FINC 458: HEALTH INSURANCE

Saint Kuttu, PhD

Moral Hazard and Prices in Health

Insurance
 Introduction
• The first major challenge for insurers was adverse
selection; the second is called “moral hazard.” The term
comes from the casualty insurance market.

• A house may face a variety of fire hazards: it may be struck

by lightning, it may burn because of faulty wiring, or it
may be destroyed because the owner set it on fire to
collect the insurance.

• This last hazard is referred to as moral hazard.

 Introduction
• The terminology has carried over to health insurance in
that it is assumed that individuals with a health insurance
policy use more health services.
• Of course, unlike the casualty market, there is nothing
immoral about using more health insurance when you
have coverage. It is simply an application of the law of
demand.
• The issues for insurers are how much people are going to
increase their use of various health services when they
pay less out of- pocket and whether there are cost-
effective strategies that can minimize the extra utilization.
 Introduction
• In this lecture, we develop the concept of moral hazard in
healthcare and examine the empirical evidence on the
extent to which higher coinsurance, copays, and
deductibles are successful in reducing use.
• Price elasticity is the economist’s rigorous way of
quantifying the effect of a change in price on the change
in quantity demanded. It is simply the percentage change
in quantity divided by the percentage change in price.
• It has the advantage of being independent of the units in
which the price or the quantity is measured.
 Introduction
• Health services generally have a price elasticity of about –
0.2.

• This means that a 10 percent increase in the out-of-pocket

price reduces the use of services by about 2 percent.

• However, the effects of changes in price differ rather

substantially across types of health services
 The Nature of Moral Hazard
• Moral hazard is nothing more than the law of demand.
Consider Figure 7-1, which shows a downward-sloping
demand curve for physician visits. At $60, individuals
might purchase X1 visits. At $20, they would buy more—
X2. This is the law of demand: at a lower price, people buy
more of a good.

• Now suppose that the market price of physician office

visits is $60 and that people buy a health insurance policy
that covers such physician visits. Under the contract,
subscribers only have to pay a small copay of $20 for each
physician visit used.
The Nature of Moral Hazard
 The Nature of Moral Hazard
• A copay is the amount the insurance contract may require
the insured to pay for each unit of a covered service,
regardless of either the actual price the provider charges
or the actual amount the insurer pays.

• Copays may differ by type of service and by which

provider the subscriber uses.
 The Nature of Moral Hazard
• In Figure 7-1, individuals purchased X1 physician visits
when they had to pay the full $60 price, but now, since
they only have to pay the $20 copay, they purchase X2
physician visits.
• This sliding down the health services demand curve in
response to the lower out-of-pocket payment is precisely
what is meant by moral hazard. It is also precisely what is
meant by the law of demand.
 The Nature of Moral Hazard
• The nature of demand is that each additional unit of
service is worth less to consumers than the preceding one.
Our consumers in Figure 7-1 stop buying at X1 because an
additional physician visit is not worth the cost.

• Suppose they are not feeling well. At $60 a visit, they will
wait and see if they feel better tomorrow. At $20 a visit,
they may try to get a physician visit later this afternoon.

• Thus, they stop consuming when the price of the service is

greater than what they perceive that unit to be worth.
 The Nature of Moral Hazard
• The problem with moral hazard is that the extra units of
health services subscribers consume as a result of having
insurance coverage are worth less to them than the price
of care the insurer pays on their behalf.
• Consider Figure 7-2. Again, the market price of a physician
visit is $60, and the copay required of the insured is $20.
For every visit between X1 and X2, the physician is paid
more for the visit than the consumer’s demand curve says
it is worth. Yet, subscribers rationally consume up to X2.
The Nature of Moral Hazard

• The triangle marked “Z” is the loss associated with this

extra consumption. It reflects the expenditure made on
behalf of the insured over and above the value of the
service.
• If the insurer could find a low-cost way of “pushing”
subscribers back up the demand curve, it could save $40
($60 – $20) on each visit averted and easily compensate
subscribers for giving up some low-valued physician
visits. One way to achieve this is to raise the copay by
$10 or $20 and lower the insurance premium.
Early Efforts to Estimate the Extent of Moral Hazard

• One approach to estimating the magnitude of the moral

hazard effect is to identify two groups of people—one
with health insurance and one without— and then
compare their use of health services.

• The problem with this approach is that adverse selection

is likely to confound the comparison. The group with
coverage is likely to have acquired insurance because
group members were more likely to use health services.
Early Efforts to Estimate the Extent of Moral Hazard
Early Efforts to Estimate the Extent of Moral Hazard
• Simply comparing use rates will overstate the effect of
differences in the out-of-pocket price. If insurers
followed this route, they would find that utilization was
not reduced as much as they anticipated. They would
have reduced their premiums too much, and they would
lose money.
Problems with Case Studies
• There are problems with case studies, even one as clean
as the Stanford University experience. For example, the
Stanford study represents only one firm and one local
area, it covers only a single small range of coinsurance,
and it also attributes all of the change in use to the natural
experiment
Case Studies
• The price responsiveness of different health services is
different. The salient findings from the empirical
literature follow. Our knowledge rests heavily on the
methodological strength of the RAND Health Insurance
Experiment (RAND-HIE):
Case Studies
Hospital services
• Hospital care is the least responsive to price. Full
coverage compared to no coverage increased admissions
by about 29 percent and total inpatient expenses of by 30
percent. Almost all of this effect was found in the
difference in usage between 25 percent coinsurance and
free care.
Case Studies
Hospital emergency department services

• Full coverage relative to no coverage increased visits by

54 percent and expenses by 45 percent. A free plan
resulted in 27 percent more visits and 16 percent more
expenditures than a plan with 25 percent coinsurance.
Case Studies
Hospital emergency department services

• Free care resulted in about a 90 percent increase in less-

urgent visits but only a 30 percent increase in visits for
more-urgent cases. Thus, emergency department cost
sharing appears to reduce less-urgent cases much more
than urgent ones.
Case Studies
Price sensitivity by income level.
• In general, higher-income groups were found to be less
sensitive to price changes than were lower income
groups.
Case Studies
Children versus adults.
• Children’s use of ambulatory services was about as price
sensitive as was adults’ use. However, hospital services
tended to be almost insensitive to differences in price, at
least under the conditions of the RAND-HIE health
insurance experiment.
Case Studies
Dental services.
• Dental services are subject to a large transitory effect
when coverage is first introduced. The RAND-HIE found
that the first year of coverage had price effects that were
twice as large as subsequent use.
• In the steady state, full coverage increased visits by 34
percent and expenses by 46 percent. Most of this effect
was seen in the differences in usage between 25 percent
coinsurance and free care. Preventive services were about
as price sensitive as basic care. More-expensive services
were more price sensitive.
Case Studies
Mental health services.

• Greatest price sensitivity was found in outpatient mental

health services. Full coverage relative to no coverage
increased expenditures 300 percent. The increase in
expenditures between those with 25 percent coinsurance
and free care was about one-third more, the same as for
ambulatory medical services. There was also evidence
that, unlike dental care, use of mental health services
increased over time.
Case Studies
Prescription drugs

• Prescription drugs appear to be about as price sensitive as

ambulatory medical services. In the RAND-HIE
experiment full coverage relative to no coverage
increased the number of prescriptions per person by 50
percent and increased drug expenditures by 76 percent.
Prescription drugs tend to be used with physician visits
and are not used as substitutes for additional visits.
Case Studies
Nursing home services.

• Remarkably little research has addressed the price

sensitivity of nursing home use. The very limited existing
research suggests that the price elasticity of demand by
private payers may be –1.0 or higher, particularly for
older married persons. One study suggests that there is
substantial cross-price sensitivity between adult foster
care and nursing home care.
Effects of Hospital Coinsurance
on Appropriate vs. Inappropriate Admissions
• Inappropriate admissions do not appear to have been
disproportionately reduced as a result of the cost sharing.
Siu (1986) and Lohr et al. (1986) showed that the same
proportions of what they identify as appropriate and
inappropriate admissions were found among those with
free care and those with each of the coinsurance rates.
Effects of Hospital Coinsurance
on Appropriate vs. Inappropriate Admissions
• Similarly, on examining small area use of services,
Chassin and colleagues (1987) found that differences in
hospital admission rates across areas were not attributable
to differences in the rate of appropriate or inappropriate
admissions..
Deductibles
• Deductibles have become a potentially more important
insurance tool with the advent of consumer-driven
healthcare plans and Health Savings Accounts (HSAs).
The RAND-HIE experiment found that a $4,160 family
deductible (in 2006 dollars) followed by free care
reduced medical care expenditures by 31 percent. More-
recent work from the Netherlands found reductions of 28
percent for a similar insurance program with a $1,200 or
more deductible (in 2004 U.S. dollars).
Deductibles
• This study suggests that a family deductible of $1,000
U.S. dollars might reduce spending by approximately 14
percent.
Thank You