C The Journal of Risk and Insurance, 2012, Vol. 79, No. 4, 1017-1038
DOI: 10.1111/j.1539-6975.2011.01459.x

MORAL HAZARD AND HEALTH INSURANCE WHEN

TREATMENT IS PREVENTIVE
S. Hun Seog
ABSTRACT
We consider a two-period model under moral hazard when treatment is
preventive. In the second period, the treatment level under moral hazard is
higher than that under no moral hazard. However, it may be lower than that
under moral hazard when overinsurance is not allowed. In the first period,
the treatment level is higher when treatment is preventive than when it
is not. Treatment level is also higher as the discount factor increases. We
demonstrate that a treatment increase following a coverage increase does
not necessarily imply moral hazard. These findings imply that moral hazard
is possibly overemphasized in the literature.

INTRODUCTION
In general, preventive health care is defined as health care that is consumed before
illness occurs. Prevention is often classified into primary prevention and secondary
prevention. Simply put, primary prevention aims to lower the probability of illness,
whereas secondary prevention aims to reduce the severity of illness. Primary preventive care includes healthy diet and smoking cessation. Secondary preventive care, on
the other hand, includes medical examinations and diagnostic screening.1
Traditionally, the insurance literature excludes the costs of preventive care from insurance coverage, since such preventive care is considered the consumers choice, not
a random event (e.g., see Zweifel and Breyer, 1997). Prevention is discussed mainly
in the context of moral hazard. When the insurance benefit cannot be contingent on
the level of prevention, the level of coverage for treatment will affect the consumers
selection of prevention level (Ehrlich and Becker, 1972; Shavell, 1979; Dionne, 1982;
Kenkel, 2000; Winter, 2000, for a survey). As a result, optimal insurance coverage
for treatment should take into account the effect of insurance on prevention level.
Recently, a few studies have suggested that insuring preventive care costs may be

S. Hun Seog is with the Business School, Seoul National University. The author can be contacted
via e-mail: seogsh@snu.ac.kr. The author would like to thank the participants in the Risk
Theory Society meeting, the American Risk and Insurance Association meeting, and the Korean
Insurance Academic Society meeting in 2009 for their comments. He gratefully acknowledges
the support from the Institute of Management Research of Seoul National University. He would
also like to thank Thi Nha Chau for her support.
1
See Kenkel (2000) for a review of prevention in the economics of health care.
1017

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optimal if, for example, it facilitates more efficient risk sharing or lower treatment
costs (Barigozzi, 2004; Ellis and Manning, 2007; Newhouse, 2006).
Although the literature makes a distinction between prevention and treatment, there
may not be a clear distinction in practice, as pointed out by Ellis and Manning
(2007). For example, early screening through self-examination for certain conditions
may lead to more sophisticated diagnostic follow-up examinations. Such diagnostic
examination can be considered preventive care because it lowers the severity of the
potential illness by detecting it at an early stage. However, it can also be regarded
as part of treatment care if it detects a disease. Moreover, treatment care itself may
work as preventive care with respect to future illness. For example, one of the aims of
treatment for diabetes is to lower the risk of developing complications such as heart
disease. Treatment for a stroke includes preventive care to lower the risk of future
strokes.
In accordance with this observation, we will attempt in this article to understand the
optimal level of treatment and insurance coverage when treatment care is also preventive. For this purpose, we set up a simple two-period model where the consumer
may be sick in each period. Insurance for treatment is available in each period. Departing from the existing literature, we assume that treatment in the first period may
affect the probability of being sick in the second period. Insurance coverage and treatment care level in the first period will be affected by their influence on second-period
outcomes.
A related issue is the trade-off between moral hazard and risk sharing, as the need for
insurance for prevention is often discussed in relation to the need for more generous
insurance coverage (Ellis and Manning, 2007; Newhouse, 2006). Since Arrow (1963),
Pauly (1968), and Zeckhauser (1970), the moral hazard problem has been one of the
main economic issues in health insurance. On the one hand, health insurance increases
the welfare level by rendering more efficient risk sharing. On the other hand, it may
lower welfare by causing a moral hazard problem, that is, excessive utilization of
health care. Optimal health insurance coverage is determined by balancing welfare
gains and losses. In general, neither full insurance nor no insurance is optimal.
Several health economics papers report that the moral hazard problem in U.S. health
insurance is not properly controlled (Feldstein, 1973; Feldstein and Friedman, 1977;
Manning and Marquis, 1996; Pauly, 1974, 1986). The average U.S. coinsurance rate
(costs shared by consumers) is known to be about 25 percent. However, several
authors, for example, Manning and Marquis (1996), find that an optimal coinsurance
rate is about 45 percent, although the efficiency loss with a 25 percent coinsurance
rate does not seem to be large. From this viewpoint, efficiency would be improved by
increasing the coinsurance rate.
Contrary to these findings, however, there is an increasing sentiment that the concern
about moral hazard might be excessive. The fact that over 40 million Americans have
no health insurance (U.S. Census Bureau, 2008) was an important consideration in the
health-care reform of 2010 (see New York Times, 2010; Harrington, 2010a, 2010b, for an
overview). In this regard, it is often argued that the current health insurance system
overemphasizes the moral hazard problem, resulting in excessive cost sharing. From
this viewpoint, efficiency would be improved by lowering the coinsurance rate.

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One strand of the literature also suggests the possibility that the conventional approach might overemphasize the moral hazard problem. For example, Nyman (1999a,
1999b) argues that the conventional measure of total welfare loss may be exaggerated
(for debates, see Blomqvist, 2001; Manning and Marquis, 2001). Newhouse (2006)
also argues that lower cost sharing could result in increases in consumption of health
services, which would eventually reduce total costs.
This article adds to the literature by investigating the trade-off between moral hazard
and risk sharing when treatment is also preventive. The optimal treatment level in
our model will be higher than that when treatment is not preventive. An important
implication of our results is that insurance coverage may have to be more generous
than when treatment is not preventive. Another interesting finding is that the treatment level may be lower under moral hazard than under no moral hazard if we do
not allow for overinsurance. This result challenges the traditional belief that moral
hazard is associated with overutilization of medical care. We also find that a coverage
increase will improve the efficiency of the health insurance market if the original insurance contract is designed to ignore the preventive characteristics of treatment, or
if consumers are shortsighted. We also show that an increase in treatment following
a coverage increase does not necessarily imply moral hazard. These findings imply
that the moral hazard problem may be overemphasized in literature.
This article proceeds as follows. The Model section outlines the model. The SecondPeriod Problem section solves the second-period problem, and the First-Period
Problem section solves the first-period problem. The Discussion section discusses
the implications of our results for the health insurance debate. Finally, the Conclusion presents our conclusion.

THE MODEL
We consider a two-period model in which a consumer faces a random health loss in
each period. Each period is denoted by t = 1, 2. The consumer is an expected utility
maximizer with an endowment wealth of W in each period. The von NeumannMorgenstern utility is denoted by U(). The discount factor for period 2 is denoted
as . There is an uncertainty regarding health status in each period. This uncertainty
is described by two states regarding loss occurrence, denoted by st , in period t: the
no-loss state (st = 0), and the loss state (st = 1). The state regarding loss occurrence
can be observed by both the consumer and the insurer. The loss state can occur with
probability pt in period t. The consumer suffers health loss Dt in the loss state in
period t. We assume that Dt is a discrete random variable and can be observed only
by the consumer. The probability of Dt is denoted by q(Dt ). In notations, Dt 
{D1 , . . ., DK ; F(.)} for some integer K > 0, where  represents a loss distribution and
F(.) is a probability distribution function.
Given health loss Dt , the consumer may receive medical treatment of cost xt = xt (Dt ),
which enhances health level by Ht (xt ). The cost xt is public information observable by
the insurer as well as the consumer. We assume that Ht (xt ) > 0 and Ht (xt ) < 0. Health
level and health loss are expressed in monetary terms. We assume that p2 is affected
by the loss occurrence and treatment in period 1. When no loss occurs in period 1,
p2 = p2 (N). Given that a loss occurs in period 1, p2 = p2 (x1 ) with p2 < 0 and p2 > 0.

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That is, treatment in period 1 is for (primary) prevention. It is assumed that p2 (N) <
p2 (x1 ) for any x1 .
The consumer may purchase health insurance for treatment before the realization of
health status in each period. Given that Dt is not observed by the insurer, the contract
is based only on the treatment costs, xt . For simplicity, we focus on a short-term linear
coinsurance contract, where at is the insurance rate paid by the insurer. The indemnity
It is thus given by at xt . The insurance premium is denoted by Qt . We assume that
the premium is actuarially fair, that is, Qt = pt E(It ) = pt E(at xt ). An insurance contract
in period t will be denoted interchangeably by either {Qt , {It }} or {Qt , {at }}. We
also assume that the indemnity payment is made immediately after treatment in each
period.
When the consumer purchases an insurance contract {Qt , {It }}, her expected utility
in period t is expressed as follows:
EV t = (1 pt )U(W Qt ) + pt EU(W Qt Dt + Ht (xt ) xt + It ).

(1)

Let us denote Wts as wealth in state s in period t: Wt0 = W Qt and Wt1 = W Qt

Dt + Ht (xt ) xt + It . Let us also denote Uts for U(Wts ).
The overall ex ante expected utility in period 1 is denoted as
EU = EV 1 + EV 2 .

(2)

The consumers problem is to select {x1 (.), a1 (.); x2 (.); a2 (.)} to maximize her expected
utility, given the moral hazard problem. A moral hazard problem occurs because the
indemnity is determined by treatment xt , which the consumer selects in the loss state,
given the insurance contract. Now, let us solve the problem via backward induction
from the second-period problem.
SECOND-PERIOD PROBLEM
In period 2, the consumer selects treatment x2 to maximize the ex post utility after a
health loss occurs, leading to moral hazard.2 Given D2 and {Q2 , {a2 }}, an optimal
x2 (.) solves the following problem:
Maxx2 (D) U(W Q2 D2 + H2 (x2 ) x2 + a 2 x2 ).
Assuming an interior solution, this condition can be expressed as

(H2 + a2 1) = 0.
U21

This type of moral hazard is often called ex post moral hazard. On the other hand, moral hazard
in the selection of loss preventive action is called ex ante moral hazard (e.g., see Shavell, 1979).

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Under the assumption that U > 0, this condition is equivalent to

H2 + a2 1 = 0.
On the other hand, the consumer selects insurance coverage a2 to maximize expected
utility. Therefore, given p2 , the second-period problem can be stated as follows:
Max{a 2 (x)},{x2 (D)},Q2 EV 2 = (1 p2 )U(W Q2 )
+ p2 EU(W Q2 D2 + H2 (x2 ) (x2 + a 2 x2 ).
s.t.

Q2 = p2 E(a 2 x2 ).

H2 + a 2 1 = 0

(3)

for each D2 .

To solve this problem, let us denote 2 and D2 for the Lagrange multipliers attached
to constraints. For simplicity, let us suppress the time subscript 2 in this section, unless
stated otherwise. Now the Lagrangian can be expressed as follows:
L = (1 p)U0 + pEU1 + (Q pE(ax)) + D (H  + a 1).

(4)

First-order conditions are

L x(D) = pqU1 (H  + a 1) pqa + D H  = 0,

for each D.

La (x) = pEr (U1 x) pEr (x) +  r D = 0, for each x, where Er (.) and  r (.) are calculated
over D with the same x.
L Q = (1 p)U0 pEU1 + = 0

(5)

L = Q pE(ax) = 0
L D = H  + a 1 = 0,

for each D.

No Moral Hazard Case

As a reference, let us first find the first-best outcome, assuming no moral hazard.
The no moral hazard case corresponds to D = 0 in (4). Note also that loss size is
contractible.
L x(D) = pqU1 (H  + a 1) pqa = 0,
L a (D,x) = pqU1 x pqx = 0,

for each D,

for each (x,D),

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LQ = (1 p)U0 pEU1 + = 0,
L = Q pE(ax) = 0.

(6)

Solving (6), we have the following results:

Lemma 1:

[First-best outcome]

(A) Treatment is determined to maximize treatment efficiency.

(B) Insurance coverage increases in health loss.
(C) Overinsurance is optimal, when D > H(x ).
Proof: From La (D,x) = 0 and LQ = 0, we have that = U1 for any (x, D), and U0 =
U1 , which implies that D + H(x) (1 a(D))x = 0 for all (x, D). With Lx (D) = 0, we
have that the optimal H(x (D)) = 1 for all D. In sum, the following two conditions
characterize the optimal solution:
H  (x ) = 1,
(7)
a (x) =

H(x )
x

+ 1.

The first condition in (7) implies that treatment is determined such that the marginal
benefit of treatment equals the marginal cost. The second condition implies that
the risk is fully removed. In sum, the first-best solution achieves cost efficiency in
treatment and a complete risk hedge, which proves (A). The second condition also
implies that the insurance coverage increases in health loss, which proves (B). On the
other hand, a is greater than 1, exhibiting overinsurance, if D > H(x ), which proves
(C).
Q.E.D.
Technically, a can be negative if H(x ) is very high. Since this case is not interesting,
we will assume a > 0 throughout this article. As it is common that a medical treatment can at best restore the health status before the loss, our main concern is with
the case where D > H(x ) (e.g., see Barigozzi, 2004; Ellis and Manning, 2007). Also
for analytic convenience, we will make the following assumption throughout this
article:
Assumption (A1): For any health loss D, D > H(x ).
On the other hand, it is often the case that overinsurance is not allowed for diverse
reasons, as commonly assumed in the literature: 0 a 1.3 For comparison, let us call
the solution in such a case the constrained first-best solution, to distinguish it from the

Under no moral hazard, the rationales for disallowing overinsurance include adverse selection
and institutional and social norms prohibiting gambling on losses.

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first-best one. Under assumption (A1), the two solutions will differ from each other.
Let us add the superscript for the constrained first-best solution. The solution
exhibits the following properties:
Lemma 2:

[Constrained first-best outcome]:

The constrained first-best outcome has the following properties:

(A) Insurance coverage increases in loss size.
(B) The treatment is equal to the first-best treatment for partial coverage, and is greater than
the first-best treatment for full coverage.
Proof: For interior coverage (0 < a < 1), = U1 and H = 1 from La (D,x) = 0 and
Lx (D) = 0. Thus, x (D) = x . This implies that wealth levels are the same for interior
coverage: D + H(x ) (1 a)x = K for some fixed K > 0, where K = W Q
)K
+ 1. For D H(x ) + K x , we have a (D) =
U1 1 (). Thus, a (D) = DH(x
x

0, implying that H = 1, and U1 . Thus, x (D) = x . For D H(x ) + K, we have
a (D) = 1, implying that U1 H = U1 . Thus, x (D) x from H 1. From these
results, the lemma is obtained.
Q.E.D.
When coverage is partial, the treatment level is first-best. When the coverage is full,
however, it is greater than the first-best level. In such a case, the treatment level
satisfies the following condition:
H  (x(D) ) =

< 1,
U1

(8)

where U
1 is evaluated at the optimal solution given D.
Although insurance coverage is full, the risk is not fully hedged, since the health
status is not fully restored. In order to compensate for the unrecovered health loss,
the consumer selects a high level of treatment.
Moral Hazard Case
Now, let us return to the moral hazard case. The solution will solve the first-order
conditions in (5). From (5), we obtain the following:
L D = 0 H  = 1 a , for each D.
L Q = 0 = E V  = (1 p)U0 + pEU1 > 0.
L x(D) = 0 pqa + DH  = 0
(9)
D =

pqa
< 0.
H 

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L a (x) = 0 pEr (U1 x) pEr (x)+ r D = 0, for each x.

L = 0 Q = pa x.
Let us consider the following technical assumption.


(x)
Assumption (A2): H
x 1, at x = x(a).
H  (x)




(x)
(x)
H
x can be called relative prudence measure, given that H
is absolute
H  (x)
H  (x)
prudence measure for H(x). Thus, the condition can be expressed as the relative
prudence measure for H(x) is greater than 1 at x(a). This condition is satisfied by

1
functions often used in economics and finance: x, log x, x1 (with > 0, = 1),
and e x (with > 0 for x 1/ ). With (A2) we can show the following result.

Lemma 3:

x  (a )
x(a )

)
is increasing in a where x(a) = dx(a
, if and only if (A2) holds.
da

Proof: From H + a 1 = 0, we have that x(a) = G(1 a) and x(a) = G(1 a), where
 (a )
 (1a )
G(.) = H1 (.). Then, we have xx(a
= GG(1a
.
)
)
 

x (a )
G  (1 a )G(1 a ) + G  (1 a )2
d
da =
.
x (a )
G(1 a )2
 (a )
Thus, xx(a
is increasing if and only if G  (1 a )G(1 a ) + G(1 a )2 0.
)

Using the differentiation rules regarding an inverse function, this condition can be
 (x)
further arranged into H
x 1, at x = x(a).4
Q.E.D.
H  (x)
Lemma 3 is reminiscent of the monotone likelihood ratio property (MLRP) in the
standard moral hazard model.5 Similar to the MLRP, Lemma 3 leads to the monotone
relation between the health loss and the coverage as shown in Proposition 1. Now, we
can characterize the solutions as follows (let us add superscript m for the solution):
Proposition 1:

Second-Period Outcome

(A) Insurance coverage is partial.

(B) Insurance coverage is increasing in health loss under (A2).
(C) The treatment is greater than the first-best.
The differentiation rules are as follows: When y = f (x), and x = g(y) = f 1 (y), we have g(y) =
1/f (x), and g(y) = f (x)/f (x)3 .
5

In a standard moral hazard setting of Holmstrom

(1979), the differentiable version of MLRP
(x:e)
states that ffe(x:e)
is increasing in x, where e is effort and f (x: e) is the probability density function
of output x, given e. This leads to the monotone relation between the output and the output
sharing.
4

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Proof:
(A) Full (or over-) insurance is not optimal for any D, because am 1 implies H 0,
an infinite or infeasible treatment.
(B) Suppose D1 > D2 . We need to show that a1 > a2 , where ai = am (Di ). On the
contrary, let us assume that a1 a2 . Then we have x1 x2 from L D = 0, where
xi = xm (Di ). We also have U(W 1 ) U(W 2 ), since W 1 W 2 where Wi = W Q Di +
H(xi ) (1 ai )xi . Now, let us simultaneously increase a1 by da1 and decrease a2 by da2 ,
keeping the premium the same. This implies that q1 (x1 + ax1 )da1 = q2 (x2 + a2 x2 )da2
from Q = pE(ax).
x +a x 

That is, da2 = qq 12 x1 +a 1 x1 da 1 .

2
2 2
Now, the effect of this change will lead to a change in expected utility as follows:
p[q 1 U  (W1 ){(H  (x1 ) 1+ a 1 )x1 + x1 }da1 q 2 U  (W2 ){(H  (x2 ) 1 + a 2 )x2 + x2 }da2 ]
= p[q 1 U  (W1 )x1 da1 q 2 U  (W2 )x2 da2 ]



x1 + a 1 x1

1 + a 1 x1 /x1

= pq1 U (W1 )x1 U (W2 )x2




= pq1x1 U (W1 ) U (W2 )


da1

x2 + a 2 x2

1 + a 2 x2 /x2


da1 > 0.

1+a x  /x

The last inequality comes from the fact that U(W 1 ) > U(W 2 ), and 1+a 1 x1 /x1 1 under
2 2 2
assumptions of a1 a2 and Lemma 3.
(C) Since am < 1, H(xm (D)) 1 = H(x ) from L D = 0. Thus, xm (D) x . Equality
Q.E.D.
holds only if am = 0.
The results of Proposition 1 are typical of those in the moral hazard literature. Let us
provide intuitive explanations as follows. For part (A), full coverage is not desirable
under moral hazard, since higher risk sharing lowers moral hazard costs. Furthermore, part (B) states that a higher loss leads to higher coverage under (A2). For this,
note that assumption (A2) and Lemma 3 implies that the effect of coverage on treatment is greater for higher coverage. Since higher coverage and treatment level lead
to a higher wealth level, a higher loss needs to be associated with higher coverage in
order to prevent a risk increase. This result implies that there is one-to-one mapping
between D and am , so that am can be considered a function of D, even though D is not
directly observable.
Part (C) states that moral hazard leads to a higher treatment level than first-best
treatment. With a lower level of coverage than first-best, the consumer is exposed to
a high risk of health loss. To compensate for the health loss, the consumer will select
a higher level of treatment than first-best.

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Let us comment further on this proposition. First, note that the Lagrange multiplier
D is negative (see 9). This result implies that the insurer wants the consumer to
reduce the treatment level, which confirms the moral hazard problem. Second, the
proposition does not say that the treatment is greater than the constrained first-best,
or xm (D) x(D) for all D. When a (D) < 1, xm (D) x(D) = x . However, for D
such that a (D) = 1, the relative sizes between xm (D) and x(D) are ambiguous. For
this, let us define b by H(x ) = 1 b, given D. Given that H(x ) < 1, b > 0. Thus,
xm (D) > x(D) if and only if am (D) > b.


From (8), b= 1 U = 1 EUV .
1

Under moral hazard, from (9),

U m

am (D) = xm (D)H(xm (D)) (1 E V1 m ), where U1m is evaluated at D under moral hazard.



m

Let us define R(D) = EUV , and R(D)m = EUVm . Note that R(D) , Rm (D) < 1. With
1
1
these notations, we have the following result:
Corollary 1: For D such that a (D) < 1, xm (D) x(D) = x .
For D such that a (D) = 1,

x m (D) x(D) if and only if x m (D)H  (x m (D)) 1
Proof:

See text above.

1
R(D)m

1 R(D) .

(10)

Q.E.D.

Although (10) is not of an explicit form, the following inferences can be made. First,
as R(D) is close to 1, xm (D) is likely to be greater than x(D) . Intuitively, R(D)
will be close to 1 when the risk contribution from D, under no moral hazard, is
well hedged. In such a case, x(D) will not be great. Thus, xm (D) is likely to be
greater than x(D) . On the other hand, R(D)m will be close to 1 when the risk
contribution from D, under moral hazard, is well hedged. From (10), as R(D)m is
close to 1, xm (D) is likely to be smaller than x(D) . Note that the treatment level
is likely to be low and the risk hedge level is likely to be high if the moral hazard problem is not severe. Thus, high R(D)m is likely to be associated with low
xm (D).
The above observation may appear to contradict the conventional belief that moral
hazard leads to a higher treatment level. However, recall that xm (D) > x . The only
factor to affect the difference between x and x is the coverage constraint. In the
no moral hazard case with the coverage constraint, risk is not fully hedged due to
the coverage constraint. As a result, a higher level of treatment is needed to compensate for the incomplete risk hedge. If the risk hedge benefit is high enough, then
the treatment level can be higher than that under moral hazard. In the Appendix, we
present an example of a constant absolute risk aversion (CARA) utility to show that
xm (D) is greater than x(D) when the risk hedge benefit is high. The example shows
that x(D) tends to be greater than xm (D) when risk aversion is greater, or when the
damage to health is greater.

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FIRST-PERIOD PROBLEM
In the first period, the consumer selects treatment x1 and coverage a1 . It is assumed
that there is no savings in the model. This problem is similar to the second-period
problem, except that the consumer now needs to take into consideration the effect
on second-period utility. As in period 2, the consumer selects treatment x1 after the
health loss occurs. However, the objective function includes not only the ex post utility,
but also the discounted expected utility of period 2. That is, an optimal x1 (D1 ) solves


Max U(W Q1 D1 + H1 (x1 ) x1 + a 1x1 ) + E V2m |x1 , given Q1 and a 1 (x1 ),
where E(V m
2 | x1 ) is the expected utility in period 2, which is optimally determined
given treatment x1 under the loss state in period 1, as described in the previous
section. The first-order condition for an interior solution is



U11
(H1 + a 1 1) + dE V2m |x1 /d x1 = 0,
Note that dEV m
2 /dx1 is positive, since higher x1 leads to lower p2 , which in turn leads
to the higher expected utility of period 2.
Now, the problem can be stated as follows:





Max{a 1 (x),x1 (D),Q1 } EV 1 + E (1 p1 )E V2m |N + p1 E V2m |x1
= (1 p1 )U10 (W Q1 ) + p1 EU11 (W Q1 D1 +H1 (x1 ) x1 + a 1 x1 )






(11)
+ E (1 p1 )E V2m |N + p1 E V2m |x1 .
s.t.

Q1 = p1 E(a 1 x1 ).


U11
(H1 +a 1 1) + dE(V2m |x1 )/d x1 = 0,

for each D.

Note that E(V m

2 | N) denotes the expected utility in period 2 given no loss occurrence
in period 1, and that U10 = U(W Q1 ), and U11 = U(W Q1 D1 + H1 (x1 ) x1 +
a1 x1 ). To solve this problem, let us denote 1 and 1 for the Lagrange multipliers
attached to the constraints. For simplicity, let us suppress the time subscript 1 in this
section, unless stated otherwise. Now, the Lagrangian can be expressed as follows:





L = (1 p)U0 + pEU1 + E (1 p)E V2m |N + pE V2m |x1 + (Q pE(a x))




(12)
+  D U1 (H  + a 1)+dE V2m |x1 /d x .
The first-order conditions are as follows:



L x(D) = pqU1 (H  + a 1) + pq dE V2m |x1 /dx pqa + D U1 (H + a 1)2



(13)
+ U1 H  + d 2 E V2m |x1 /d x2 = 0, for each D

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= pa + pU1 (H  + a 1)2 + pU1 H  + d 2 EV m

2 /d x = 0
L a (x) = 0 pE r (U1 x) pE r (x)+ r D [U1 (H  + a 1)x + U1 ] = 0

for each x.

L Q = (1 p)U0 pEU1 + DU1 (H  + a 1) = 0.

L = Q pE(a x) = 0.


L D = U1 (H  + a 1)+ dE V2m |x1 /dx = 0.
Let us add superscript 1m for the solution. The solution to (13) has the following
properties:
Proposition 2:

First-period outcome

(A) Insurance coverage is partial.

(B) Insurance coverage increases in health loss under (A2).
(C) Treatment is greater under the preventive treatment case than under the no preventive
treatment case.
Proof: (A) and (B) Although there is an additional term dE(V 2 m | x1 )/dx1 , the logic
of the proof of Proposition 1 (A) and (B) can be employed without difficulty to show
that full or zero coverage cannot be optimal for x1m to be an interior solution. (C) Let
us first consider the first-order conditions under no preventive effect. These first-order
conditions can be obtained from (13) by noting that dEV 2 m /dx = 0.

L x(D) = pqU1 (H  + a 1) pq a + D U1 (H  + a 1)2 + U1 H  = 0,

for each D.
(14)

L a (x) = 0 pE r (U1 x) pE r (x)+ r D [U1 (H  + a 1)x+U1 ] = 0 for each x.

L Q = (1 p)U0 pEU1 + DU1 (H  + a 1) = 0.
L  = Q pE(a x) = 0.
L  D = U1 (H  + a 1) = 0
Although the problem is the same as in the previous section, (14) differs from (5) since
the incentive constraint is written differently: pU1 (H + a 1) = 0, instead of H +
a 1 = 0. The reason for this difference is to make a clear comparison between the
preventive case and the no preventive case.

MORAL HAZARD

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HEALTH INSURANCE 1029

Since dEV m
2 /dx > 0, we should have H + a 1 < 0 under the preventive case. As
a result, given a, the treatment level will be higher under the preventive case than
under the no preventive case, ceteris paribus. Let us show that x1m xm for all D.
For this, suppose on the contrary that x1m < xm for some D. This implies that a1m
should be lower than am . Now, let us slightly increase a1m to a0 , so that x1m < x0 <
xm , where x0 is the treatment corresponding to a0 under the preventive case. It is
more intuitive to regard the consumers problem as maxa (.) [(1 p){U0 + E(V 2 |
N)} + maxx (.) p{U1 + E(V 2 | x)}]. By definition, (am , xm ) solves the same problem,
assuming E(V 2 | x) is fixed. Since (a0 , x0 ) can be chosen to be arbitrarily close to (am ,
xm ), (a0 , x0 ) produces higher expected utility than (a1m , x1m ) does, assuming E(V 2 |
x) is fixed. Moreover, E(V 2 | x) is higher with x0 than with x1m , since x0 > x1m . Thus,
Q.E.D.
we arrive at a contradiction to the optimality of (a1m , x1m ).
The intuitions of parts (A) and (B) are the same as in Proposition 1. Part (C) is also
intuitive, since an increase in treatment has an additional positive effect on the future
expected utility under the preventive case. By reasoning similar to that in part (C), we
can show the more general fact that the optimal treatment will increase as increases.
In other words, as the consumer becomes more concerned about the future, she will
select a higher level of treatment. This result is also intuitive.
Corollary 2: A short-sighted (low ) consumer selects a lower level of treatment than a
far-sighted (high ) consumer, ceteris paribus.
On the other hand, the relative amount of insurance coverage is not clearly determined.6 However, an intuitive explanation can be derived from observation of the
first-order conditions. Given D, let us denote x = x(a), = (a), and = (a) to be
the solutions corresponding to a, ignoring La = 0 in the first-order conditions. From
the first-order conditions, we have a1m > am , if L a |a m = pqU1 x pqx + D [U1 (H +
a 1)x + U1 ] > 0, where variables are evaluated at a = am . The first term represents the benefit of the marginal coverage from the utility increase after the loss. The
second term represents costs following the premium increase. These two terms can
be referred to as the nonmoral hazard net benefit of marginal coverage. The third
term measures the moral hazard costs resulting from increased coverage. Under the
preventive case, the increase in coverage changes the costs with respect to the moral
hazard, since the increase in treatment has preventive effects. The net effect should
weigh the nonmoral hazard net benefit and the moral hazard costs. When the former is
greater than the latter, then the optimal coverage a1m is greater than am , ceteris paribus.
Intuitively, as the preventive effect is greater, allowing more treatment is preferred.
As a result, insurance coverage will be greater. However, if the preventive effect is
small, moral hazard costs may be greater than the nonmoral hazard net benefit. In
this case, insurance coverage will be reduced.
DISCUSSION
In the second-period problem, we find that the treatment level is generally higher
under moral hazard than under no moral hazard. However, when overinsurance is

Determining the relative sizes of coverage requires complex technical assumptions.

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not allowed, the treatment level can be lower under moral hazard. This finding may
contradict the conventional belief that moral hazard leads to a higher utilization of
resources. The treatment level is high under no moral hazard, since it helps hedge the
risk. With no coverage constraints, risk is hedged via overinsurance. With the coverage
constraint, a high level of coverage may be needed to lower the risk exposure. A
main cause for this outcome is that health damage is so high that it cannot be fully
compensated for by an affordable range of treatment. This result is similar in spirit
to what is postulated by Ellis and Manning (2007), who argue that uncompensated
health costs lead to lower cost sharing.
It is important to note that although treatment under moral hazard is lower than
that under no moral hazard, this does not mean that an increase in treatment level
improves efficiency. That is because this treatment level is a second-best one.
In the first-period problem, we investigate the optimal treatment level, where treatment not only increases health level but also lowers the future possibility of health
damage. The treatment level tends to be higher when treatment is preventive. We also
find that the treatment level is higher as the discount factor becomes higher. These
results have implications for the current debate around health insurance coverage in
the United States (Gruber, 2008; Newhouse, 2006; Nyman, 1999b).
Suppose that the current coverage level is set without taking into account the preventive characteristics of treatment. For example, coverage is set at am . If treatment
were not preventive, treatment would be xm . Given that treatment is preventive,
the consumer selects treatment x(am ), which is higher than xm . It would appear that
overtreatment exists. If the insurer considers the overtreatment excessive moral hazard, then it may seek to lower the coverage level to control the moral hazard problem.
Lowering coverage will reduce the treatment level, as anticipated. It also obviously
reduces the health-care costs spent in that period. However, this does not mean that
efficiency is improved.
The effect of lowered coverage on efficiency depends on the relative sizes of a1m and
am . If a1m am , then reducing coverage will lower efficiency. However, if a1m < am ,
then lowering coverage toward a1m will increase efficiency. That is, controlling moral
hazard does not necessarily improve efficiency, even though it lowers short-term
health-care costs. This result emphasizes the importance of the preventive characteristic of treatment. When treatment is preventive, the relevant health-care costs
should be the long-term costs, which incorporate the effects of treatment on future
health.
Corollary 3: Suppose that the preventive characteristic is ignored in health insurance design.
Then, a coverage increase may improve efficiency.
Another case for increasing coverage may be found where the consumer is shortsighted. Suppose that the consumer thinks of as zero, whereas the true is in fact
positive. For the coverage given, the consumer selects a lower level of treatment under
= 0 than under > 0. For example, with a1m , the consumer selects an x that is less
than x1m . Now, there is less treatment. If a benevolent social planner knows the true
of the consumer, then it is possible to improve efficiency by increasing coverage,
which leads to increased treatment.

MORAL HAZARD

AND

HEALTH INSURANCE 1031

Corollary 4: Suppose that consumers are more shortsighted than they should be. Then, a
coverage increase may improve efficiency.
Finally, the discussion in the preceding section (specifically Corollary 1) has an interesting implication in the debates on moral hazard and health insurance coverage.
As an illustration, suppose that there is no moral hazard problem. However, suppose further that health insurance is designed with the false assumption that a moral
hazard problem exists. For example, let us assume that coverage is set at am . With
am , the consumer, under no moral hazard, will select, say, x (am ), not xm . Now, the
increase in coverage from am to x may be followed by an increase in treatment, even
though there is no moral hazard (see the Appendix). That is, the increase in treatment
does not necessarily imply moral hazard. Moreover, if x > x (am ), then the increase
in coverage leading to an increase in treatment may improve efficiency. However, if
the increase in treatment is interpreted as moral hazard, the insurer may not want
to increase coverage, resulting in a failure to improve efficiency.7 This observation
points out the possibility that the moral hazard problem may be overemphasized.
This case is illustrated in the Appendix. In Table A1, we report x (am ) in a CARA
utility example, showing that x > x (am ) in many cases. As an example, let us
consider the base case. From Table A1, we know that am = 0.71, a = 21.22, and a
= 1 in the base case. Figure A1 depicts treatment as a function of coverage under
no moral hazard. In the range of low coverage, the increase in coverage will lead to
an increase in treatment. Both treatment and coverage increase until (and beyond)
full coverage. Since the constrained first-best outcome is obtained with full coverage,
efficiency is improved by increasing coverage toward 1.

CONCLUSION
We consider a two-period model under moral hazard when treatment is also preventive. In the second period, we find the standard result that the treatment level under
moral hazard is higher than that under no moral hazard. However, it may be lower
than that under moral hazard if overinsurance is not allowed. In the first period, the
treatment level is higher when treatment is preventive than when it is not. Treatment
level is also higher as the discount factor increases. These results imply that an increase
in insurance coverage may improve the efficiency of the health insurance market if
the original insurance contract is designed ignoring the preventive characteristics of
treatment, or if consumers are shortsighted. We also demonstrate that an increase in
treatment following a coverage increase does not necessarily imply moral hazard.
These findings point out that the moral hazard problem is possibly overemphasized
in literature.
Even though this article points out the possibility of efficient prevention following an
increase in coverage, the results should be understood with some caveats. First, there

See, for example, Gruber (2008), as well as Manning and Marquis (1996), for discussions of
the deadweight loss due to the negative elasticity of health-care demand with respect to its
price.

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are different types of prevention in reality. In some prevention, only a small amount
of medical spending may be needed. However, there can also be wasteful prevention,
such as an expensive magnetic resonance imaging (MRI), which can detect a disease
with high Type II error. It may be important to distinguish between different types of
prevention, which will require future empirical research. Second, this article focuses
on the demand side, ignoring the supply side. However, coverage for prevention may
affect the medical supply decisions of doctors (McGuire, 2000). Third, a health loss
may change the utility function whereas this article adopts the standard expected
utility (see Dionne, 1982). Under the state dependent utility, the interaction between
prevention and moral hazard will be different from this article.
APPENDIX
We provide a simple numerical example for the second-period problem. For expository simplicity, we consider a degenerate distribution of health loss; that is, D is
fixed.
Assumptions and notations:
U(W) = exp(AW), where A is a positive constant.
U0 = U(W Q) = exp{ A(W Q)},
U1 = U(W Q D + H(x) (1 a )x)
= exp{ A(W Q D + H(x) (1 a )x)}.

H(x) = h x, where h is a positive constant.

H  (x) = (1/2)hx 1/2 = h/(2 x).

H  (x) = (1/4)hx 3/2 = h/(4x x).

Q = pax
E V = (1 p)U0 + pU1 .
Let us first find the outcomes under moral hazard. The program under moral hazard
can be stated as follows:
Max EV

(A1)

MORAL HAZARD

s.t.

AND

HEALTH INSURANCE 1033

Q = pax,

H  (x) + a 1 = 0.

From the second constraint, we have

a = 1 H  (x) = 1 h/(2 x).

(A2)

Thus, Q = pax = p[1 h/(2 x)]x = p[x h x/2].

(A3)

We also have

Q = d Q/d x = p[1 h/(4 x)].

H(x) (1 a )x = h x h x/2 = h x/2.

d{H(x) (1 a )x}/d x = h/(4 x).

Now, let us replace Q and a in EV with the earlier results.
EV = [(1 p)e A(WQ) + pe A(WQD+H(x)(1a )x) ]

(A4)

EV  = dEV/d x
= [(1 p)e A(WQ) (a Q)+ pe A(WQD+H(x)(1a )x)
(AQ Ad{H(x) (1 a )x}/d x)] = 0.
[(1 p)e A(WQ) Q + pe A(WQD+H(x)(1a )x)
(Q d{H(x) (1 a )x}/d x)] = 0.
e A(WQ) [(1 p)Q + pe A(D+H(x)(1a )x)
(Q d{H(x) (1 a )x}/d x)] = 0.

(1 p) p[1 h/(4 x)] + pe A(D+h x/2) ( p[1 h/(4 x)] h/(4 x)) = 0

(1 p)[1 h/(4 x)] + e A(D+h x/2) ( p[1 h/(4 x)] h/(4 x)) = 0

(1 p)(4 x h) + e A(D+h x/2) ( p[4 x h] h) = 0

(A5)
(1 p)(4 x h)[1 p + pe A(D+h x/2) ] he A(D+h x/2) = 0.
In sum, from (A2) and (A5), the solution under moral hazard is determined as follows:

xm solves (A5) and am = 1 h/(2 x m ).

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Now, let us consider the case of no moral hazard. The first best outcome will solve
the following program.
Max EV
s.t.

(A6)

Q = pax.

Let us replace Q with pax in EV and solve the first-order conditions.

EV/ x = 0,

e A(Wpax) [(1 p) pa + pe A(D+h x(1a )x) ( pa {h/(2 x) (1 a )})] = 0.

(A7)
EV/a = 0.

[(1 p)e A(Wpax) (Apx) + peA(WpaxD+h x(1a )x) (A)( p 1)x)] = 0.

[(1 p)e A(Wpax) p pe A(WpaxD+h x(1a )x) (1 p)] = 0

[e A(Wpax) e A(WpaxD+h x(1a )x) ] = 0.

D + h x (1 a )x= 0.

(A8)

From (A8) to (A7),

(A7) [(1 p) pa + p( pa {h/(2 x) (1 a )})] = 0

a h/(2 x) + (1 a ) = 0

h/(2 x) + 1 = 0.

(A9)

From (A8) and (A9), the solution under no moral hazard is determined as follows:

Note that a > 1 if D > h2 /2.

x = h 2 /4,

(A10)

a = (4/h 2 )D 1.

(A11)

MORAL HAZARD

AND

HEALTH INSURANCE 1035

Assuming that D > h2 /2, coverage a exhibits overinsurance. If we do not allow

overinsurance, we have the following (constrained first best) outcome:
a = 1.

(A12)

x solves EV = 0

eA(Wpax) [(1 p)pa + pe A(D+H(x)) (pa H (x)] = 0.

e aA(Wpax) [(1 p) p + pe A(D+h x) ( p h/(2 x))] = 0.

(1 p) + eA(D+h x) (p h/(2 x)) = 0.

(A13)

Table A1 provides numerical results for several parameter values. The table shows
that xm becomes smaller than x as risk aversion (A) becomes higher or as health
damage (D) increases.

0.200
0.100
3.000
50.000

26.812
40.323
2.250
11.643
0.710
1.000
21.222

Outcome
xm
x
x
x (am )
am
a
a

Base Case

A1

29.519
54.570
2.250
12.700
0.724
1.000
21.222

0.200
0.200
3.000
50000

A2

15.985
20.675
2.250
7.339
0.625
1.000
21.222

0.200
0.050
3.000
50.000

A3

3.523
3.189
2.250
2.410
0.201
1.000
21.222

0.200
0.005
3.000
50.000

B1

59.795
71.790
2.250
27.058
0.806
1.000
21.222

0.100
0.100
3.000
50.000

B2

17.798
22.068
2.250
7.319
0.644
1.000
21.222

0.300
0.100
3.000
50.000

B3

14.592
13.252
2.250
5.497
0.607
1.000
21.222

0.400
0.100
3.000
50.000

C1

3.125
5.842
0.250
1.348
0.717
1.000
199.00

0.200
0.100
1.000
50.000

C2

61.066
46.858
6.250
27.478
0.680
1.000
7.000

0.200
0.100
5.000
50.000

C3

68.692
25.000
25.000
40.094
0.397
1.000
1.000

0.200
0.100
10.000
50.000

5.183
4.104
2.250
3.002
0.341
1.000
3.444

0.200
0.100
3.000
10.000

D1

D2

17.359
18.778
2.250
7.932
0.640
1.000
12.333

0.200
0.100
3.000
30.000

D3

29.153
52.789
2.250
12.547
0.722
1.000
30.111

0.200
0.100
3.000
70.000

RISK

p
A
h
D

OF

Parameter

TABLE A1
A Numerical Example

1036 THE JOURNAL

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MORAL HAZARD

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HEALTH INSURANCE 1037

FIGURE A1
Treatment As a Function of Coverage in the Base Case Under No Moral Hazard: x (a)

60

50

40

30

20

a**

19
19.5
20
20.5
21
21.5
22
22.5
23

16
16.5
17
17.5
18
18.5

15
15.5

14
14.5

13

13.5

12

12.5

11

11.5

9.5
10
10.5

8.5

3.5
4
4.5
5
5.5
6
6.5
7
7.5

2.5
3

am

1.5

0.6

0.1

10

a*

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