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

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

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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

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Sources of imperfect and asymmetric information
in health care markets

• Health care finance Health care providers (e.g.
  insurers, government) are relatively uninformed
  about a clients health risk and health related
  behaviour
• 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

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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)

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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)

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Horses for courses?

• Different countries may not want the same things
  from their health care system
• All have different advantages and disadvantages
• The 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

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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

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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

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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

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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.

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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

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Rationing in a private market for health care
no excess supply/demand at the equilibrium price
but this does not mean everyone is covered
Price
S MC
D MWP
Uninsured demand due to rationing by price
Pp
Qp
Quantity
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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-t
he-uninsured-fact-sheet.pdf
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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?
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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

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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

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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 income
• A 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

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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

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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

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• Moral hazard in health care provision and finance
• Consumer moral hazard
• Supplier moral hazard

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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 reduced
• incentives 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

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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)

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Measures to counter consumer moral hazard

1. Insurance based
2. Insurance organisation based
3. Non-price rationing (state provision)

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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

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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?

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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.

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Impact of the RAND Health Insurance Experiment

• 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.

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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 plans network
  e.g. in HMOs primary care physicians authorise
  services
• coverage greater (costs lower) e.g. when when
  using the PPOs provider network

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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.

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Rationing under social provision excess demand
at the administered price, Pa ? waiting lists
S inelastic as determined by state
Price
Excess demand Waiting lists or time based
rationing
D MWP
Pc Pa
Unmet demand
Qp Q
Quantity
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Rationing under social provision can also lead to
a private market for health care - a useful
safety valve for the state system?
Price
S MC
D MWP
Revenue to private system
Pp
Qpr lt Q - Qp
Quantity
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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 payers utility
  function e.g. maximising population health gain
• Impacts on pay contracts (for medics) e.g.
  treatment fees

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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 patients 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

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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 patients demand for care
  against the physicians interpretation of the best
  interest of the patient. McGuire, T. (2000)

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Diagrammatic illustration

• 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

S0
S1
E1
E0
D1
D0
0
Q
Q0 Q1
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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)

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Questions to consider1. 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?
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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

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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

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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

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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

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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?

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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?

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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?

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

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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 wont 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?

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

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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

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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 resources
• E.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

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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 isnt Buntys 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

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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

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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?

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

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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

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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

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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)

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Resource/service cost determination under
competition on buyers side
Price
D MWP
S MC
Expenditure or Resource costs under competition
Pc
Quantity
Qc
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Resource/service cost determination under
competition and monopsony
Price
MC
D MWP
S AC
Expenditure or Resource costs under monopsony
Pm
Quantity
Qm
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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?

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Disadvantages of public health systems

• Medical practitioners dont face up to resource
  constraints provider moral hazard remains an
  issue
• Need better incentives to be efficient but how?
• Market? Community?
• Peoples 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)

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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.

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Problematic side of USA system

• As well as coverage problems as already discussed
• More than 20 of population without health care
  coverage
• Also too expensive perhaps due to consumer and
  supplier moral hazard
• highest utilisation of high tech health care.
• More than 17 of GDP spent on health care.

66
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

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Some comparative statistics
Which system is the most successful?
68
Theoretical appendix SID can also imply
reductions in demand in response to changes in
funding

• 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

S1
S0
S2
E1
E0
E2
D2
D0
D1
0
Q