Is "Moral Hazard" Inefficient? The Policy Implications of a New Theory
By John A. Nyman
Health Affairs
September/October 2004
Excerpts:
Insurers call the change in behavior that occurs when a person becomes insured “moral hazard.” Moral hazard occurs, for example, when an insured person spends an extra day in the hospital or purchases some procedure that he or she would not otherwise have purchased. Insurers originally viewed moral hazard unfavorably because it often meant that they paid out more in benefits than expected when setting premiums - hence the negative term.
Economists also viewed moral hazard negatively because, under the conventional theory, the additional health care spending generated by insurance represents a welfare loss to society. When people become insured, insurance pays for their care. In economists’ view, insurance is reducing the price of care to zero. When the price is reduced in this way, consumers purchase more health care than they would have purchased at the normal market prices-this is the moral hazard. But because consumers purchase care when the price drops to zero that they would not have purchased at the market price, economists interpret this behavior as revealing that the value of this care to consumers is less than the market price. The additional care, however, is still costly to produce. The difference between the high cost of the resources devoted to producing this care (reflected in the high market price) and its low apparent value to insured consumers (reflected in the low insurance price) represents an inefficiency. Thus, health care spending increases with insurance, but the value of this care is less than its cost, generating an inefficiency that economists call the “moral-hazard welfare loss.”
Conventional insurance theory also provided the policy solution: Impose coinsurance payments and deductibles to increase the price of medical care to insured consumers and reduce these inefficient expenditures. In the 1970s many insurers adopted copayments to reduce health care spending. In the 1980s and 1990s economists also promoted utilization review and capitated payments to providers as further ways to reduce moral hazard. The managed health care system we have now is largely a product of this theory.
A fundamental ambiguity exists, however, in the welfare implications of moral hazard, which economists have, perhaps, always suspected but could never voice because they did not have the appropriate theory to explain it. That is, conventional theory makes sense for health care such as cosmetic surgery or drugs to improve sexual functioning or designer-style prescription sunglasses, but not for serious treatments such as coronary bypass operations or organ transplants. Clearly, insured people would purchase more of all these procedures than would uninsured people, so they would all be considered moral hazard to insurers.
Mark Pauly, one of the architects of the conventional insurance theory, recognized this ambiguity as early as 1983. He pointed out that his original theory of moral-hazard welfare loss was intended to apply only to “routine physician’s visits, prescriptions, dental care, and the like” and that “the relevant theory, empirical evidence and policy analysis for moral hazard in the case of serious illness has not been developed. This is one of the most serious omissions in the current literature.” This distinction, however, has been lost on most health economists. For example, health economics textbook writers continue to present moral hazard as being unambiguously welfare decreasing, and health policy analysts continue to use the conventional theory in developing their recommendations for optimal cost-sharing rates, managed care programs, and other policies designed to curb U.S. health care costs.
If insurers actually transferred income to an ill person in one lump-sum payment, the welfare implications of moral hazard would be unambiguous.
Health insurance policies, however, generally pay off by paying for the ill person’s care. The welfare ambiguity arises because of this payoff mechanism. …we cannot tell whether this additional moral-hazard spending represents a welfare loss or a welfare gain.
…there is some unknown portion of patients who would respond to insurance paying for their care in exactly the same way that they would respond to insurance paying them a cashier’s check for the same amount. For these patients, moral hazard is efficient and represents a welfare gain.
Implications For Policy
Cost sharing often not appropriate: Because some of the moral hazard that was considered a welfare loss under the conventional theory must now be reclassified as a welfare gain, health insurance under the new theory is generally much more valuable to consumers than economists have thought it was. Many of the more serious procedures - organ transplants; trauma care; many cancer treatments;and, indeed, a large portion of the costly, life-saving medical care that people could only afford to purchase with insurance - would now be tallied in a welfare gain column instead of a welfare loss column when determining the value of insurance. Because such a large portion of moral hazard spending represents a welfare gain, the recategorization of losses as gains dramatically changes the welfare calculations.
The new theory suggests that cost-sharing policies have been directed at problems that largely do not exist. Furthermore, it suggests instead that coinsurance is too blunt a policy instrument and that it should be refined to focus only on the inefficient moral hazard. Moral hazard that generates welfare gains should be left alone or even encouraged. That is, for those with serious illnesses, whose care might also be associated with a great deal of pain and suffering anyway, it makes little sense to apply copayments.
Subsidizing insurance premiums is beneficial: The new theory suggests that health insurance generally makes the consumer better off. Therefore, the subsidies that encourage consumers to purchase insurance voluntarily, or a national health insurance program for the entire U.S. population, would improve society’s welfare.
High prices are harmful: …under conventional theory, high health care prices are not bad. Indeed, a few economists have even argued that high prices should be encouraged because they reduce moral hazard. …according to conventional theory, any reduction of moral hazard is a welfare gain. Under the new theory, the high prices that providers charge because they have market power would again be considered harmful. With the new theory… economists would be able to revert to the standard analysis that monopoly pricing causes an undesirable reduction in use, even for the insured.
More than anything else, the new theory suggests that health insurance provides an economywide redistribution of income from those who remain healthy to those who become ill. Those who become ill use this income either to cover the costs of health care that they would otherwise purchase, or to purchase more care, often care that they would not be able to afford without insurance. Those who remain healthy simply pay into the system, but they do so voluntarily because everyone has a chance of becoming ill. Because people value the additional income they receive from insurance when they become ill more than they value the income they lose when they pay a premium and remain healthy, and because everyone has in theory an equal chance of becoming ill, this national redistribution of income from the healthy to the ill is efficient and increases the welfare of society. Thus, the new theory identifies efficiency as a new justification for adopting some form of national health insurance.
http://content.healthaffairs.org/cgi/content/abstract/23/5/194
Comment: Although steeped in the rhetoric of health policy economists, the concepts presented are fundamental to the health care reform movement. It is imperative that we have a solid grasp of the issues.
The decades old Rand studies are still frequently cited to show that cost sharing through deductibles, copayments and coinsurance is effective in reducing health care costs. Cost sharing has been widely adopted in response to concerns about rising health care costs. Some features of managed care were designed to further reduce utilization of health care services. Largely ignored has been the well documented fact that this reduction included a reduction in the utilization of truly beneficial services. Avoiding the “moral hazard” has proven to be too blunt of a cost containment tool, even though it is still widely supported.
Today, the consumer-directed health care (CDHC) movement expands on that concept. The supporters of CDHC and health savings accounts (HSAs) contend that the moral hazard is eliminated because individuals will not spend funds on care that they perceive to have a value less than its cost. A major flaw in this concept is that individuals with major acute or chronic problems would rapidly deplete their funds. CDHC supporters state that catastrophic coverage would then provide an umbrella to cover the losses. But these plans are high deductible, managed care PPO plans which provide protection that is about as effective as a sieve. Coverage under these plans has already proven to be inadequate to protect against significant financial loss or even bankruptcy. Again, this tool is too blunt because it prevents the delivery of welfare-increasing health care.
There are other mechanisms to reduce ineffective, welfare-reducing care that are much more precisely targeted. Pricing can be improved through negotiation with providers which takes into consideration legitimate costs and fair profits. Excess capacity which results in higher spending without a commensurate improvement in outcomes can be controlled through planning and budgeting of capital improvements. Physicians who inappropriately upcode or who provide an excessive frequency or intensity of services can be identified as outliers and provided with education opportunities or subjected to punitive measures if refractory to the educational process.
Global budgeting can slow the expansion of health care services down to levels closer to inflation and growth of the GDP. The $1.8 trillion that we are spending should be sufficient to ensure that there is adequate capacity in our system to meet our needs for beneficial services.
John Nyman has provided us with an invaluable contribution to the health policy literature. As he says, “There is a new argument for national health insurance: efficiency.”