Application: Adverse selection and moral hazard in the finance and supply of health care

Objectives For you to be able to:

Explain how problems of adverse selection arise in relation to health insurance. Explain how the problems associated with adverse selection in relation to health insurance can be resolved. Explain why equity issues may arise as a result of the solutions to adverse selection employed by private insurance providers. Explain how these equity issues can be addressed.

Explain how consumer and supplier moral hazard arises in the context of health care provision. Using examples, discuss how the problems associated with moral hazard in health care provision can be resolved.

Suggested background reading Allen et al. 2009. Managerial Economics. Norton. Chapters 14-15 Kreps, D. M. 2004. Microeconomics for Managers. Norton Chapters

18-19 (16-17 provide more background) Frank, R. H. 2008. Microeconomics and behaviour. McGraw Hill.

Chapter 6 Wall,S., Minocha, S. and Rees, B. 2010. International Business,

Pearson. Chapter 6 Grimes, P, Register, C. and Sharp, A. 2009. Economics of Social

Issues, McGraw Hill. Chapter 15 Rasmusen, E. 2007. Games and Information, Blackwell. Chapters

7-9 And any introductory Health Economic text you can access e.g.

Mooney, G., (2003) Economics, Medicine and Health Care, Dorset: Prentice Hall

Sources of imperfect and asymmetric information in health care markets1. Health care finance: Health care providers (e.g.

insurers, government) are relatively uninformed about a client’s health risk and health related behaviour

2. The doctor-patient relationship: The consumer/patient is relatively uninformed about health care treatments but the health practitioner is relatively informed

Implies potential for moral hazard and adverse selection - particularly in private health insurance markets

Problems vary depending on system

Different health care systems Pure market provision

Health care is like any other good and demand and supply respond efficiently to price - Embodies consumer sovereignty in a decentralised market

Private insurance based approach Private Insurance (or no insurance) and minimal state

control Employer or individual based insurance plus private

ownership of health care supply The USA (although some publicly funded health as well;

Medicare, Medicaid)

Different health care systems Public production, allocation and finance

Aim is improvement of health for the population Health is a right and access is by need

Universal medical care

Public/tax financed - mostly free at point of service Earnings related social-insurance contributions

Tax funding plus public ownership/control of health care supply e.g. UK, Sweden, New Zealand

Mixed public/private involvement e.g. private provision but public finance government tax-based subsidies to a privatised system or

tax-based national insurance Compulsory cover through tax system supplemented by tax funding

plus some private sector involvement in supply of healthcare e.g. Canada, Germany

Singapore (some government subsidy through taxation)

Horses for courses?

Different countries may not want the same things from their health care system

All have different advantages and disadvantagesThe US system has short waits but the UK

NHS is more equitable/accessible Life expectancy is more or less the same

Women: 80.4 in the UK, 79.8 in the USA Men: 75.7 in the UK, 74.4 in the USA

Problems for all health systems Cost containment: Most countries (except the

UK) have seen an escalation in health expenditure

E.g. 2002 USA medical spending as a % of GDP was 14.6%; Canada 9.6%; UK 7.7%; France 9.7%

(OECD Health Data, www.oecd.org)

Possible explanations: Availability of new and expensive technology Third-party payment due to asymmetric information

as well as uncertainty and risk

Adverse selection and moral hazard in health-care

Adverse selection due to imperfect information about individual risks

Consumer moral hazard as people can influence the probability of ill health

Producer/supplier moral hazard as doctors do not bear the costs of treatment:

Adverse selection in private health insurance

Adverse selection arises from the information asymmetry about health risks between the insurance company and the insured person Insurance company (principal) only knows

average risk in a population Individual (the agent) knows more about own

health risk

Adverse selection in private health insurance If insurance contracts/premiums based on

average risk (community ratings) only people of average or higher than average risk will

buy the insurance - more than averagely healthy people will not buy expensive insurance

Implies adverse selection

puts the insurance companies at risk of paying out more than they receive

Negative impact on profits as premiums based on average risk not high risk of the people who actually buy the insurance.

Solutions for the insurance companies Insurance companies use ‘screening’ methods to

identify high and low risk people e.g. base premium calculations on medical examinations, individual experience of ill-health, lifestyles (smoking, occupation) and other characteristics e.g. age, ethnicity, gender, wealth. This can lead to premiums that are too high for many sick

people (or those most at risk) to afford Highest premiums unaffordable by poorer people but they

are at the most risk so they are the people likely to be charged higher premiums

Implies rationing by price, income and risk Some people unable to acquire private insurance because

they are high risk and/or too poor

Rationing in a private market for health care: no excess supply/demand at the equilibrium price but this does not mean everyone is covered

D = MWP

S = MC

Quantity

Price

Qp

PpUninsured demand due to rationing by price

Problematic side of private based system like the one in the USA Coverage problems

More than 20% of the US population are without health care coverage

Highest infant mortality rate of developed countries.

Myths about the uninsured in the USA:

http://www.kff.org/uninsured/upload/myths-about-the-uninsured-fact-sheet.pdf

Why, if at all, does it matter if poorer and/or sicker people are not covered by health insurance?

If it does matter, what possible solutions are there for this coverage problem?

Why access to health care matters

Poorer people are more likely to suffer from ill-health – poverty as a cause of ill-health The poor tend to be ill more often and more severely

ill than the rich. They live shorter lives and are in poorer health while they are alive

“A boy born in Hackney, next to Newham, is more than twice as likely to die in the first year of his life as a boy born in Bexley, in the south-east suburbs.” Carvel, 2001

A strong relationship between health and economic status within and between countries

“First and foremost there is a need to reduce greatly the burden of excess mortality and morbidity suffered by the poor” WHO, 1999

2 way causality

The links between poverty and ill-health are not just one way Ill-health can cause or worsen poverty

but if good health care reaches the poor, it can help to relieve poverty

Policy directed to health can therefore have positive economic implications for individuals and countries

Externality effects: Ill-health leads to a decline in productivity and earnings

Why access to health care matters --equity issues

People are concerned about the health of others and inequalities in health – more so than inequalities in incomeA kind of externality - humanitarian overspill

Leads to general support of a health-care system that is redistributive or at least provides a safety net

Enabling people on low incomes to access more health-care than they could afford to buy in a competitive health care market

Gives a role of government in health-care

Why access to health care matters - global public health issues

Externality effects of ill-health that extend beyond national borders Transmission of diseases (e.g. HIV/AIDS,

tuberculosis, malaria) Heightened by travel but incidence and impact highest in

Sub-Saharan Africa, Middle East and India

Threat of bio-terrorism The emergence of drug-resistant strains of disease

e.g. tuberculosis, Malaria and leprosy

Social insurance as a policy solution to the coverage problem Potential for adverse selection in health care

and related coverage problems weakened by public provision AS and related coverage problem spread of

compulsory/universal social insurance schemes in health:

Social insurance schemes enable risk pooling - the state insurse the ‘uninsurable’ by compelling universal coverage

Reduces the risk of adverse selection The state = third party in the relationship between patients

and health practitioners

Moral hazard in health care provision and finance

Consumer moral hazardSupplier moral hazard

Consumer Moral Hazard Consumer moral hazard arises because

insurance (private and social) reduces the cost of consuming health care at the point of consumption.As the cost of consumption falls, the cost of

being ill is reducedincentives to reduce the risk of falling ill are reduced

people take risks with their health through health related (bad) behaviour

Smoking, driving recklessly, poor diet, less exercise

Consumer Moral Hazard Less personal investment in health implies

higher consumption of health care than if there were no insurance

Socially inefficient outcome Higher costs for private (and public) health

insurance companies – lower profits (higher taxes)

Measures to counter consumer moral hazard

1. Insurance based

2. Insurance + organisation based

3. Non-price rationing (state provision)

1. Insurance based solutions

Co-payments, coinsurance and deductibles - The insured person pays some fraction of the cost of the procedure - out of pocket expenditures. Co-payments: flat rate charges (e.g. prescriptions) Coinsurance (% share of total cost) Deductibles (e.g. excesses)

Limitations: Fixed maximum coverage schemes; the financial exposure of the insurer is fixed. E.g. life time coverage limited

The insured have an incentive to ensure that costs remain within the agreed value as excesses will have to be met by them.

Evidence from health insurance experiments have found that utilisation is reduced by some of these kinds of methods

Evidence relating to hospital use and different payment schemes: RAND Health

Insurance Experiment http://www.rand.org/health/projects/hie/

Randomized families to health insurance plans that varied cost sharing from none ("free care") to a catastrophic plan that approximated a large 95% family co-insurance deductible (with a stop-loss limit of $1,000 in late-1970s dollars - scaled up for the low-income population).

The participants in the large-deductible plan (95 percent coinsurance) used 25-30 percent fewer services than those in the free-care plan…. 23 percent less likely to be hospitalized in a year Substantial reductions in use were found among all income

groups But how did this impact on health?

Evidence relating to health status: RAND Health Insurance

Experiment For most people enrolled in the RAND

experiment (mainly typical of Americans covered by employment-based insurance) the variation in use across the plans appeared to have minimal to no effects on health status.

But for those who were both poor and sick (might be covered by Medicaid or lacking insurance) the reduction in use was harmful. E.g. Hypertension was less well controlled among that

group, sufficiently so that the annual likelihood of death in that group rose approximately 10 percent.

There is still a debate over the appropriate role for patient cost sharing… whether any reduction in use induced by increased cost sharing was among "necessary" or "unnecessary" services and therefore whether it adversely affected health.

Impact of the RAND Health Insurance Experiment

Alternative solutions to consumer moral hazard: Managed care agreements

Insurers enter into volume discount contracts with specific providers. Insured must pay extra to use ‘non-preferred

providers’ e.g. US arrangements. Managed Care Plans (Health maintenance organisations,

HMOs) and Preferred provider agreements (PPOs) Fairly comprehensive care but either

all care is delivered through the plan’s network e.g. in HMOs primary care physicians authorise services

coverage greater (costs lower) e.g. when when using the PPO’s provider network

Alternative solutions to consumer moral hazard: Non-price rationing

(public finance/provision)

No patient is refused access to health care But…………

Capacity is fixed leading to waiting lists for certain therapies.

People pay a time cost which should discourage unnecessary use.

Rationing under social provision : excess demand at the administered price, Pa → waiting lists

D = MWP

S: inelastic as determined by state

Quantity

Price

Qp Q*

Pc

Pa

Excess demand = Waiting lists or time based rationing

= Unmet demand

Rationing under social provision can also lead to a private market for health care - a useful safety valve for the state system?

D = MWP

S = MC

Quantity

Price

Qpr < Q* - Qp

Pp

Revenue to private system

Provider moral hazard Provider moral hazard derives from the

infrastructure of modern health care, where a third party (insurance or state) pays for the health care provided by the doctor. The payer may have different priorities to either the

doctor or patient. Systems will reflect the payer’s utility function; e.g.

maximising population health gain Impacts on pay contracts (for medics) e.g. treatment fees

Implications of third party payment If doctors are paid a fee for services by a third party

(insurance company or government - not the patient) then the marginal cost of health care is ‘free’ to the patient and doctor is not constrained by patient’s ability to pay

Moral hazard can arise because: Information asymmetry between doctor and the patient The doctor does not know the cost of medical care The doctor has a financial or similar incentive to increase

consumption of health care e.g. fee for service arrangements, Can lead to supplier induced demand (SID); demand

higher than socially efficient

Supplier Induced Demand (SID)“Supplier induced demand is the amount of

demand created by doctors, which exists beyond that which would have occurred in a market in which consumers are fully informed.” Donaldson & Gerard (1992)

“Supplier induced demand exists when the physician influences a patient’s demand for care against the physicians interpretation of the best interest of the patient.” McGuire, T. (2000)

Diagrammatic illustration

D0

D1

0 Q

£

S0

S1

E0

•E0 = Initial equilibrium

•Following an increase in overall supply (to S1) due to an increase in funding (new doctors or hospitals etc), doctors increase demand (to D1) to maintain (or increase) target income.

•E1= resulting equilibrium

E1

Q0 Q1

Implications SID (excess demand) can lead to:

Higher service costs and fees: rising health care costs

Higher usage of new and expensive technology

Potentially less of a problem when there are state imposed spending limits (as e.g. in the UK, Canada)

The NHS is cheap by international standards and health outcomes not that much different - supply side incentives to economize through budgets and method of doctor payment (Doctors are not paid directly for medical activity)

Questions to consider:1. What sort of health system is in place where you are (or where you come from)? and; 2. how does this system address potential problems of adverse selection and moral hazard?3. what are the advantages and disadvantage of this system?

Policy implications: Social insurance as an alternative to market provision Market failures in health care due to asymmetric

information lead to problems associated with moral hazard and adverse selection

Also other market failures due to: Externalities; Uncertainty; Economies of scale; Entry barriers

leading to a near monopoly of control by medical practicioners Explains the spread of compulsory and universal social

insurance schemes in health provision: Reduces the risk of adverse selection: the state can insure the

‘uninsurable’ by compelling universal coverage - risk pooling Reduces some moral hazard problems: the state can act as a

third party in the relationship between patients and health practitioners

Does this approach imply an idealised view of public system

…its guiding principle the improvement of the health of the population at large; it allows selective access according to effectiveness of health care in improving health (need). It seeks to improve the health of the population at large through a tax financed system free at the point of service. It allows public ownership of the means of production subject to central control of budgets; it allows some physical direction of resources; and it allows the use of countervailing monopsony power to influence the rewards of suppliers.”

Culyer, Maynard and Williams, 1981

Criticisms of the UK NHS Consumers have no choice (the NHS is a monopoly)

But patients can change doctors and ask for second opinions Spends too much on bureaucracy

Spending is low by international standards Rationing problems: not enough resources are allocated

to the NHS leading to waiting lists Funding has risen and is now budgeted to reach 9.4% of GDP

Allocation problems The way it allocates resources to different treatments

Perverse incentives, over-centralisation, lack of accountability and inflexibility

The way resources are allocated to different geographical regions

Equalisation or by need? The latter is currently the aim

Does the alternative suggest an idealised view of private system

• “..guiding principle consumer sovereignty in a decentralised market, in which health care is selective according to willingness and ability to pay. It seeks to achieve this sovereignty by private insurance; it allows insured services to be available freely at time of consumption; it allows private ownership of production and has minimal state control over budgets and resource distribution; and it allows the reward of suppliers to be determined by the market.”

• Culyer, Maynard and Williams, 1981

Rationing and allocation are problems (all types of systems) Conflict between maintaining quality and

incentives to cut costs; being cost effective Conflict between limited resources and coverage

- implies a need for some kind of rationing Even more of a problem if also trying to maintain

universal coverage and if rationing is not by price then who receives treatment and when?

Rationing problems under social provision

Limited resources in public health care systems mean that policymakers need to address allocation problems For instance, should public health care

systems fund cosmetic surgery or very expensive surgery that leaves patients with low life expectancy?

What are the consequences of this kind of funding?

Case study 1

Jake and Bunty both need kidney transplants but there is only enough capacity to treat one of them, even though both will die quickly if untreated. How would you decide which patient to treat? What information would you ask for before

making a decision?

Suppose you know that Jake is younger than Bunty but Jake is heavier drinker

Case study 2 Jessie and Rosie both need medical treatment.

Jessie requires a relatively cheap hip replacement but Rosie requires expensive heart surgery. Capacity is limited and it is only possible to treat one of them over the short-term (6 months). Rosie will die quickly if untreated. Jessie won’t die but she is in severe pain. How would you decide which patient to treat? What information would you ask for before making a

decision?

Suppose you know that Rosie is older and has other health issues but Jessie is otherwise healthy

Criteria for rationing The ‘Fair Innings’ argument

Younger people given priority in health care Consistent with QALY maximisation

Responsibilities (Etzioni, 1988) Smokers given lower priority in health care

Social contracts and fairness (Rawls, 1972) Health care goes to people because they need it: a

‘needs’ approach Inconsistent with QALY maximisation

First come first served subject to budgets A lottery

Economics based criteria - micro level efficiency The cost/quality/coverage conflict

suggests there is a role for economic evaluation to maximise the use of limited resourcesE.g. health economic evaluation methods

such as Quality Adjusted Life Years (QALYs) Multidimensional measure/index of health that

combines quantity of life (life expectancy) with quality of life in a single index

Criteria for rationing applied to case study 1

QALY maximisation and the Fair Innings argument would dictate that in case study 1Jake would have priority if he were younger (assuming that either patient would have a similar quality of life) But isn’t Bunty’s claim just as legitimate? Would we have to give

Jake priority? What if Jake was only a few years/weeks younger than Bunty?

As Jake is a heavier drinker the responsibilities argument would favour Bunty but what if he only drinks a little more than Bunty?

Nevertheless, resource constraints mean equal rights to treatment cannot be recognised – choices have to be made

Final points and questions: is any kind of health care system is optimal? How should health care systems balance the ever-

increasing benefits provided by scientific research, the costs of provision and the protection of human rights? New drugs, equipment and treatments are solutions to health

problems but they are expensive Poorer people can be excluded under private insurance but

there are limited resources in publicly funded systems No health care system is perfect.

The problems of health systems in different countries are to some extent predictable outcomes of their chosen health-care strategy

Test your understanding

Try to answer the following: In the context of health care insurance explain how

adverse selection problems can arise and how they could be resolved.

Explain how consumer and supplier moral hazard can arise in the context of health care provision. How can the associated problems be resolved

How can and how should health care be rationed?

Extra material on the advantages and disadvantages of different health care systems – for background only

Questions to consider

1. What are the advantages/disadvantages of public health care systems?

2. What are the advantages/disadvantages of private systems?

3. What would be your preferred health care system and why?

Advantages of public health systems not related to asymmetric information

Most social insurance schemes also redistribute from the rich to the poor through income related payments They promote equity in health care

E.g. by promoting early diagnosis as treatment is mostly free may enhance fairness in society

But if individual choice is weighted more highly then this is better served under a privately funded or perhaps a mixed system

Other specific and tangible advantages of public health systems They Avoid the need for safety-net facilities They promote universal coverage and by doing so

improve health and productivity of the population through accessibility Weakens the link between poverty and ill health if health care is

provided on the basis of need rather than income By delivering health care to low-income people – more than they could buy

Evidence Countries that rely more on private insurance (e.g. the USA, Switzerland)

have regressive health care financing systems overall Health care finance is more unequal than pre-tax incomes: people on low

incomes buy less insurance but pay on average a higher proportion of their income for it

More variation in countries where there is social insurance: In France and the UK health care finance is progressive; in Germany and the

Netherlands it is regressive

Other specific and tangible advantages of public health systems

Cheaper admin costs as no need to verify eligibility

Give provider monopsony power to the provider to enable lower costs/charges

E.g. monopsony power of NHS keeps prices low (e.g. drugs, equipment)

Resource/service cost determination under competition on buyers side

S = MC

D = MWPPrice

Quantity

Expenditure or Resource costs under competition

Pc

Qc

Resource/service cost determination under competition and monopsony

S = ACD = MWP

Price

Quantity

Expenditure or Resource costs under monopsony

MC

Pm

Qm

Less tangible advantages of public health systems Titmuss (1970) described the establishment of the UK

NHS in the following way: “The most unsordid act of British social policy in the twentieth

century has allowed and encouraged sentiments of altruism, reciprocity and social duty to express themselves; to be made explicitly and identifiable in measurable patterns of behaviour by all”

He showed that supplying blood through voluntary donation was more effective/more efficient than the commercial alternative Behaviour characterised by altruism has wider positive effects? Public health systems encourage altruism; A kind of positive

caring externality?

Disadvantages of public health systems Medical practitioners don’t face up to resource

constraints; provider moral hazard remains an issue Need better incentives to be efficient – but how?

Market? Community?

People’s expectations of the health service are unrealistic

Redistributive social insurance schemes may be perceived negatively Compels coverage of low risk and rich people (as well as high

risk people)

Example of more market based system: the USA Primarily a private enterprise based health care

system but four public health care funding streams: Medicare – health care funding for the elderly

Federal health care funding

Medicaid – health care funding for the poor Collaboration between Federal Government and the States.

Veterans Administration Health Care Federal Government funding for veterans of the armed

services.

Health insurance for federal and state employees.

Problematic side of USA system

As well as coverage problems as already discussedMore than 20% of population without health

care coverage Also too expensive – perhaps due to

consumer and supplier moral hazardhighest utilisation of high tech health care. More than 17% of GDP spent on health care.

Alternative more mixed systems; Canada National Health Insurance system with universal

coverage Collaboration between provincial and national

governments. 75% of health care expenditure Province/territory administration

of comprehensive and universal care supported by grants from federal government

Hospitals are private institutions but budgets approved by provinces

Most physicians are in private practice but paid by provinces on nationally agreed fee-for-service base under negotiated fee schedules

System is generally seen as less costly and more effective than the US system

Some comparative statistics

Which system is the most successful?

Theoretical appendix: SID can also imply reductions in demand in response to changes in funding

D1

D0

D2

0 Q

£

S1

S0

S2

E0

•E0 = Initial equilibrium

•Following a reduction in supply (funding); doctors reduce demand to maintain target income. E1 = resulting equilibrium

•Following an increase in supply doctors increase demand to maintain target income. E2= resulting equilibrium

E1

E2