Adverse selection and moral hazard in the finance

Application: Adverse selection and moral
hazard in the finance and supply of health
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
 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
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 79
And any introductory Health Economic text you can access e.g.
Mooney, G., (2003) Economics, Medicine and Health Care, Dorset:
Prentice Hall
Sources of imperfect and asymmetric
information in health care markets
Health care finance: Health care providers (e.g.
insurers, government) are relatively uninformed
about a client’s health risk and health related
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
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
 Employer or individual based insurance plus private
ownership of health care supply
The USA (although some publicly funded health as well;
Medicare, Medicaid)
Different health care systems
Public production, allocation and finance
 Aim
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
is improvement of health for the population
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)
Horses for courses?
Different countries may not want the same
things from their health care system
 All have different advantages and
 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
Problems for all health systems
Cost containment: Most countries (except the
UK) have seen an escalation in health
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:
 Availability
of new and expensive technology
 Third-party payment due to asymmetric information
as well as uncertainty and risk
Adverse selection and moral
hazard in health-care
 Adverse
selection due to imperfect
information about individual risks
 Consumer moral hazard as people can
influence the probability of ill health
 Producer/supplier moral hazard as doctors
do not bear the costs of treatment:
Adverse selection in private health
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
Adverse selection in private health
If insurance contracts/premiums based on
average risk (community ratings)
 only
people of average or higher than average risk
will buy the insurance - more than averagely healthy
people will not buy expensive insurance
 Implies
adverse selection
 puts
the insurance companies at risk of paying out
more than they receive
 Negative
impact on profits as premiums based on average
risk not high risk of the people who actually buy the
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
Rationing in a private market for health care:
no excess supply/demand at the equilibrium price
but this does not mean everyone is covered
S = MC
Uninsured demand
due to rationing by price
Problematic side of private based
system like the one in the USA
Coverage problems
 More
than 20% of the US population are
without health care coverage
Highest infant mortality rate of developed
Myths about the uninsured in the USA:
Why, if at all, does it matter if
poorer and/or sicker people are
not covered by health
If it does matter, what possible
solutions are there for this
coverage problem?
Why access to health care matters
Poorer people are more likely to suffer from illhealth – 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
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
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
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
kind of externality - humanitarian overspill
Leads to general support of a health-care system
that is redistributive or at least provides a safety
Enabling people on low incomes to access more healthcare than they could afford to buy in a competitive health
care market
 Gives a role of government in health-care
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
Social insurance as a policy
solution to the coverage problem
Potential for adverse selection in health care
and related coverage problems weakened by
public provision
and related coverage problem  spread of
compulsory/universal social insurance schemes in
 AS
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
hazard in health care provision
and finance
moral hazard
Supplier moral hazard
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
 people
to reduce the risk of falling ill are reduced
take risks with their health through health related
(bad) behaviour
 Smoking, driving recklessly, poor diet, less exercise
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
Measures to counter consumer
moral hazard
Insurance based
Insurance + organisation based
Non-price rationing (state provision)
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
Evidence relating to hospital use and
different 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
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
But how did this impact on health?
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.
Impact of the RAND Health Insurance
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.
Alternative solutions to consumer moral
hazard: Managed care agreements
Insurers enter into volume discount contracts
with specific providers.
 Insured
must pay extra to use ‘non-preferred
providers’ e.g. US arrangements.
 Managed
Care Plans (Health maintenance organisations,
HMOs) and Preferred provider agreements (PPOs)
Fairly comprehensive care but either
 all care is delivered through the 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
Alternative solutions to consumer moral
hazard: Non-price rationing
(public finance/provision)
No patient is refused access to health care
Capacity is fixed leading to waiting lists for
certain therapies.
 People pay a time cost which should discourage
unnecessary use.
Rationing under social provision : excess
demand at the administered price, Pa →
waiting lists
S: inelastic as determined by state
Excess demand
= Waiting lists or
time based
= Unmet demand
Rationing under social provision can also lead to a
private market for health care - a useful safety
valve for the state system?
S = MC
Revenue to
private system
Qpr < Q* - Qp
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
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
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.
Diagrammatic illustration
•E0 = Initial
•Following an increase
in overall supply (to
S1) due to an
increase in funding
(new doctors or
hospitals etc),
doctors increase
demand (to D1) to
maintain (or
increase) target
•E1= resulting
SID (excess demand) can lead to:
 Higher
service costs and fees: rising health
care costs
 Higher usage of new and expensive
Potentially less of a problem when there are state
imposed spending limits (as e.g. in the UK,
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
Questions to consider:
1. What sort of health system is in
place where you are (or where you
come from)?
2. how does this system address
potential problems of adverse selection
and moral hazard?
3. what are the advantages and
disadvantage of this system?
Policy implications: Social insurance
as an alternative to market provision
Market failures in health care due to asymmetric
information lead to problems associated with moral
hazard and adverse selection
Also other market failures due to:
Externalities; Uncertainty; Economies of scale; Entry barriers
leading to a near monopoly of control by medical practicioners
Explains the spread of compulsory and universal social
insurance schemes in health provision:
Reduces the risk of adverse selection: the state can insure the
‘uninsurable’ by compelling universal coverage - risk pooling
 Reduces some moral hazard problems: the state can act as a
third party in the relationship between patients and health
Does this approach imply an
idealised view of public system
…its guiding principle the improvement of the health
of the population at large; it allows selective access
according to effectiveness of health care in improving
health (need). It seeks to improve the health of the
population at large through a tax financed system free at
the point of service. It allows public ownership of the means
of production subject to central control of budgets; it allows
some physical direction of resources; and it allows the use
of countervailing monopsony power to influence the
rewards of suppliers.”
Culyer, Maynard and Williams, 1981
Criticisms of the UK NHS
Consumers have no choice (the NHS is a monopoly)
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
But patients can change doctors and ask for second opinions
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
The way resources are allocated to different geographical
Equalisation or by need? The latter is currently the aim
Does the alternative suggest an
idealised view of private system
“..guiding principle consumer sovereignty in a
decentralised market, in which health care is
selective according to willingness and ability to pay. It
seeks to achieve this sovereignty by private
insurance; it allows insured services to be available
freely at time of consumption; it allows private
ownership of production and has minimal state
control over budgets and resource distribution; and it
allows the reward of suppliers to be determined by
the market.”
Culyer, Maynard and Williams, 1981
Rationing and allocation are
problems (all types of systems)
Conflict between maintaining quality and
incentives to cut costs; being cost effective
Conflict between limited resources and coverage
- implies a need for some kind of rationing
 Even
more of a problem if also trying to maintain
universal coverage and if rationing is not by price then
who receives treatment and when?
Rationing problems under social
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
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?
Suppose you know that Jake is younger
than Bunty but Jake is heavier drinker
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?
Suppose you know that Rosie is older and
has other health issues but Jessie is
otherwise healthy
Criteria for rationing
The ‘Fair Innings’ argument
 Younger people given priority in health
 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
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
 E.g.
health economic evaluation methods
such as Quality Adjusted Life Years (QALYs)
Multidimensional measure/index of health that
combines quantity of life (life expectancy) with
quality of life in a single index
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)
As Jake is a heavier drinker the responsibilities argument
would favour Bunty
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?
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
Final points and questions: is any kind
of health care system is optimal?
How should health care systems balance the everincreasing 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
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
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?
Extra material on the
advantages and disadvantages
of different health care systems
– for background only
Questions to consider
What are the advantages/disadvantages
of public health care systems?
What are the advantages/disadvantages
of private systems?
What would be your preferred health care
system and why?
Advantages of public health systems
not related to asymmetric information
Most social insurance schemes also redistribute
from the rich to the poor through income related
 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
Other specific and tangible advantages
of public health systems
They Avoid the need for safety-net facilities
They promote universal coverage and by doing so
improve health and productivity of the population through
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
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
Other specific and tangible advantages
of public health systems
 Cheaper
admin costs as no need to verify
 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)
Resource/service cost determination under
competition on buyers side
S = MC
Expenditure or
Resource costs
under competition
Resource/service cost determination
under competition and monopsony
S = AC
Expenditure or
Resource costs
under monopsony
Less tangible advantages of
public health systems
Titmuss (1970) described the establishment of the UK
NHS in the following way:
“The most unsordid act of British social policy in the twentieth
century has allowed and encouraged sentiments of altruism,
reciprocity and social duty to express themselves; to be made
explicitly and identifiable in measurable patterns of behaviour by
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?
Disadvantages of public health
Medical practitioners don’t face up to resource
constraints; provider moral hazard remains an
 Need better incentives
 Market? Community?
to be efficient – but how?
People’s expectations of the health service are
Redistributive social insurance schemes may be
perceived negatively
Compels coverage of low risk and rich people (as well as high
risk people)
Example of more market based
system: the USA
Primarily a private enterprise based health care
system but four public health care funding
 Medicare
Federal health care funding
 Medicaid
– health care funding for the poor
Collaboration between Federal Government and the States.
 Veterans
– health care funding for the elderly
Administration Health Care
Federal Government funding for veterans of the armed
 Health
insurance for federal and state employees.
Problematic side of USA system
As well as coverage problems as already
 More
than 20% of population without health
care coverage
Also too expensive – perhaps due to
consumer and supplier moral hazard
 highest
utilisation of high tech health care.
 More than 17% of GDP spent on health care.
Alternative more mixed systems;
National Health Insurance system with universal
Collaboration between provincial and national
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
Some comparative statistics
Which system is the most successful?
Theoretical appendix: SID can also imply
reductions in demand in response to changes in
•E0 = Initial
•Following a reduction
in supply (funding);
doctors reduce
demand to maintain
target income. E1 =
resulting equilibrium
•Following an increase
in supply doctors
increase demand to
maintain target
income. E2=
resulting equilibrium