalize to other insured populations, or even to the
Medicare elderly, if the program changed significantly. For example, the
expansion of Medicare benefits might lead to greater adverse selection in
supplemental insur- ance markets, because the only patients who would find it
worthwhile to insure against the remaining expenses are those at high risk. Even
within Medicare, selection into supplemental insurance may be different for the
elderly than for other groups, for example, if the elderly are more risk averse and
purchase supplemental insurance at higher rates than the disabled. The finding of
adverse selection is hence even more striking, given that it occurs within a
population with
high rates of supplemental coverage.
The results presented here can be compared with other studies that focus
specifically on the elderly. My results differ from those of Blustein (1995), who
shows that mammography rates are not significantly different for elderly women
560 S.L. Ettner/ Journal of Health Economics 16 (1997) 543—5d2

with employer-provided vs. individually purchased supplemental private insurance

in the Medicare Current Beneficiary Survey. They are similar, however, to the
conclusions of Long (1994), who examined prescription drug expenditures in
the 1987 National Medical Expenditure Survey. After adjusting for
sociodemographic characteristics, Long found a 26% increase in prescription
drug expenditures among respondents purchasing individual policies with drug
benefits. He attributed this increase solely to adverse selection, after finding no
evidence of a moral hazard effect among the group covered by employer-
provided insurance. My findings are most similar to the longitudinal results of
Wolfe and Goddeeris (1991), who find that retired persons with large medical
expenditures are more likely to have supplemental private insurance in
subsequent years, and that the estimated moral hazard effect is reduced by
controlling for these adverse selection effects. Wolfe and Goddeeris also find
that the moral hazard effect is largest for physician expenditures and that the
selection is likely to be related to unobservable propensity to use services,
because observable health proxies are related to health care spending but not
demand for insurance. As with the current study, the adverse selection effect
was significant but not particularly large.
If the proxies used here are adequate measures of health status, then the
adverse selection effect found after adjusting for case mix suggests that
unobservable preferences regarding the use of medical services may be an
important factor in insurance choices. Such a conclusion would be consistent
with the results of Vistnes and Banthin (1995), who showed that 1987 National
Medical Expenditure Survey respondents who had a more positive attitude
towards physicians and medical care were also more likely to purchase
supplemental insurance and had higher average medical expenditures. To the
extent that unobservable preferences play a large role, risk adjustment schemes
alone are unlikely to solve the problem of fairness in the premiums paid to
competing insurers, regardless of how well the schemes capture health status,
unless they also take into account previous or current utilization. This
conclusion is consistent with the recommendation of Newhouse (1994) that
insurance plans be paid only partly on the basis of risk-adjusted capitation,
with the remainder of the payment based on actual use.

Acknowledgements
The author wishes to thank two anonymous referees and participants of the
Harvard-BU-MIT health economics seminar and National Bureau of Economic
Research summer health workshop for numerous valuable suggestions. The
usual disclaimer applies.

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