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Table of Contents:
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Introduction ...
Research methodology...
Conclusion..
Index of Authorities
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Introduction
Insurance is an instrument used to mitigate the adverse effects of taking risks. It
functions by accumulating the risks faced by the entire number of insured customers of
the particular insurance provider. Theoretically all of the insured customers may claim
but in reality only a few do so. Thus a degree of affordability is gained by insurance
because the cost of providing monetary assistance to an adversely affected individual is
spread over the entire base of insured individuals.
Moral hazard means that people (or organizations) with insurance may take risks that
are greater than what they would have taken if they did not have insurance because they
know that they enjoy protection(monetary) from the adverse effects that might arise out
of the risky behaviour. So the insurer may face claims that are in excess of the number it
had anticipated and factored into its business plan when selling the insurance. 1 The issue
of moral hazard is a cause of heartburn for private insurers as well as public policy
makers since it is supposed to be one of the causes that make insurance (particularly
health insurance) inefficient and create welfare loss for the general public.
1
No particular authors name mentioned, (ECONOMIC TERMS A-Z ) MORAL HAZARD, available at
http://www.economist.com/RESEARCH/ECONOMICS/searchActionTerms.cfm?query=moralhazard, (Last
visited on September 8,2010)
In this paper the researcher will go through the mechanism of creation of a moral
hazard , its attendant effect on the economy, the various methods mooted by economists
to mitigate moral hazard in the health insurance industry and try to arrive at an effective
solution to the problem.
Research Methodology
Aims and Objectives : The purpose of the paper is to provide a detailed analysis of
the mechanism of creation of a moral hazard situation in the health insurance industry
and to determine how a health insurance contract be designed to avoid the welfare loss
that a moral hazard is supposed to create.
Scope and Limitations: The researcher has made use of a substantial amount of
literature on the subject and has confined himself to giving an overview of the concept of
moral hazard, its creation and an analysis of its effects of welfare loss to society and the
measures adopted by the health industry to contain its effects and their efficacy.
The limitation faced by the researcher while conducting his research was that the seminal
papers on the topic by Nyman, Arrow et al contained mathematical concepts and
derivations that were beyond the level of comprehension enjoyed by the researcher and as
a result a substantial portion of the conclusions arrived at by the esteemed authors in their
writings could not be used by the researcher in this project.
Research Questions and Hypothesis: The issues that the researcher has attempted to
address in this paper can be stated to be the answers to the following research questions
1). What is moral hazard as far as the particular issue of health insurance is concerned?
2). What is the mechanism by which moral hazard is created in the course of executing a
health insurance contract?
3). What is the empirical evidence surrounding the issue of moral hazard in health
insurance and the welfare loss it creates?
4). What are the measures that can be adopted to mitigate moral hazard and their
respective efficacies?
5). In light of the differing opinions regarding the welfare loss created by moral hazard
what is the best way to address this complex issue?
The conventional theory is that moral hazard creates a welfare loss to society 2 as a whole
and that it should be weeded out through the use of innovation when a health insurance
contract is drafted. The paper will investigate into this claim and try to arrive at a
conclusion regarding the same.
Sources of Data: The researcher has used both primary and secondary sources of data
in the course of his research and has made particular use of sources available on the
internet.
Method of Writing: An analytical style of writing has been followed by the researcher
in this paper and in the course of writing a descriptive style has also been used when the
intricacies of the subject matter has been dealt with in the paper.
Mode of Citation: The NLS Citation Guide has been followed in this paper.
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plan might have indulged in some mode or form of treatment or made some medical
expense that is quite unnecessary and frivolous. An expense that he definitely would not
have incurred if he did not have the insurance coverage that pays for his expenses. It
might be an extra couple of days stay in a luxurious hospital room or even designer
prescription sunglasses. Thus the insurance coverage might have made him behave
differently, with less consideration towards the financial aspects of his actions and thus
incurred a financial wastage for his insurer provider. This is moral hazard in health
insurance in its simplest avatar.
In economic terms moral hazard rears its head when an information assymetry existsthere exists a disconnect between the insurance provider and the insured regarding their
respective intentions and actions. Individual knows the risks that he bears whereas his
insurance provider cannot keep a tab on those risks. Thus the insurance provider is forced
to offer insurance on same terms to everyone.4
A substantial number of health insurance customers indulge in behaviour after taking out
the insurance policy that increases their exposure to health risks and also demand for and
use pricier healthcare services than what is necessary. For example some clients would
engage in a sedentary lifestyle, choosing to forego exercise and wholesome food for the
more easier, subsidised option of medicine and visits to a physician if Thus insurance
companies can protect its customers against risks that arise out of genuine medical illness
strikes. If insurance providers had the means to observe their customers actions to the
fullest extent then they could deny coverage to those customers whom they deem to be
indulging in risk enhancing behaviour. Then they could provide monetary assistance to
policyholders who have medical problems or ailments that are not a result of risky
behaviour on the clients part without raising the cost of premiums (which is the most
likely result of attempts to make-up for losses due to moral hazard).
if he had to pay the prevailing market price for it himself out of his own resources. This
represents a moral hazard.
market price charged for it.10 But the additional care still incurs substantial cost in order
to be produced and the insurance company has to pay for that cost.
Healthcare is supposed to have a high degree of price inelasticity (data concerning the
U.S.A show that 1% increase in healthcare cost leads to only .17% decrease in healthcare
expenditure and that income elasticity for healthcare is between 0-0.2)11.
So the consumer does not exhibit any marked reluctance to shell out money for
healthcare when faced with a medical problem.
But the case of consumers opting for medical care only when its effective price has
dropped to zero because of insurance represents an inefficiency in the light of the price
elasticity enjoyed by healthcare expenditure. The difference between the considerable
expenditure incurred in creating the healthcare service( shown by its high market price)
and its apparently low value to the insured consumer enjoying it ( shown by the lower
insurance price paid by him that lets him enjoy the costly healthcare) represents an
inefficiency.12 Thus health insurance acts as an incentive to demand pricier healthcare but
the real value of this care to the customer is lesser than market cost. This is what
conventional economic theory deems to be moral hazard welfare loss.
According to Pauly insurance reduces the price of healthcare to the insured individual to
below the marginal cost and thus acts as any other subsidy. 13
The economic mechanism behind the creation of a moral hazard and its welfare loss
effect will be further explained in the following pages with the help of indifference
curves and budget lines.
10
10
Figure 1. Situation faced by a consumer suffering from an ailment. Two different cases
are explored here- consumer with insurance cover and consumer without insurance cover.
The budget line AC denotes the options that can be accessed by the ill consumer without
insurance cover. The said customer maximizes his welfare by choosing care that costs
OB.
In case of sick customer having insurance cover the resources available to him to buy
other products and services will be lesser by the amount his insurance policy costs him.
In spite of this the concerned budget line will exhibit a smaller absolute slope because of
the subsidy provided by health insurance (Nyman).
Line DEF is the budget line confronting a consumer enjoying an insurance plan with 20%
co-insurance rate. On being made to deal with this budget line the consumer response is
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choosing care costing OE. He is now better off than he was at B because of the income
transfer from the common pool of money collected by insurance company to his pocket
for reimbursal of his healthcare expenditure.
But this income effect is accompanied by a subsidy effect that decreases the gains. GEN
shows the budget line based on prices prevailing in the market passing through E. If the
consumer had been given access to this funding or income and given the liberty to buy
healthcare at prevailing market price then he would opt to be at the point G. The
difference in welfare that exists between points E and G measures the welfare loss
caused by the subsidy effect (moral hazard) of insurance.14
EFFECTS :
14
Joseph P. Newhouse, and Vincent Taylor, THE ECONOMICS OF MORAL HAZARD :FURTHER
COMMENT , available at http://www.rand.org/pubs/papers/2008/P4680-1.pdf , (last visited on September
8, 2010)
15
No particular authors name mentioned, RAND HEALTH INSURANCE EXPERIMENT, available at
http://www.rand.org/pubs/research_briefs/RB9174/index.html, ( last visited on September 8,2010)
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1). After averaging across all levels of co-insurance it was found that the participants in
the Health Insurance Experiment made one to two fewer visits to the doctors chamber
annually and there were twenty percent fewer hospitalizations than those enjoying free
care.16
2). Participants in cost sharing plans incurred less expenditure on healthcare and this
saving on costs were a result of using fewer services rather than finding lower prices.
Those with twenty five percent co-insurance plans spent twenty percent less, those with
ninety five percent co-insurance spent thirty percent less on healthcare. 17 But a point of
concern is the finding that reduction on spending came from participants deciding not to
initiate care which might not be the best thing to do from the point of view of personal
health and wellbeing. It was found that cost-sharing had only a modest effect on the cost
of an episode of care.
So the RAND experiment under study proved the existence of moral hazard by finding
that participants used less healthcare when faced with payments from their own resources
because of co-payment obligations.
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17
Id.
Id
13
A positive consequence of the health insurance plan she enjoys( from the point of view of
beneficial health safeguarding practices) is that she readily visits her physicians office
when she is in discomfort or is advised to do so. But this very same lack of hesitation in
accessing healthcare irrespective of its costs (ex-post moral hazard) is where the issue
of moral hazard rears its head.
In the opinion of the researcher ( Smt. Banerjees son) the health insurance plan that the
subject of the case study enjoys has lulled her into a sense of security since she feels that
the medical care to which she has free access to will be sufficient to ameliorate the health
issues she suffers from. Thus she shows a marked indifference to taking preventive action
in the form of adopting health safeguarding practices like doing physical exercise and
practicing healthy dietary habits like consumption of fruits and vegetables as part of a
balanced diet( ex-ante moral hazard). She rationalizes her risk enhancing behaviour
with her firm belief that the medical care she enjoys because of the insurance plan can
obviate any damage that she might be causing to her health.
We find that a case of information assymetry exists here because the insurance
company does not know about her health risk enhancing behaviour that she indulges in
and the insurance company has to foot the bill that she incurs as a result of overdependence on healthcare.
In course of an interview with Smt. Banerjee regarding this topic she mentioned that her
physician prescribes a fairly excessive amount of medical testing procedures on each one
of her visits and recommends frequent reconsultations (to the tune of almost once a
week). In the opinion of the researcher this is a probable case of the healthcare provider
inducing excessive expenditure on his clients(who enjoys insurance cover and thus
would have almost no objection to this practice on financial grounds) part . The
researcher knows that the physician of Smt.Banerjee is aware of the comprehensive
insurance plan enjoyed by her.
Thus through this case study we find that both demand induced moral hazard and
supply side induced moral hazard exist in a fairly mundane physician-patient
relationship.
14
The benefit package bestowed by the insurance contract on the consumer should
have clearly laid out terms that limit coverage to high impact, low frequency
risks corresponding to random and inelastic services. 19
Levying co-payment for each and every healthcare service utilized by consumer.
This will act as a financial incentive to the customer to make responsible
consumere decisions when it comes to buying healthcare.
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of scrutiny and control over the healthcare expenditure of its customers and in turn can
offer lower rates of premium to the customer too.
Criticism of the Methods Adopted by Insurance Companies to Counter
Moral Hazard
Using co-payments as a method of controlling demand side moral hazard has led to
success in curbing medical expenditure on part of the customer as shown by the RAND
health insurance experiment(1971-1982). But this reduction in spending came from
people deciding not to initiate healthcare and cost-sharing in the form of deductibles and
co-payments reduced the use of both effective, essential and less-effective or frivolous
care similarly.20Cost sharing was ineffective in the sense that it could not discriminate
between unnecessary expenditure and
16
Instead of pushing for more economically sound medical decisions managed care shifts
the financial responsibility of containing moral hazard to care providers who now stand
as the gatekeepers of healthcare.
Managed care has also weakened the weakened the relationship between price elasticity
and moral hazard in health care.22
A Better Way to Contain Moral Hazard Prevalent in Health Insurance:
Co-payments have behaved as blunt instruments in the sense that they have managed to
curtail essential, critical healthcare spending by insured individuals which is not a desired
result. Co-payments should be linked to the ailment suffered by the insured customer and
the health insurance company has to make the necessary effort to verify the nature and
extent of illness. This will have an welfare increasing effect on society in the long run.
(case study):
A RAND study showed that exemption from payment of co-insurance on cholesterol
level lowering drugs led to improvement in the state of health indicators for patients for
whom it is an essential drug and consequently more than one billion dollars was saved in
medical costs by increasing adherence to medical advice and reducing costs that are
incurred in hospitalization.23
Since an insurance company is usually not able to or not inclined to monitor expenditure
on or efforts towards prevention of illness the insurance premium it demands is
dependent only on the extent of benefits it has to pay out and not on the preventive
measures adopted by customer. Usually, in the current state of affairs ,there is no financial
incentive for the customer to take preventive measures against illness in return for a
reduced premium. But introducing such financial incentive could kill two birds with the
same stone- it can control healthcare expenditure by leading to fewer hospitalizations
and also exempt the economy from the loss of man-hours due to hospitalizations.
This incentive for increased preventive efforts could be brought about by adopting the
following principle and measure:
22
17
The incentive for the insured customer to take preventive measures progressively
decreases with increase in extent of healthcare insurance coverage. Thus the probability
of contracting illness also greatly increases and as a consequence the costs incurred by
the insurance company also increases.
premiums to cover for losses. Provided the insurer takes this into consideration it should
charge an insurance premium that increases progressively with the level of benefits
chosen rather linearly. Individual will take this into account and indulge in preventive
actions which would decrease hospitalizations and potential moral hazard.24
18
A price-pay off insurance plan represents a reduction to zero of the of the price of
medical care and a movement along the consumers original demand curve. The true
marginal cost of the medical care has not changed and the additional consumption that
is, moral hazard- is not worth the resources to provide it and represents a welfare loss.26
Nyman opines that different interpretations arrive at from the same theory implies a
flawed understanding of moral hazard.
Economists have not factored in the consideration that healthcare customers wont go
for such risky, life threatening procedures like limb amputation, coronary bypass surgery
or organ transplants just because their insurance company will pay for it if they really
had no need for it. But the conventional view of moral hazard and its welfare loss effect
has led to imposition of co-payments and the like that act as constraints in the pursuit of
healthcare for a large number of people. Imposing co-insurance payments on patients
undergoing angioplasties and open heart surgery is a manifestly senseless and insensitive
act.
John Nyman opines that moral hazard is actually a generator of welfare gain and has
turned conventional theory on its head. In essence an insurance contract obligates the
insurer to transfer income from the many clients who pay into the resource pool
maintained by the company and remain healthy to those who become ill enough to need
medical care.27
According to Nyman income effect derived from transfer of income from those who
remain healthy to those who become illcauses additional medical care to be purchased
thus generating welfare gain to society.28
Conclusion:
Thus we see that the issue of moral hazard generates pretty sharp
opinions and also intense debate on how to control it in the best possible manner. But it
has to be admitted that it is a disturbing issue confronting insurance companies and their
balance sheets. The redressal mechanism that has been outlined in this paper is the
groundwork for further specialized study about moral hazar and its effective containment.
Index of Authorities:
26
Id
Id
28
Id
27
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