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


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From a course by Fiona Carmichael of Birmingham Business School, University of Birmingham. The course puts economics concepts in context for Business Management undergraduates. In this lecture, concepts from economics are applied to the provision of healthcare. This is a selection from the hundreds of teaching and learning materials available from the Economics Network site at

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

  1. 1. Application: Adverse selection and moralhazard in the finance and supply of healthcare
  2. 2. 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.
  3. 3. 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
  4. 4. Sources of imperfect and asymmetricinformation 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 behaviour2. 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
  5. 5. 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)
  6. 6. 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)
  7. 7. 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
  8. 8. 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, Possible explanations:  Availabilityof new and expensive technology  Third-party payment due to asymmetric information as well as uncertainty and risk
  9. 9. Adverse selection and moralhazard 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:
  10. 10. Adverse selection in private healthinsurance 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
  11. 11. Adverse selection in private healthinsurance 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  putsthe 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.
  12. 12. 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
  13. 13. Rationing in a private market for health care:no excess supply/demand at the equilibrium pricebut this does not mean everyone is covered Price S = MC D= MWP Uninsured demand Pp due to rationing by price Qp Quantity
  14. 14. Problematic side of private basedsystem like the one in the USA Coverage problems  Morethan 20% of the US population are without health care coverage  Highest infant mortality rate of developed countries.Myths about the uninsured in the USA:
  15. 15. Why, if at all, does it matter ifpoorer and/or sicker people arenot covered by healthinsurance? If it does matter, whatpossible solutions are there forthis coverage problem?
  16. 16. 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
  17. 17. 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
  18. 18. 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
  19. 19. 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
  20. 20. Social insurance as a policysolution 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
  21. 21. Moral hazard in health care provisionand finance Consumer moral hazard Supplier moral hazard
  22. 22. 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  peopletake risks with their health through health related (bad) behaviour  Smoking, driving recklessly, poor diet, less exercise
  23. 23. 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)
  24. 24. Measures to counter consumermoral hazard1. Insurance based2. Insurance + organisation based3. Non-price rationing (state provision)
  25. 25. 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
  26. 26. Evidence relating to hospital use anddifferent payment schemes: RAND Health Insurance Experiment 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?
  27. 27. 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.
  28. 28. 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.
  29. 29. Alternative solutions to consumer moralhazard: 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
  30. 30. 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.
  31. 31. Rationing under social provision : excessdemand at the administered price, Pa →waiting lists S: inelastic as determined by state Price Excess demand D = MWP = Waiting lists or time based rationing Pc = Unmet demand Pa Qp Q* Quantity
  32. 32. Rationing under social provision can also lead to aprivate market for health care - a useful safetyvalve for the state system? Price S = MC D= MWP Revenue to Pp private system Qpr < Q* - Qp Quantity
  33. 33. 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
  34. 34. 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
  35. 35. 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)
  36. 36. Diagrammatic illustration •E0 = Initial equilibrium £ •Following an increase in overall supply (to S1) due to an S0 S1 increase in funding (new doctors or hospitals etc), doctors increase E1 demand (to D1) to E0 maintain (or increase) target D1 income. D0 •E1= resulting equilibrium 0 Q0 Q1 Q
  37. 37. 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)
  38. 38. Questions to consider:1. What sort of health system is inplace where you are (or where youcome from)?and;2. how does this system addresspotential problems of adverse selectionand moral hazard?3. what are the advantages anddisadvantage of this system?
  39. 39. Policy implications: Social insuranceas 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
  40. 40. Does this approach imply anidealised view of public system …its guiding principle the improvement of the healthof the population at large; it allows selective accessaccording to effectiveness of health care in improvinghealth (need). It seeks to improve the health of thepopulation at large through a tax financed system free atthe point of service. It allows public ownership of the meansof production subject to central control of budgets; it allowssome physical direction of resources; and it allows the useof countervailing monopsony power to influence therewards of suppliers.” Culyer, Maynard and Williams, 1981
  41. 41. 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
  42. 42. Does the alternative suggest anidealised 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
  43. 43. Rationing and allocation areproblems (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?
  44. 44. 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?
  45. 45. 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?
  46. 46.  Suppose you know that Jake is younger than Bunty but Jake is heavier drinker
  47. 47. 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?
  48. 48.  Suppose you know that Rosie is older and has other health issues but Jessie is otherwise healthy
  49. 49. 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
  50. 50. 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  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
  51. 51. 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
  52. 52. Final points and questions: is any kindof 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
  53. 53. 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?
  54. 54. Extra material on theadvantages and disadvantagesof different health care systems– for background only
  55. 55. Questions to consider1. 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?
  56. 56. Advantages of public health systemsnot 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
  57. 57. Other specific and tangible advantagesof 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
  58. 58. Other specific and tangible advantagesof 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)
  59. 59. Resource/service cost determination undercompetition on buyers side Price D = MWP S = MC Pc Expenditure or Resource costs under competition Quantity Qc
  60. 60. Resource/service cost determinationunder competition and monopsony Price MC D = MWP S = AC Expenditure or Resource costs Pm under monopsony Quantity Qm
  61. 61. Less tangible advantages ofpublic 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?
  62. 62. Disadvantages of public healthsystems 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)
  63. 63. Example of more market basedsystem: 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.
  64. 64. 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  highestutilisation of high tech health care.  More than 17% of GDP spent on health care.
  65. 65. 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
  66. 66. Some comparative statistics Which system is the most successful?
  67. 67. Theoretical appendix: SID can also implyreductions in demand in response to changes infunding £ •E0 = Initial equilibrium S1 •Following a S0 reduction in supply S2 (funding); doctors reduce demand to E1 maintain target E0 income. E1 = resulting E2 equilibrium D2 •Following an increase D0 in supply doctors increase demand to D1 maintain target 0 Q income. E2= resulting equilibrium