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MORAL HAZARD

Adapted from Bhattacharya, Hyde and Tu – Health Economics

What is moral hazard?

Definition: Moral hazard is the tendency for insurance against loss to reduce incentives to prevent or minimize the cost of loss.1

Moral hazard with health insurance

Insured people take risks with their health that similar uninsured people would not take, and demand more expensive treatment from their doctors when they get sick.

Moral hazard is the downside of health insurance because it raises society’s level of health care expenditures.

The moral hazard pattern

An individual faces some risk of a bad event X, and his actions can increase or decrease its likelihood

He holds an insurance contract that will help pay some or all of the costs of X, if it occurs. Thus his price of X is now lower.

In response to the price distortion, he changes his behavior in a way that increases the chance of X or increases the costs of recovering from X.

The insurance company cannot observe this behavior change – there is an information asymmetry. Otherwise the contract would have been written to discourage the riskier behavior.

The individual’s riskier behavior creates a social loss, because the costly event X occurs more than it would have without insurance.

Ex ante vs. Ex post

Ex ante moral hazard: behavior changes that occur before an insured event happens and make that event more likely.

leaving the stove on

skipping the flu vaccine

Ex post moral hazard: behavior changes that occur after an insured event happens and make recovering from that event more expensive.

using expensive drugs instead of generics

knee replacement surgery instead of painkillers

How does moral hazard lead to social loss?

Consider an individual who loves cheeseburgers but is at risk for a heart attack.

Without health insurance: his cost for each cheeseburger includes both the price of the burger and the increased chance of a heart attack

With health insurance: the cost of each cheeseburger declines, since the insurer picks up the costs of heart attack care.

In this case, social loss takes the form of extra money, labor, time, and effort that others expend on caring for heart attacks caused by cheeseburger overconsumption

Responses to changes in price

Counterfactual:

Bob has insurance. How many cheeseburgers would Bob eat if he didn’t have insurance?

Price

Quantity

Demand

Social loss caused by moral hazard

Point A is the socially efficient equilibrium.

Point B is the outcome with partial insurance.

Varying price distortion and price sensitivity

What determines the level of price distortion and price sensitivity?

Completeness of insurance

The fuller the insurance, the greater the price distortion

Price sensitivity: how controllable is the disease?

Consider Parkinson’s disease vs heart attacks

Moral hazard occurs if and only if three conditions hold:

The cost of a risky or wasteful action to an individual is reduced, usually as a consequence of insurance.

Asymmetric information prevents an insurer from adequately pricing the action.

That individual responds to the price distortion by changing his behavior—either by taking more risks or demanding more covered goods and services.

HOW TO LIMIT MORAL HAZARD

How do health insurers limit moral hazard?

The extent of moral hazard depends on both how sensitive demand is to price and the amount of price distortion caused by insurance.

Insurers cannot alter customers’ price sensitivity (which is a property of their demand functions), but they do have ways to reduce the price distortion due to insurance

Coinsurance

Copayments

Deductibles

Monitoring

Cost-sharing: coinsurance and copayment

Coinsurance: enrollees pay a percentage of each medical bill, and the insurer covers the remaining portion.

Copayment: insurance provision in which enrollees pay only a fixed amount, called a copay

Without insurance, the individual would consume at point QU.

Every unit of medical care he consumes would provide at least as much marginal benefit as marginal cost.

But with full insurance, his marginal costs of medical care (from his perspective) fall to zero.

His effective demand curve is DF and he consumes at point QA

Cost-sharing: coinsurance and copayment

Cost-sharing: coinsurance

Imagine the consumer starts at 0% coinsurance (full insurance from the previous slide).

His insurer then increases the level of coinsurance.

As coinsurance rises, out-of-pocket prices move closer to actual prices, and the demand curve rotates back toward the uninsured demand curve DU.

At the extreme, coinsurance of 100% is equivalent to no insurance.

Effect of coinsurance

Cost-sharing: copayment

Alternatively, imagine his insurer institutes a copay of PC , which becomes the effective price for each episode of care.

This reduces his demand from QA to QB.

Deductibles

In addition to coinsurance and copayment, many insurers also include deductibles as part of their offered plans.

Deductibles set minimal levels of expenses below which the insurer does not help reimburse medical expenses.

Example: A person insured with a deductible of $1,000 pays for his first thousand dollars of health care expenditures out-of-pocket. His insurance policy then helps pay for expenses beyond the thousandth dollar.

Deductibles

Monitoring

Some insurance companies try to observe and guide the preventative measures their customers take, while others choose to supervise the medical care that customers receive.

Motivation

Employee incentive programs with payouts if you:

see a nutritionist

do yoga once a week

get a fitness test

Gatekeeping

EVIDENCE OF MORAL HAZARD IN HEALTH INSURANCE

Empirical evidence of moral hazard

Moral hazard is quite difficult to study empirically.

Researchers suffer from the same information asymmetry that prevents insurers from eliminating moral hazard: behavior changes are very hard to observe.

But a few careful studies do find credible evidence of moral hazard.

Ex ante moral hazard

RAND HIE: people on the free plan more likely to show up at the hospital with broken bones or drug abuse

Ghana: insured households less likely to use mosquito nets, key for preventing malaria

Seguro Popular: low-income Mexicans assigned to receive free insurance were less likely to get a flu shot and cancer screenings

Ex ante moral hazard

Ex post moral hazard

Stanford employees: after a 1967 change that required a new 25% copay, visits to the doctor declined by 24%

RAND HIE: those on the free plan more likely to visit hospital

Germany: introducing deductibles leads to greatly decreased health expenditures

Canada: people with prescription drug coverage visit doctor more often

The End

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282 | Modern Health Economics

Figure 11.1: The basic analysis of social loss caused by moral hazard.

QU QI

Extent of price distortion

Extent of price sensitivity

social loss

elastic demand for cheeseburgers would imply a large angle and major moral hazard.

Varying price distortion and price sensitivity

Figure 11.2: Varying the extent of price distortion and price sensitivity affects the social loss from moral hazard.

(a)

Greater price distortion

Greater price sensitivity

huge social loss

(b)

Less price distortion

Less price sensitivity

tiny social loss

In Figure 11.2, we vary the extent of price distortion and the degree of price sensitivity to

282 | Modern Health Economics

Figure 11.1: The basic analysis of social loss caused by moral hazard.

QU QI

Extent of price distortion

Extent of price sensitivity

social loss

elastic demand for cheeseburgers would imply a large angle and major moral hazard.

Varying price distortion and price sensitivity

Figure 11.2: Varying the extent of price distortion and price sensitivity affects the social loss from moral hazard.

(a)

Greater price distortion

Greater price sensitivity

huge social loss

(b)

Less price distortion

Less price sensitivity

tiny social loss

In Figure 11.2, we vary the extent of price distortion and the degree of price sensitivity to

292 | Modern Health Economics

off his demand curve, we find that this reduces the consumer’s demand to QB.

Figure 11.7: Social loss from different insurance plans.

(a) Full insurance

social loss

D A

(b) Copayment plan

social loss

Effect of coinsurance

By contrast, a coinsurance plan rotates the insured individual’s demand outward (Figure 11.7c). Imagine the consumer starts at full insurance – 0% coinsurance. His demand curve is then vertical since he faces no out-of-pocket costs for any services he consumes. The insurer pays 100% of the bill and graphically, the demand curve becomes a vertical line over Point A. As coinsurance rises, out-of-pocket prices become closer and closer to actual prices, and the demand curve rotates back toward the uninsured demand curve DU . At the extreme, coinsurance of 100% is equivalent to no insurance.

In Figures 11.7b and 11.7c, the imposition of either a copay or coinsurance increases the marginal cost of additional medical care to the consumer and lowers the quantity demanded. This reduces social loss at the expense of increasing uncertainty faced by consumers who are no longer fully insured.

Deductibles In addition to coinsurance and copayment, insurers also sometimes include deductibles as part of their offered plans. Deductibles set minimal levels of expenses below which the insurer does not help reimburse medical expenses. For example, a person insured with a deductible of $1,000 pays for his first thousand dollars of health care expenditures out-of-pocket. His insurance policy then helps pay for expenses beyond the thousandth dollar. Depending on the policy, deductibles may apply to an individual episode of care or over an entire year of expenditures.

Deductibles may be paired with coinsurance or copayments in the same policy. Figure 11.8 shows the relationship between total medical care expenses and out-of-pocket expenditures for a health insurance policy with 33% coinsurance, a deductible of ⌦, and full insurance for catastrophic care expenses above . For the first ⌦ dollars of medical care, the insured individual pays the whole price, so the slope m in this region equals 1. However, each dollar of medical care above ⌦ only costs the customer $0.33 because his coinsurance has now taken effect. The slope in this region is therefore only 0.33. Lastly, this hypothetical policy provides full insurance for catastrophic care,

292 | Modern Health Economics

off his demand curve, we find that this reduces the consumer’s demand to QB.

Figure 11.7: Social loss from different insurance plans.

(a) Full insurance

social loss

D A

(b) Copayment plan

social loss

Effect of coinsurance

292 | Modern Health Economics

off his demand curve, we find that this reduces the consumer’s demand to QB.

Figure 11.7: Social loss from different insurance plans.

(a) Full insurance

social loss

D A

(b) Copayment plan

social loss

Effect of coinsurance