How To Choose A Helth Insurnce

Transcription

1 Chpter 11 THE ANATOMY OF HEALTH INSURANCE* DAVID M. CUTLER nd RICHARD J. ZECKHAUSER Hrvrd University nd Ntionl Bureu of Economic Reserch Contents Abstrct 564 Keywords Helth insurnce structures in developed ntions Helth insurnce in the United Sttes The principles of insurnce Insurnce with fixed spending Morl hzrd nd principl-gent problems Morl hzrd Evidence on the price elsticity of medicl cre demnd Coinsurnce in prctice Optiml insurnce given morl hzrd Ptients, doctors, nd insurers s principls nd gents Trnsctions costs Reltionships between insurers nd providers Equilibrium tretment decisions in mnged cre Evidence on supply-side pyment nd medicl tretment Optiml mix of demnd- nd supply-side controls Mrkets for helth insurnce: pln choice nd dverse selection Equilibrium with dverse selection - the bsics Equilibri with multiple individuls in risk group Continuous risk groups Evidence on the importnce of bised enrollment Evidence on the importnce of pln mnipultion The trdeoff between competition nd selection Risk djustment Person-specific pricing, contrct length, nd premium uncertinty Insurnce nd helth outcomes 629 *We re grteful to Dn Altmn for reserch ssistnce, to Jon Gruber, Tom McGuire, Joe Newhouse, nd Alexndr Sidorenko for helpful comments, nd to the Ntionl Institutes on Aging for reserch support. Hndbook of Helth Economics, Volume 1, Edited by A.J. Culyer nd J.P. Newhouse 2 Elsevier Science B. V All rights reserved

2 564 D.M. Cutler nd R.J. Zeckhuser 9. Conclusions nd implictions 631 Appendix 634 References 637 Abstrct This rticle describes the ntomy of helth insurnce. It begins by considering the optiml design of helth insurnce policies. Such policies must mke trdeoffs ppropritely between risk shring on the one hnd nd gency problems such s morl hzrd (the incentive of people to seek more cre when they re insured) nd supplier-induced demnd (the incentive of physicins to provide more cre when they re well reimbursed) on the other. Optiml coinsurnce rrngements mke ptients py for cre up to the point where the mrginl gins from less risk shring re just offset by the mrginl benefits from reduced provision of low vlued cre. Empiricl evidence shows tht both morl hzrd nd demnd-inducement re quntittively importnt. Coinsurnce bsed on expenditure is crude control mechnism. Moreover, it plces no direct incentives on physicins, who re responsible for most expenditure decisions. To plce such incentives on physicins is the gol of supply-side cost continment mesures, such s utiliztion review nd cpittion. This gol motivtes the surge in mnged cre in the United Sttes, which unites the functions of insurnce nd provision, nd llows for ctive mngement of the cre tht is delivered. The nlysis then turns to the opertion of helth insurnce mrkets. Economists generlly fvor choice in helth insurnce for the sme resons they fvor choice in other mrkets: choice llows people to opt for the pln tht is best for them nd encourges plns to provide services efficiently. But choice in helth insurnce is mixed blessing becuse of dverse selection - the tendency of the sick to choose more generous insurnce thn the helthy. When sick nd helthy enroll in different plns, plns disproportiontely composed of poor risks hve to chrge more thn they would if they insured n verge mix of people. The resulting high premiums crete two dverse effects: they discourge those who re helthier but would prefer generous cre from enrolling in those plns (becuse the premiums re so high), nd they encourge plns to dopt mesures tht deter the sick from enrolling (to reduce their overll costs). The welfre losses from dverse selection re lrge in prctice. Added to them re further losses from premiums tht vry with observble helth sttus. Becuse insurnce is contrcted for nnully, people re denied vluble form of intertemporl insurnce - the right to buy helth coverge t verge rtes in the future should they get sick tody. As the bility to predict future helth sttus increses, the lck of intertemporl insurnce will become more problemtic. The rticle concludes by relting helth insurnce to the centrl gol of medicl cre expenditures - better helth. Studies to dte re not cler on which pproches to helth insurnce promote helth in the most cost-efficient mnner. Resolving this question is the centrl policy concern in helth economics.

3 Ch. 11: TheAntomy of Helth Insurnce 565 Keywords dverse selection, gency problems, HMOs, indemnity insurnce, intertemporl insurnce, mnged cre, morl hzrd, pooling equilibrium, seprting equilibrium, supplier-induced demnd JEL clssifiction: I1

4 566 D.M. Cutler nd R.J. Zeckhuser Insurnce plys centrl role in the helth cre ren. More thn 8 percent of helth cre expenditures in the United Sttes re pid for by insurnce, either public or privte, with n even greter percentge supported in most other developed ntions. Insurnce thus provides the money tht motivtes nd supports the helth cre system. This pper describes the ntomy of helth insurnce. At the micro level, it detils why individuls seek insurnce, nd the chllenges in structuring insurnce policies. At the mcro level, it explins the role of helth insurnce in the medicl cre sector. The medicl cre trid (Figure 1) depicts tht sector in fundmentl fshion. Insurers medite between individuls 1 nd their providers. Often times, the flow of funds is more roundbout: governments or employers nominlly py insurers, but these costs re then pssed on to individuls, vi incresed txes or lower wges. The insurer intermediry must design policy to py for (nd possibly provide) cre. This is trecherous tsk. Designing helth insurnce policy is not nerly so chllenging technologiclly s, sy, designing personl computer system, but it must still overcome some distinct nd substntil economic obstcles. The most importnt of these obstcles re gency problems. Insurers cnnot get relevnt prties to do wht efficiency requires. Thus, people with generous insurnce spend more on medicl cre thn people with less generous insurnce (morl hzrd), nd providers pid on fee-for-service (piece-rte) bsis my provide more cre due to supplier-induced demnd thn they would if they were not pid per tsk. In sitution where gency reltionships re imperfect, insurnce is necessrily second-best. Insurers must trde off the benefits from more generous insurnce - primrily the reduction in risk it ffords - ginst the costs of more generous insurnce - morl hzrd or supplier-induced demnd. Throughout this chpter, we highlight centrl lessons bout helth insurnce, which re then collected in Tble 1. This clsh between risk shring nd incentives is Lesson 1 bout helth insurnce. Figure 1. The medicl cre trid. Solid lines represent money flows; the dshed line represents service flows. 1 Throughout the pper, to fcilitte exposition, we mostly refer to ptients or insureds s individuls, lthough most helth insurnce is purchsed on behlf of fmilies.

5 Ch. 11: TheAntomyofHelthInsurnce 567 Agency problems in helth cre cn be llevited in two wys. The demnd-side pproch discourges excessive utiliztion by mking people py something when they consume medicl cre. Demnd-side rtioning is epitomized in the trditionl indemnity insurnce pln, which previled in the United Sttes for hlf century. The supply-side pproch discourges utiliztion by monitoring providers crefully, penlizing them if they re profligte, nd giving them finncil incentives to provide only essentil cre. Incresingly, supply-side limittions re fostered by integrting insurnce nd provision. Some HMOs, for exmple, re both insurers nd providers of cre. Integrtion of the insurnce nd provision functions is unique to medicl cre, nd results from the fundmentl difficulties with solely demnd-side rtioning. The integrtion of helth insurnce nd provision of medicl services is Lesson 2 bout helth insurnce. Sections 3 through 5 of the chpter ly out the issues involved in demnd- nd supply-side rtioning. We then move from these micro reltionships to the broder ren of the mrket for helth insurnce. People hve preferences for different types of helth insurnce, nd those preferences should be ccommodted to the extent possible. In ddition, competition in helth insurnce cn encourge production efficiency, driving down overll costs. But competition in helth insurnce produces results unlike competition in other mrkets, for fundmentl reson: the costs of providing insurnce, s opposed to sy computers or food, depend on the chrcteristics of the buyer. People with poor medicl history will benefit more from nd cost more to insure thn those with helthy pst. Thus, the sick will sort themselves into more generous plns thn will the helthy. This process, clled dverse selection, cn substntilly limit the benefits of helth pln choice. Individuls will hve incentives to choose less generous policies over more generous ones (to pool with the helthy insted of the sick) nd insurers will hve incentives to reduce the generosity of their benefits (to ttrct the helthy insted of the sick). Lesson 3 describes the consequences of competition when buyer identity ffects costs. Section 6 discusses dverse selection nd pproches to del with it. The nturl tendency of insurers to chrge the sick greter premiums thn the helthy presents further chllenge to helth insurnce: lck of coverge ginst the longterm risk of becoming sick nd hving higher expected costs in the future. Using the thought experiment of individuls mking choices behind the veil of ignornce, they would choose to insure their risk of becoming sicker thn verge - multi-yer risk - just s individuls in ny yer wish to insure their medicl costs tht yer. Mrkets for multi-yer insurnce do not exist, however, for understndble resons, nd in prctice individuls re left without this insurnce. The kernel of the problem is tht informtion on risk levels becomes vilble before insurnce contrcts re drwn. Lesson 4 is tht erly informtion dries up insurnce mrkets. Long-term insurnce is tken up in Section 7 of the chpter. However effectively helth insurnce controls costs or spreds risks (the focus of most of this chpter), its key gol is to promote helth. In Section 8 we exmine the reltionship between helth insurnce nd helth. Vritions in insurnce generosity hve reltively little impct on helth outcomes mong those with insurnce. This finding is

6 568 D.M. Cutler nd R. J Zeckhuser consistent with the ide tht insurnce generlly restricts cre offering reltively low vlue. But the time frme over which these issues hs been exmined is not lrge. We know less bout the long-run effect of different helth insurnce rrngements on helth thn we should. We mrk the centrlity of helth s opposed merely to finncil trnsfers nd the lck of cler evidence on the reltive benefits of different systems s Lesson 5 bout helth insurnce. At the outset, it is importnt to tke ccount of the distinctive role helth insurnce plys in society. Economists trditionlly mesure vlue by willingness to py, nd the vlue of helth insurnce, or its byproduct medicl cre, is clibrted in dollr terms - the sme s pples or television sets. In much of the world, however, prticulrly outside the United Sttes, medicl cre nd medicl insurnce re treted differently. Medicl cre is often viewed s right, for which mrket-bsed lloction is not pproprite. For some, the right is bsolute; mrkets should ply no role in the lloction of medicl services. More moderte positions ssign government specil responsibility for medicl cre, which leds to government insurnce system or set of subsidies. Rights-oriented sentiments show up even in the United Sttes. The United Sttes subsidizes medicl insurnce directly for poor people nd old people, nd indirectly for the working-ge popultion (through the exclusion of helth insurnce from individul txble income). While some such subsidies my be justified on externlity grounds (when people get medicl cre, they re less likely to spred infectious diseses to others), merit-good rguments, or fiscl externlity rguments (when people re helthier, they ern more, py more in txes, nd receive less in public benefits), we suspect tht right to medicl cre is the more bsic motive. But the rtionle for subsidizing helth insurnce, s opposed to medicl cre, is less cler. The government could promote consumption of medicl cre through direct delivery of services or by subsidizing inputs, without intervening in the medicl insurnce mrket. We thus focus primrily on the economic nlysis of helth insurnce, leving side normtive views bout ccess to bsic medicl services [Hurley (2), Wgstff nd vn Doorsler (2), nd Willims nd Cookson (2)]. We come bck to the ccess issue in the lst section. In this essy, we follow common prlnce by [primrily] using the terms helth cre nd helth insurnce, lthough the terms medicl cre nd medicl cre insurnce might be better descriptors. Helth sttus cnnot be insured. The costs of medicl cre cn be, nd re, lbeit often bering the lbel helth insurnce. We begin in the first section by discussing the provision of helth insurnce round the world nd in the second with review of the principles of insurnce. We then exmine the micro nd mcro issues in helth insurnce. 1. Helth insurnce structures in developed ntions Helth insurnce is common to ll developed countries, but the mechnism for obtining insurnce differs from country to country. In most countries, helth insurnce is

7 Ch. 11: TheAntomyofHelthInsurnce 569 universl; everyone is entitled to coverge nd is required to purchse it. 2 In some ntions, such s Cnd, the finncing is through txtion; people py n income or pyroll tx, nd the proceeds re used by the government to purchse or provide helth insurnce. In other ntions, the finncing is through privte insurnce; individuls or their employers contribute to helth insurnce compnies, which then provide insurnce for the popultion. While the pyment for ny individul my differ in these two systems ( tx-finnced system generlly imposes reltively more on the rich), the implictions for the provision of helth insurnce re generlly slight. Governments in both systems re intimtely involved in determining wht services re covered, the cost shring tht ptients fce, nd the restrictions imposed on providers. The specifics of helth insurnce structures differ significntly cross developed ntions. Countries such s the UK nd Itly finnce helth insurnce through generl txtion nd (t lest historiclly) provide services publicly. 3 Countries such s Cnd nd Germny finnce insurnce publicly but contrct for services through privte providers Helth insurnce in the United Sttes Describing the detiled structures for helth insurnce in different ntions would tke n entire volume. We focus our ttention primrily on the United Sttes. The United Sttes is distinctive mong OECD countries becuse helth insurnce is not universl. 4 Tble 1 shows the sources of helth insurnce in the United Sttes. About one-qurter of the United Sttes popultion is insured through the public sector. The primry public progrms re Medicre, which mostly insures the elderly, long with the disbled nd people with kidney filure; nd Medicid, which insures younger women nd children, the elderly (for services not covered by Medicre such s nursing home cre), nd the blind nd disbled. Other public progrms, primrily for veterns nd dependents of ctive-duty militry personnel, insure nother 1 percent of the popultion. Another 6 percent of the popultion hs privte helth insurnce. Most of this insurnce is provided by employers; less thn 1 percent of the popultion purchses insurnce privtely. The predominnce of employer-provided insurnce results from the fvorble tx tretment of tht method of pyment. Compenstion to employees in the form of wges nd slries is txed through federl nd stte income txes, nd through the federl Socil Security tx. Compenstion pid s helth insurnce, in contrst, goes untxed. Since mrginl tx rtes rnge from 15 to 4 percent for most employees, 5 the 2 In some countries, such s Germny, temporry workers do not receive helth insurnce, but they comprise smll prt of the popultion. All citizens re entitled to insurnce. 3 Countries such s the UK hve moved to more of decentrlized provision system in recent yers. Hospitls hve been set up s privte trusts, for exmple, nd physicins re no longer slried. 4 Since 1996, helth insurnce coverge hs been required in Switzerlnd, but before then it ws subsidized so hevily tht essentilly everyone purchsed it. 5 Income tx rtes cn rnge s high s 4 percent, but the income level t which these rtes re reched re pst the cp on ernings subject to the pyroll tx.

8 57 D.M. Cutler nd R.J. Zeckhuser Tble I Sources of helth insurnce coverge for the United Sttes popultion Source Groups insured Shre of totl Shre of totl popultion (%) pyments (%) Public Medicre Elderly; disbled; end-stge renl disese Medicid Elderly; blind nd disbled; 1 15 poor women nd children Other* Militry personnel nd 1 8 their dependents Privte Employer sponsored Workers nd dependents 56 Nongroup Fmilies 6 Uninsured 16 2 * Other public spending includes non-insurnce costs such s public hospitls, the Veterns Administrtion, etc. Source: Authors' clcultions bsed on dt from Deprtment of Helth nd Humn Services, Ntionl Helth Accounts (medicl spending), nd from Employee Benefit Reserch Institute (insurnce coverge). subsidy to employer-provided insurnce, s opposed to individully-purchsed insurnce, is substntil. The subsidy to employer-provided helth insurnce generlly does not extend, however, to out-of-pocket pyments mde by employees. As result, there re incentives to hve generous insurnce, pid for by employers, with few individul copyments. We return to the effects of this subsidy structure below. The remining 16 percent of the United Sttes popultion is uninsured. The implictions of being uninsured re subject of vigorous debte [Weissmn nd Epstein (1994)]. Some of the uninsured (perhps 4 percent) re eligible for public insurnce (prticulrly Medicid) but hve chosen not to tke up tht insurnce. Presumbly, if these people become sick they will enroll in Medicid. 6 Others will receive "uncompensted" cre if they become sick - they will get emergency cre if they need it, but they will not py for it. The costs of uncompensted cre then get shifted to people with insurnce, for whom pyments mde exceed the cost of services provided. In this sense, the United Sttes hs form of universl insurnce coverge for ctstrophic cre, lthough the ptchwork nture of tht coverge is undoubtedly suboptiml. It lso limits primry nd preventive cre for those without helth insurnce. The lst column of Tble 1 shows the shre of totl pyments tht ech group mkes. As in ny insurnce policy, people my use more or less of the service thn they py 6 Since it is difficult to deny tretment, providers hve strong interest to enroll eligible people in Medicid, so tht they cn receive some pyment for them.

9 Ch. 11: The Antomy of Helth Insurnce 571 for. This is prticulrly true for the uninsured, whose out-of-pocket pyments re much lower thn the cost of services they receive. The tble reports the shre of totl pyments mde by ech group; the shre of services tht is used by ech group will be somewht different. Becuse people insured through the public sector re older nd sicker thn people insured privtely, nd becuse some of the costs of the uninsured re pssed on to the public sector, the public sector ccounts for much more of medicl spending thn its demogrphic shre of insurnce coverge. Close to hlf of medicl spending in the United Sttes is pid for publicly. While this mount is extremely high reltive to most goods nd services in society, it is low by interntionl stndrds for medicl cre. In OECD ntions, governments generlly py for 75 to 9 percent of medicl cre. Whether run publicly or privtely, helth insurnce encounters fundmentl problems tht ny insurer must fce. Adverse selection, though diminished for government since some of its progrms re so hevily subsidized tht the vst mjority choose to prticipte, still exists, nd morl hzrd ffects governments no less thn privte insurers. Thus, when we discuss the optiml design of helth insurnce policies, we do not distinguish between public or privte insurers. We return to public versus privte insurnce issues in the conclusion. 2. The principles of insurnce In this section nd the next three, we discuss the optiml design of helth insurnce policies. Our perspective is tht of n insurer - public or privte - wnting to optimlly insure its enrollees ginst the costs of treting dverse helth outcomes. The vlue of helth insurnce is rooted in the unpredictbility of medicl spending. While individuls know something bout their need for medicl services, the exct mount they will spend on medicl cre is to significnt degree uncertin. Medicl spending is extremely vrible. Tble 2 shows the distribution of medicl spending in the United Sttes in 1987 [Berk nd Monheit (1992)]. The top 1 percent of medicl cre users consume n verge of nerly $5, ech in yer (in 1987 dollrs), nd Tble 2 Distribution of medicl spending, 1987 Shre of distribution Cumultive shre of spending (%) Top 1 percent 3 Top 5 percent 58 Top 1 percent 72 Top 5 percent 98 Totl popultion 1 Source: Berk nd Monheit (1992).

10 572 D.M. Cutler nd R.J. Zeckhuser ccount for 3 percent of medicl spending. The top 1 percent of users ccount for nerly three-qurters of totl medicl spending. The shorter the time period, of course, the greter is the percentge disprity in medicl spending mong individuls. But even looking over severl yers, the skewness of medicl spending is substntil [Roos et l. (1989), Eichner, McClelln, nd Wise (1998)]. In such sitution, insurnce cn significntly spred risks. Risk-verse individuls will wnt to gurd ginst the potentil of requiring substntil mount of medicl cre. One wy to do this is to wit, borrow money for tretment should they get sick, nd then repy the money when well. But borrowing when debilitted is difficult, since the individul my not live long enough or be helthy enough to repy the lon. The borrowing process, moreover, my lso tke more time thn the sick individul hs vilble. A resonble lterntive might be for individuls to sve money when they re helthy to py for medicl cre should they get sick. But some sicknesses re significntly more expensive thn others. The substntil expenses of very severe illness mke sving prior to illness imprcticl s protective mesure. All of us would hve to significntly curtil consumption to sve up for expenses tht would be borne by only few. The nturl solution is to insure ginst the possibility of medicl illness by pooling risks with others in the popultion. Annul consumption would be reduced only by the premium, the verge cost of cre. Risks to helth hve lwys been with us, but helth insurnce is reltively new phenomenon, only becoming economiclly significnt in the postwr er. Fire nd life insurnce were well developed by the end of the 19th century, nd mrine insurnce ws lredy being written in the 12th century. There ws little role for helth insurnce in erlier ers, however, since expensive medicl tretments could ccomplish little for helth. Insurers lso fered they could not control individul use of medicl services if the services were insured. Once effective hospitl cre - n extremely expensive commodity - becme possible, significnt helth insurnce becme desirble nd inevitble Insurnce with fixed spending The simplest insurnce sitution is one where sickness entils fixed cost nd insurnce is priced t its cturil cost. Imgine sitution where initilly identicl individuls re either helthy or sick in period of one yer. There is one disese. People re helthy with probbility 1 - p, in which cse they require no medicl cre. People get sick with probbility p. Let d = or d = 1 indicte whether bsent medicl cre the person is helthy or sick. Tretment of person who is sick requires medicl spending of m. The fter-expenditure helth of sick person is h = H [d, mi]. To simplify exposition, we ssume tht medicl spending restores person to perfect helth, so tht H [1, m] = H[, ]. Before proceeding, we lert the reder to our use of mthemtics. We use mthemtics to derive sttements precisely. We lso endevor to explin ll of our results intuitively. Thus, reders who wish to skip the mthemticl portions of the chpter cn still follow the centrl rguments.

11 Ch. 11: TheAntomyofHelthInsurnce 573 Individuls receive utility, u, which depends on their consumption, x, nd their ftertretment helth, h. Thus we hve u = U (x, h). Assume, for simplicity, tht people hve exogenous income endowments, y; nd tht they cn neither borrow or lend. Thus, n individul's consumption is wht is left over fter pying medicl expenditures, or if insured, his insurnce premium, r. Thus, for uninsured people, x = y when helthy nd x = y - m when sick. For insured people, x = y - r whether helthy or sick. We use the subscripts I nd N to indicte whether the individul is insured or not insured. Let U(x) U(x, H[, ]); i.e., it is the reduced form utility function for consumption given perfect helth. In the bsence of insurnce, n individul's expected utility is given by: VN = (1 - p)u(y, H[O, ]) + pu(y - m, H[1, mi), = (1 - p)u(y) + pu(y - m), where the second equlity follows from the ssumption tht medicl cre restores the person to perfect helth. 7 We ssume tht U hs the stndrd property tht utility is incresing in consumption lbeit t declining rte: U' > nd U" <. We further ssume tht medicl expenditures re worthwhile even if the individul is not insured. Suppose the individul purchses insurnce ginst the risk of being sick. For n insurnce compny to brek even, the fir insurnce premium would hve to be 7r = pm. The insurnce compny collects the premium ech yer nd pys out m when the individul is sick. If n individul chooses this policy, his utility would lwys be: Vi = U(y - r). (2) Using Tylor series expnsion of Eqution (1),8 we cn pproximte tht eqution s: Therefore, VN U(Y - 7r) + U'(U"/2U')r(m - rt). (3) Vlue of Insurnce = (VI - VN)/U'/ (1/2)(-U"/U')r(m - 7r). (4) 7 Assuming tht medicl expenditure is worthwhile, this nlysis ctully requires less stringent condition. The sme eqution would pply if restored helth imposed fixed utility cost, k, reltive to initil perfect helth, so tht U(c, H[O, ]) = U(c, H[1, ml) + k for ll c. 8 The Tylor series is tken bout the level of income net of insurnce premiums. From Eqution (1), VN (1 - p)[u(y - 7r) + U'7r + (1/2)U"r 2 ] + p[u(y - r) - U'(m -7r) + (1/2) U"(m - 7 ) 2 ]. Collecting terms, this simplifies to VN U(y - r) + U'{(1 - p)7 - p(m - r) + (1/2)U"{(1- p)r 2 + p(m - r) 2 }. The term (1 - p)7t - p(m - t) is zero. The term (1- p)7r 2 + p(m -r) 2 cn be expnded s (1 - p)7r 2 + pm 2 2pm7r + pir 2. Since pm = Jr, this simplifies to pm 2-7r 2 = 7r(m - 7r).

12 574 D.M. Cutler nd R.J. Zeckhuser The left hnd side of Eqution (4) is the difference in utility from being uninsured reltive to being insured, scled by mrginl utility to give dollr vlue for removing risk. The right hnd side is the benefit of risk removl. Here, (-U"/ U') is the coefficient of bsolute risk version; it is the degree to which uncertinty bout mrginl utility mkes person worse off. Becuse U" < nd U' >, this term is positive. The term 7r(m - r) represents the extent to which fter-medicl expenditure income vries becuse the person does not hve insurnce. It too is positive. The product of terms on the right hnd side of Eqution (4), therefore, is necessrily positive, implying tht fir insurnce is preferred to being uninsured. The dollr vlue of risk spreding increses with risk version nd with the vribility of medicl spending. The intuition supporting this result is tht risk verse individuls would like to smooth the mrginl utility of income - to trnsfer income from sttes of the world where their mrginl utility is low to sttes of the world when their mrginl utility is high. In the bsence of insurnce, person's mrginl utility of income when helthy is U'(y) nd when sick is U'(y - in). Since mrginl utility flls s income increses, mrginl utility is lower when helthy thn when sick. Trnsferring income from helthy sttes to sick sttes until mrginl utility is equlized mximizes totl utility, ssuming fir insurnce. Helth insurnce crries out this trnsfer, chrging premiums up front nd reimbursing expenditures lter. 9 There is digrmmtic wy to mke the sme point; it is shown in Figure 2. We think of the two sttes of the world - being sick nd being helthy - s if they were two goods. Individuls would like more consumption in ech stte. In the bsence of ny probbility of being sick, people would be ble to consume y in ech stte. Becuse of required medicl spending, however, people cn only consume y - m when sick. This is shown s point E in the figure. 9 The sitution is more complex when medicl spending fils to restore the person to perfect helth, nd the mrginl utility of income is ffected by helth sttus. Suppose tht when sick person still needs medicl spending of m, but tht his fter-expenditure helth remins below wht it would be hd he never got sick; i.e., tht H[l, m] < H[O, O]. Expected utility for people without insurnce is given by VN = (1 - p)u(y, H[O, ]) + pu(y - m, H[1, m]), nd the mrginl utilities of income re Ux (y, H[O, ]) when helthy nd Ux (y - m, H[1, m]) when sick, where the subscripts indicte prtil derivtives. Becuse the mrginl utility of income my be ffected by helth nd helth vries cross sickness sttes, it is not cler how much insurnce the person will wnt. If people ttch little vlue to money when sick - for exmple, if there re few plesurble ctivities they cn engge in - they my not wnt ny helth insurnce t ll. Alterntively, if the vlue of money when sick is prticulrly high, sy becuse ides re needed to crry out the ctivities of dily life, people my wnt more thn full insurnce ginst medicl expenditures. This exmple highlights the difference between medicl cre insurnce nd wht, if we used strict interprettion, would be lbeled helth insurnce. Helth insurnce trnsfers money cross people - generlly from the helthy to the sick. The money cn be used to purchse medicl services the individul otherwise could not fford, or to llow the individul to purchse more of other goods nd services fter medicl cre hs been pid for. But helth insurnce cnnot gurntee tht n individul's helth will be unffected by outside fctors. Insuring one's helth is technologiclly infesible.

13 Ch. 11: The Antomy of Helth Insurnce 575 Dollr 45n y insurnce line y Dollrs when helthy Figure 2. The welfre gins from helth insurnce. The fir odds insurnce line is the individul's implicit budget constrint. It is drwn for the cse where p =.2. The slope of the line is -l/p, or -5.1 The indifference curve for consumption is lso steeply sloped, recognizing tht the sick stte is unlikely to rise. Thus, people re not willing to give up much consumption when helthy to get consumption when sick. A person cn trde consumption when sick for consumption when helthy, t rte given by the insurnce premium. People will choose to purchse some insurnce. If insurnce is priced cturilly firly, individuls will choose to be fully insured - they will hve the sme consumption when sick s when helthy. This optimum is shown s point E' in the figure. People re better off t E' thn they re t E; they hve moved to higher indifference curve. In our simplified world, the optiml insurnce policy is n indemnity policy - it pys fixed mount of money for prticulr condition when the individul is sick. The mount pid equls the cost of the pproprite tretment for the person's disese; if there is more thn one disese, the pyments vry. Since ech disese requires fixed mount of cre - there is no more nor less tht person cn consume - there re no wsted resources in the policy; the indemnity insurnce pln is efficient. Beyond its efficiency properties, the indemnity policy is the simplest helth insurnce policy. In effect, it opertes s contingent clims mrket; people get pid specified mount depending on which contingency occurs [Zeckhuser (197)]. Helth insurnce strted off s qusi-indemnity policy - in most cses pying fixed mount per dy in the hospitl. The first Blue Cross policies, for exmple, were o1 A fir insurnce policy tht chrges $1 ech yer nd pys n mount k when sick is defined by: pk+ 1 =. Thus, k = -p. Some uthors ssume the insurnce pyment is mde only when the person is helthy, in which cse the fir odds policy is defined by: pk' + (1 - p) =, or k'= -(1 - p)/p.

14 576 D.M. Cutler nd R.J. Zeckhuser developed just before nd during the Gret Depression. These policies, run by hospitls, gurnteed certin number of hospitl dys per yer (for exmple, 21 dys) for n nnul premium (for exmple, $5 to $1 in the erly 193s). After World Wr II, life insurnce compnies entered the helth insurnce mrket, driven by the profits of Blue Cross policies nd the expnding demnd for helth insurnce resulting from its fvorble tx tretment. These nscent helth insurers offered indemnity policies s well, limiting their potentil losses by fixing the mximum mount they would py per hospitl dy. 3. Morl hzrd nd principl-gent problems Helth insurnce must ddress severl problems beyond risk spreding. We now turn to some of these chllenges Morl hzrd Morl hzrd refers to the likely mlfesnce of n individul mking purchses tht re prtly or fully pid for by others [Arrow (1965), Puly (1968, 1974), Zeckhuser (197), Spence nd Zeckhuser (1971), Kotowitz (1987)].1 He will overspend; i.e., he will use more services thn he would were he pying for the medicl cre himself. Since insurnce is n rrngement where others py for the lion's shre of one's losses, it cretes morl hzrd to use dditionl medicl resources. The designtion morl hzrd, disquieting term, frequently connotes some morl filure of individuls, but this is not ment to be so. Indeed, Kenneth Arrow (1985) employs the less judgmentl nd more informtive term "hidden ction" for morl hzrd. Morl hzrd is concern becuse it conflicts with risk-spreding gols. Insurnce is vluble becuse it llows people to trnsfer income from when they need it less to when they need it more. But this trnsfer is not perfect becuse people increse their consumption of medicl cre when it is subsidized. This cretes n inherent secondbest problem in designing insurnce policies: insurers must trde off the benefits from spreding more risk ginst the cost of incresed morl hzrd. We formlize this Lesson 1 bout helth insurnce: Lesson 1: Risk spreding versus incentives. Helth insurnce involves fundmentl trdeoff between risk spreding nd pproprite incentives. Incresing the generosity of insurnce spreds risk more brodly but lso leds to incresed losses becuse individuls choose more cre (morl hzrd) nd providers supply more cre (principl-gent problems). 11 The theory of morl hzrd, if not the words, goes bck t lest to Adm Smith: "The directors of such compnies, however, being the mngers rther of other peoples' money thn of their own, it cnnot well be expected, tht they should wtch over it with the sme nxious vigilnce with which the prtners in privte coprtnery frequently wtch over their own... Negligence nd profusion, therefore, must lwys previl, more or less, in the mngement of the ffirs of such compny" [Smith (1776, p. 7)].

15 Ch. 11: TheAntomy of Helth Insurnce 577 Morl hzrd, or hidden ction, emerges in one form in the risks tht individuls choose to tke. People my tke worse cre of themselves when they hve insurnce thn if they do not. If their ctions were redily observed, the insurnce compny would merely not py off were they reckless or negligent. But individul ctions re difficult to observe; they re hidden. The extent of morl hzrd in terms of ctions tht ffect helth my not be lrge for helth insurnce in most instnces, since the uncompensted loss of helth itself is so consequentil.1 2 Thus, it would be surprising if people smoked becuse they knew helth insurnce would cover the costs of lung cncer. Hidden ction lso rises becuse individuls my get tretments they would not py for themselves. Though the ction itself (seeking medicl cre) is not hidden, the motivtion behind it is. 13 Optiml insurnce plns would py for tretment only if the individul would hve chosen the sme tretment hd he borne the full bill. The thought experiment here is whether the person would py for the medicl expenditure in expecttion, before he knew his condition. For exmple, suppose tht person hs income of $25,, nd fces 1 percent probbility he will hve serious illness. If he could commit in dvnce, he would gree to receive $5, of medicl cre when sick in exchnge for $5 premium. If fully insured, however, the individul will choose to consume $6, of cre. The morl hzrd in this exmple is $1, - the dditionl spending beyond the optiml mount of cre he would contrct for in dvnce of being sick. In the terminology of demnd theory, morl hzrd is the substitution effect of people spending more on medicl cre when its price is low, not the income effect of people spending more on medicl cre becuse of insurnce, by efficiently trnsferring resources from the helthy stte to the sick stte, mkes them richer when sicker [De Mez (1983)]. In the exmple considered, sy the individul would hve spent hlf his income, $12,5, on medicl cre in the bsence of insurnce. Insurnce thus rises medicl spending by $47,5, but only frction of this increse is due to morl hzrd. If some fixed m were the known optiml medicl expenditure for ny sick person, insurnce plns would experience no morl hzrd. They could simply py m in medicl expenditures to or for those who re sick. Morl hzrd rises becuse medicl needs re not fully monitorble, nd different people with the sme condition hve different optiml expenditures, t lest s best the insurnce compny cn determine. Suppose tht the optiml medicl expenditure for treting prticulr condition is mi, which vries cross people, indexed by i. The insurnce compny requires the individul to py coinsurnce mount c(m) for medicl cre received. The rest of the cre, m - c(m), is pid by the insurer. In effect, the insurer tkes the individul's medicl expenditure 12 This does not men tht people will not smoke or fithfully tke their medictions. But there is no morl hzrd if their ctions would be the sme if they hd no helth insurnce, i.e., if these helth-hrming behviors re inelstic with respect to cost shring. 13 Morl hzrd lso results from ptients mking less effort to serch for low-cost providers. For exmple, when ptients py but one-fifth of the cost of their drugs, they will hve wek incentives to switch to generic brnds or stry beyond the locl phrmcy.

16 578 D.M. Cutler nd R.J. Zeckhuser to be signl of his true medicl needs; the coinsurnce pyment cretes the necessry costs to hve signling operte. Two polr extremes for the form of c(m) re commonly found. The first is the indemnity policy discussed bove: the insurer pys fixed mount, cll it m*, nd the individul pys c(m) = m - m*. The second is full insurnce: the insurer pys the full costs of medicl cre, regrdless of its cost, nd the individul pys nothing (i.e., c(m) = ). The full insurnce policy removes ll risk from the insured, but engenders greter morl hzrd. To understnd the optiml insurnce policy, consider cse where n indemnity policy is not optiml. Suppose tht rther thn being helthy or sick, the individul hs rnge of potentil illness severities, s, with s distributed with density function f(s). Helth is given s before by h = H[s, m]. The ptient's s will determine the optiml tretment. The insurer cnnot observe s, however. Thus, mking fixed indemnity pyment to nyone sick is not optiml. The ex nte utility function for the insured consumer is: V = u(y - r - c(m(s)), H[s mf m(5) (s), ds, where mr(s) tells how much medicl cre n individul with condition s chooses to receive. We consider first the optiml policy - the mount of medicl services the person would like to contrct for if he could write perfect stte-contingent contrct nd thereby eliminte morl hzrd. When s is observble, the coinsurnce rte depends only on s, hence cn be written s c(s). The individul will choose m*(s) mximum fesible utility: Mx(s) f U(y - - c(s), H[ s) dss,(6) where 17 = f(m(s) - c(s))f(s) ds. The solution to this problem sets Hm UH = E[Ux], (7) where the subscripts denote prtil derivtives nd x = y c(s). The left-hnd side represents the gin in utility from spending nother dollr on medicl cre; it is the product of the effect of medicl cre on helth nd the effect of helth on utility. The right hnd side is weighted verge expecttion of the mrginl utility of consumption in different illness sttes, nmely: E[U,] = f U,(y - - c(s), H[s, m])f(s)ds. (8)

17 Ch. 11: The Antomy of Helth Insurnce 579 Eqution (7) sys tht with the optiml first-best policy, the expected mrginl utility gined from n dditionl dollr of medicl cre in ech stte of the world equls the utility cost of dollr. 14 In the cse where the mrginl utility of income does not depend on the helth stte, 15 imposing coinsurnce pyment in ny helth stte, i.e. vrible c(s), increses the vribility of income nd thus reduces expected utility. The optiml policy for this commonly studied cse in thus no coinsurnce, nd pyment m*(s) tht fully reimburses optiml spending in ech stte. 16 Now consider sitution where severity of illness is not monitorble, hence the optiml policy just discussed cnnot be implemented. At the time the consumer is seeking medicl cre, he lone knows his severity. We ssume the consumer trets the insurnce premium s fixed - nothing he does will rise or lower his insurnce premium tht yer. Further, we ssume for now tht individuls re not penlized in future yers for dditionl medicl spending this yer, becuse expected future chnges in costs re spred eqully over everyone in the group. The cost to the consumer of nother dollr of medicl expenditure will be c'(m).17 The sick consumer will therefore choose medicl cre utiliztion to mximize utility when sick. Thus, he will choose m#(s) s the m which mximizes utility given knowledge of s: Mx(s)U(y -17-c(m), H[s, m]) for ech s. (9) The solution to this problem will depend on the specific s the individul hs relized, nd is given by the first order condition: Hm Uh = c'(m)uzx forechs. (1) The left-hnd side once gin represents the gin in utility from spending nother dollr on medicl cre. The right-hnd side is the utility cost to the individul from spending 14 This ssumes tht these functions re well behved, hence tht locl optim re globl optim. Some medicl expenditures my offer incresing returns over relevnt rnge. For exmple, it my cost $2, to do hert trnsplnt, with $1, ccomplishing much less thn hlf s much. Efficiency then requires the insurnce progrm spend t lest to the minimum verge cost of benefits point, or not t ll. 15 This cse would rise if utility is dditively seprble between income nd helth. 16 If utility does depend on the helth stte, for exmple, if disbled person needs more non-medicl services, then optiml coincurnce will ctully py the individul when disbled. 17 The structure of the insurnce pln my present the insured with rnge of decresing mrginl cost. Sy pln hs deductible of $6 with copyment of 2% beyond tht point, common structure. The insured cn receive $6 of benefits for $6, but $12 of benefits for $72. Sy the individul solves, nd finds $4 expenditure is loclly optiml. He must lso look globlly to the optiml expenditure beyond $6, which my be superior. Recognizing tht using up deductible gets one to rnge of lower costs, gives the insured n interesting dynmic optimiztion progrm where there re two benefits from spending below the deductible: (1) the helth cre itself, nd (2) the incresed potentil for getting to the low-cost rnge [Keeler, Newhouse, nd Phelps (1977)].

18 58 D.M. Cutler nd R.J. Zeckhuser tht dollr; it is the product of the out-of-pocket cost of medicl cre nd the utility loss from losing tht dollr for consumption. Compring Equtions (7) nd (1) shows the loss due to morl hzrd. When c'(m) < 1, s it will be when mrginl spending is in ny wy insured, people will overconsume medicl cre when sick nd thus py more for helth insurnce thn is optiml.l Evidence on the price elsticity of medicl cre demnd How does n individul's demnd for medicl cre respond to his required out-of-pocket expenses? Economists used to differ on this question. Tble 3 detils estimtes of the elsticity of demnd for medicl cre. 19 A substntil literture in the 197s estimted the elsticity of demnd for medicl cre using cross-sectionl dt, or cross-sectionl time series dt. Pre-eminent mong these ppers re Feldstein (1971), Phelps nd Newhouse (1972b), Rosett nd Hung (1973), nd Newhouse nd Phelps (1976). Feldstein (1971) ws the first sttisticlly robust estimte of price elsticities using time-series micro dt, in this cse on hospitls. Feldstein identified the effect of coinsurnce rtes on demnd using stte-vrition in insurnce coverge nd generosity, estimting demnd elsticity of bout -.5. The subsequent ppers use ptient-level dt nd more sophisticted study designs. The elsticities tht emerged from these ppers rnged from s low s -.14 [Phelps nd Newhouse (1972b)] to s high s -1.5 [Rosett nd Hung (1973)]. The impliction of this rnge of elsticity estimtes ws tht morl hzrd ws likely significnt force. This estimtion literture suffered from two mjor difficulties, however. First, the generosity of helth insurnce t either the stte or the individul level might be endogenous. Generous insurnce might boost utiliztion of medicl services, s posited; or lterntely, res where people desire or need more medicl cre my lso be res where people demnd more helth insurnce. One cnnot seprte these two effects sttisticlly without n instrument for the rte of insurnce coverge in n re, but such instruments were not esy to find. Second, the studies typiclly filed to distinguish verge nd mrginl coinsurnce rtes. Usully for dt resons, most of these studies relted medicl spending to the verge coinsurnce rte in n re. But theory predicts tht medicl spending should relte to the mrginl coinsurnce rte. Becuse insurnce policies re non-liner, verge nd mrginl prices my differ substntilly. 2 As result of these problems, s lte s the 197s mny critics still believed tht medicl cre ws determined by "needs" nd no other economic fctors, i.e., tht demnd ws totlly 18 This cn be derived by tking expecttions of both sides of Eqution (1) nd compring to Eqution (7). There is lso risk-bering loss when severity, is not monitorble, s reflected by the term U. in (1) s opposed to E(ux) in (7). 19 Zweifel nd Mnning (2) discuss the elsticity of demnd for medicl cre in more detil. 2 Of course, if individuls re ppropritely forwrd looking, it is the expected mrginl coinsurnce rte t the end of the yer tht should ffect behvior, rther thn the ostensible mrginl coinsurnce rte t the time services re used.

19 Ch. 11: TheAntomy of Helth Insurnce 581 OD,.2 = :g =,X C 7 - o l tv u e, t ~o C. N O _ 6 t6 C o - % 'g' 8 - = ec, c' o - o 8 1 F C) o _O ej., -,. -- C fg t o OC. o,, - t - '- r- CO o _ sm. C C- E o 5 'Zw CO E, >., o-, C C ON ONo P e, ~ ~ ~ OO COO d L4 F4 ~~~~~~~~~~~~~~~~~~~,~ donq

20 582 D.M. Cutler nd R.J. Zeckhuser ) t..~5 O :> * 5s - 7 rr I E- 'o r- * ~ O -h - O c CO o d r 9Z ~ - "Zi, 41 1 C) ). CO.2 -s 1. H E H Y w.fc E Ed o -c o Jo -='Sp ) C. o c5 oi o v o o~. 9 99o O, - C O 9 P C C R. 5 5 o ).5 5 ~ g SH SH.9. t b.9.) 't ) ) 5 3 i - 5.i 5 8~.9r / o 5 - O = N I I I.. E ) r - o 9; ' 5.J ) 9. C. 9 o '. CO> CO o CO CO C 5 t C o O... F _m. 9 5 U o~h ) 9 o 9 o 7 t. I On ~,- ' CO U 'C. ON o - CO C.-. PI. rn ) 9 i E COB - '8 I U R c 8? - ) - CO 9 I O O i m, U 5'9 U ) - CO "-SC 9A5 Z ~2 o - - N A C- C - C V) <C -m, -. - CO 4 ) t, U, cz 3 CL C- r- -C'. z- - ) z ,. cl Or O z I CO,.1 cn 5 Euz. CO<o oo

21 Ch. 11: The Antomy of Helth Insurnce 583 I - o "I - I C) C W) C-]~ NN - o4 C~~~ = 7,: ~.c ' m m O * C) i> c9 ~ ~~~~ I,._ - ; CT,. C- C5 I I -5!] 1 'E 6~ 9v C- C] 6: o -,Z, C-= cc 9 C) - E E.g C) z to SC) o pe 8E = C) C) C) B.S c) o u t Y c Q I C) 'CI C. C r CQ2 4 m U 7 z 5:o~ C) ' G dv ) C)~ C) m Q. t 6j. o - v 4 C = In, C] P C- z ) ""~~ ~: u c E C 44 - m P 'o I - N - 5 O-w - - ~ C - - W O O ~ - 3 o S - ~ s ~ ' C o TC) ', - 4 C)C),C) ' - 4~ 8, F -4l C).< ra C) tr. C)

22 584 D.M. Cutler nd R.J. Zeckhuser inelstic, lthough others believed tht the demnd elsticity ws substntil - perhps -.5 or more. To ddress these problems, the United Sttes government funded socil insurnce experiment, designed to estimte the demnd elsticity for medicl cre. The Rnd Helth Insurnce Experiment [Newhouse et l. (1993), Zweifel nd Mnning (2)] rndomized nerly 6, people in 6 res to different insurnce plns over 3- to 5-yer period in the erly 197s. The insurnce plns vried in contrctul levels of cost shring. Elsticity estimtes were formed by compring utiliztion in the different plns. The Rnd Experiment found n overll medicl cre price elsticity of bout -.2. This elsticity is sttisticlly significntly different from zero, but noticebly smller thn the prior literture suggested. Sound methodology, supported by generous funding, crried the dy. The demnd elsticities in the Rnd Experiment hve become the stndrd in the literture, nd essentilly ll economists ccept tht trditionl helth insurnce leds to moderte morl hzrd in demnd. The Rnd estimtes re lso commonly used by cturies in the design of ctul insurnce policies Coinsurnce in prctice The indemnity policy, which chrcterized helth insurnce t its inception, becme outdted over time. With incresed medicl technology, the rnge of optiml spending within given condition becme gret. Indemnity policies left individuls bering too much risk. As result, insurnce structures moved from indemnity pyments to service benefit policy - policy tht covers ll medicl expenses, with some cost shring. Service benefit policies grew stedily in importnce in the post-wr period, reching their height in the erly 198s. Service benefit policies use three cost-shring fetures, sometimes in concert: the deductible, the coinsurnce rte, nd the stop loss mount. Figure 3 nd Tble 4 show how these cost shring fetures operte. The deductible is the mount tht n individul must py before the insurnce compny pys nything. The deductible is usully set nnully; the typicl deductible in 1991 ws bout $2 for n individul nd $5 for fmily. Consumers py the full price for cre consumed under the deductible. The coinsurnce rte is the percentge of the totl bill bove the deductible tht ptient pys. Nerly ll indemnity plns hd coinsurnce rte of 2 percent. The coinsurnce is pid until the ptient reches the stop loss - the mximum out-of-pocket pyment by the person in yer. A typicl stop loss in n indemnity policy ws bout $1, to $1,5 in yer. In ddition to these fetures, mny policies impose further cost shring through cps on vrious types of expenditures. For exmple, policies my permit 8 mentl helth visits per yer, or hve $1 million lifetime limit on overll medicl expenditures. Such provisions discourge use, nd my deter high cost users from selecting the insurnce pln, nd providers from turning expensive cses into subsidized mel tickets. Tble 4 detils the frequencies with which vrious policy fetures were found in insurnce policies in 1991.

23 Ch. 11: The Antomy of Helth Insurnce 585 Ptient's Cost (Dollrs) J yment stop-loss dul plyment deductible Medicl Expenditure Dollrs Figure 3. Cost shring under indemnity insurnce. Tble 4 Risk-shring fetures of indemnity insurnce policies, 1991 Chrcteristic Deductible Individul Fmily Coinsurnce rte* <2 percent 2 percent >2 percent Stop loss <$5 $51-$1, $1,1-$2, >$2, Mximum lifetime benefit - individul <$25, $25,1-$999,999 )$1,, Averge/percent $25 $475 13% 78% 4% 21% 3% 32% 17% 9% 6% 85% Source: HIAA Employer Survey, * Remining responses re "rte vries" nd "other".

24 586 D.M. Cutler nd R.J. Zeckhuser Somewht misledingly, the service benefit policy is frequently clled n "indemnity insurnce pln" by economists, with the system tht developed to provide this policy termed the "indemnity insurnce system". In fct, true indemnity helth insurnce policies ( fixed pyment per disese) hd existed but were lrgely replced by the service benefit policy. For consistency with other literture, we follow this nomenclture despite its inccurcies. This nomenclture is prticulrly unfortunte since recently insurnce hs been moving bck towrds the indemnity model, frequently with the risk of bove-verge spending being plced on the provider rther thn the ptient. We discuss regimes of provider responsibility in Section Optiml insurnce given morl hzrd Knowledge of the utility function nd the prmeter vlues tht determine medicl spending elsticities cn be combined to design the optiml insurnce policy - the cturilly fir policy tht mximizes expected utility subject to the constrint tht individuls will ct in self-interested fshion, i.e., tht morl hzrd will operte. Such policy is inherently second-best; in clibrting its level of generosity, it blnces the utility benefits of greter risk-shring cross people ginst the morl hzrd costs incurred. The insurer's chllenge is to define the function of risk shring by insureds, the c(m) function, tht mximizes expected utility. To nlyze the optiml policy, we ssume ptients differ in the severity of their illness. 21 The insurer will seek to find the c*(m#) function tht produces the mximum possible expected utility with: E[U*] = Mxc(m,#) U(Y - - c* (m#), Hs, m#])f (s) ds, (11) where m # is defined s the solution to Eqution (9). Becuse insurers cnnot determine n individul's helth stte, the insurnce policy cnnot differentite pyments on the bsis of illness severity. An dditionl constrint opertes on the insurnce compny: premiums must cover expected costs. Thus, = f [m#(s) - c(m#(s))]f(s) ds. (12) The optiml insurnce policy cn be formlly written s problem in dynmic optimiztion [Blomqvist (1997)].22 Als, this is complicted problem, whose lgebr is 21 Morl hzrd rises, let us remember, becuse individuls differ in unmonitorble wys. Thus it could be on income, on helth sttus, or on some spect of preferences. 22 The problem is formlly nlogous to the optiml tx problem in public finnce when bility is unobservble [Mirrlees (1971), Dimond (1998)].

25 Ch. 11: TheAntomyofHelthInsurnce Tble 5 Estimtes of the optiml insurnce policy 587 Author Optiml policy Feldstein nd Friedmn (1977) Buchnn, Keeler et l. (1991) Newhouse et l. (1993)* Mnning nd Mrquis (1996) 58 percent coinsurnce rte $2 deductible; 25 percent coinsurnce rte $2 to $3 deductible; 25 percent coinsurnce rte; $1, stop loss (ssumed) 25 percent coinsurnce rte; >$25, stop loss Blomqvist (1997)** Cost shring declines from 27% t roughly $1, of spending to 5% bove roughly $3, * Amounts re in 1983 dollrs. ** Amounts re bsed on the Rnd Helth Insurnce Experiment dt. not prticulrly reveling. The nlytic solution blnces two fctors. The first is the reduced overconsumption from mking people py more out of pocket for medicl cre. If the coinsurnce rte is incresed in some rnge, people in tht rnge py more for medicl cre, s do people t ll higher levels of spending (becuse their coinsurnce rtes hve been incresed). This increse boosts the efficiency of provision. Countering this, however, is loss in risk spreding benefits. As people re mde to py more out of pocket, they re exposed to more risk, nd this reduces their welfre. The optiml coinsurnce rte blnces these two incentives. A smll literture hs simulted optiml insurnce policies using this frmework. Tble 5 shows the results of these simultions. Tble 5 revels wide rnge of disprities in optiml insurnce policies. Some of the studies find tht simulted insurnce policies re substntilly less generous thn ctul indemnity policies of the pst 2 yers [Feldstein nd Friedmn (1977), Blomqvist (1997)], while other studies find tht they re bout the sme [Buchnn et l. (1991), Newhouse et l. (1993), Mnning nd Mrquis (1996)].23 The difference between these vrious estimtes hs not been fully reconciled, lthough one suspects tht differing degrees of risk version nd morl hzrd re importnt. One suspects tht rel world policies will be more generous thn optiml policies becuse of the tx distortions fvoring more generous insurnce: pyments to insurnce which re then mde to providers re not txed s income to employees, while wge nd slry pyments, which might be used to py for medicl cre out-of-pocket, re. Indeed, other reserch shows tht the benefits tht employer helth insurnce policies offer re sensitive to employee tx rtes [Puly (1986)]. 23 The impliction of the Blomqvist estimtes for helth insurnce cost shring depend on whether income losses re compensted or not.

26 588 D.M. Cutler nd R.J. Zeckhuser A second importnt difference between rel world nd optiml policies is tht the former lmost invribly hve constnt coinsurnce rte, i.e., liner structures, wheres the ltter do not. The optiml policy cn be substntilly superior. Blomqvist (1997), for exmple, finds tht coinsurnce rtes should rnge from over 25 percent t low levels of spending to 5 percent t high levels of spending. There is likely trdeoff between optimlity nd simplicity. Optiml policies cn be very complicted, while rel world situtions re chrcterized by reltively simplistic structures. If services or diseses differ in the degree of morl hzrd they entil, the optiml insurnce policy will differ by service or disese s well. Suppose, for exmple, there is fixed number of diseses tht person cn hve nd tht morl hzrd vries by disese. The insurnce compny cn observe the disese of the person (e.g., cncer or ppendicitis) but not the severity of illness within the disese. Then, the optiml insurnce policy will hve different cost shring by disese [Zeckhuser (197)]. Coinsurnce formuls could just s esily depend on service (e.g., outptient psychitry) or locle of medicl cre (e.g., hospitl cre). 2 4 In prctice, elsticity estimtes do differ cross services. The Rnd Helth Insurnce Experience found higher demnd elsticity for outptient cre thn for inptient cre, nd within outptient cre greter demnd elsticity for mentl helth cre. Most helth insurnce policies, including Medicre, drw distinctions between services in their coinsurnce schedules. Thus, Medicre hs seprte hospitl deductible, nd privte insurnce plns frequently cover fixed number of psychitric visits. Morl hzrd is significnt concern in insurnce policies but it is not one tht necessrily rgues for government intervention. Government insurnce policies, fter ll, my engender just s much morl hzrd s privte insurnce policies. There is rtionle for government to be involved in goods subject to morl hzrd only if the government is better ble to monitor or punish morl hzrd thn the privte sector. This is not obviously the cse in medicl cre Ptients, doctors, nd insurers s principls nd gents Thus fr, we hve implicitly ssumed tht ptients choose the mount of medicl cre they wnt, knowing their illness, the rnge of possible tretments, nd the prices of the tretments to them. But few ptients re so well informed. In most cses of serious expenditure, it is the doctors who mke the resource-spending decision, with ptients nd insurers bering the costs; ptients usully do not know the chrge until the bill comes. Ptients, physicins, nd insurers re in principl-gent reltionship: the ptient (principl) expects the doctor (gent) to ct in his best interest when he is sick. Similrly, the 24 This is nlogous to the Rmsey rule of optiml txtion. The Rmsey rule sttes tht optiml txes on set of commodities should be inversely relted to the elsticity of demnd for ech commodity - in minimizing inefficiency, inelstic fctors should be txed more. The sttement here is the equivlent but for subsidies insted of txes.

27 Ch. 11: The Antomy of Helth Insurnce 589 insurer would like the doctor to ct in its interests. Of course, ptients lso ber the insurnce costs for seeking cre, so tht ex nte the ptient's incentives nd the insurer's incentives line up. But once the ptient becomes sick nd requires cre, the prties' incentives diverge. This three-plyer gency problem cretes substntil problems for helth insurnce. To the extent tht medicl tretments re decided upon jointly by physicins nd ptients, the supply side of the helth insurnce policy (the rules bout pying physicins) will mtter long with the demnd-side of the insurnce policy (the rules bout cost shring for ptients). With the trditionl service-benefit insurnce policy, doctors nd ptients frequently hve reltively congruent interests, which my differ from those of the insurer. Ptients who fce but frction of the costs they incur will desire excessive tretments. Servicebenefit insurers usully py more to physicins who provide more medicl services. The result is tht ptients nd physicins wnt essentilly ll cre tht improves helth, respectively ignoring nd welcoming resource expenditures. The view tht physicins should do only wht is best for the ptient is codified in the Hippocrtic Oth - providers should promote the best medicl outcomes for their ptients. Hippocrtes sid nothing bout providing cre the ptient or society would hve deemed ex nte to be wsteful. Plto nticipted the ppliction of gency theory to the helth cre ren by goodly mrgin. He wrote tht, "No physicin, insofr s he is physicin, considers his own good in wht he prescribes, but the good of his ptient; for the true physicin is lso ruler hving the humn body s subject, nd is not mere moneymker" (The Republic, Book 1, 342-D). 25 With the pssge of 2,+ yers, fidelity to principls hs slipped bit, nd new prticipnts - insurers, government, employers, nd provider orgniztions - hve strode into the ren. But the principles re very much the sme. A more sinister view of the principl-gent problem contends tht physicins mnipulte ptients into receiving more services thn they would wnt, so tht physicins cn increse their income. This hs been termed supplier-induced demnd in the literture. An enormous mount of work in helth economics hs been devoted to the question of whether nd to wht extent suppliers induce demnd. The empiricl evidence on this issue is discussed by McGuire (2). Lesson 1 notes the trdeoff between risk spreding nd pproprite incentives pplies on both the demnd- nd supply-sides of the mrket. Incresingly, the rrows of responsibility mong the plyers - who is gent, who principl - now point in ll directions. For exmple, doctors now hve responsibilities to other providers nd insurers, not just to ptients. Such dded doctor responsibilities, primrily to hold down expenditures, ultimtely enhnce ptient welfre, t lest on n expected vlue bsis, if not when the ptient is sick. Insurers, cting for their customers s whole, wnt to limit spending to only tht cre tht is necessry; i.e., the cre 25 One might insted heed the wrning of George Bernrd Shw nerly century go: "Tht ny sne ntion, hving observed tht you could provide for the supply of bred by giving bkers pecuniry interest in bking for you, should go on to give surgeon pecuniry interest in cutting off your leg, is enough to mke one despir of politicl humnity" [Shw (1911)].

28 59 D.M. Cutler nd R.J. Zeckhuser ptients would select given lump-sum trnsfer tht depends on their condition nd mking them py ll costs t the mrgin. With ptients, physicins nd insurers pulling in different directions, conflict over wht cre will be provided frequently results Trnsctions costs Processing clims costs money; the more clims processed the more it costs. Ntionl estimtes of medicl expenditure suggest tht 15 percent of insurnce premiums re devoted to dministrtive expense. 26 Someone must red the bill, pprove the spending, nd py the clim. Insurnce compnies seek to control these costs, nd policies re designed ccordingly. 2 7 A mjor prt of clims processing costs - monitoring, trnsferring money, nd the like - re invrint to the size of the clim. Size-invrint costs re greter percentge burden for smll bills thn for lrger bills. This suggests limiting helth insurnce to lrger clims nd hving individuls py directly smller expenses [Arrow (1963)]. This insight gives further justifiction to the widespred use of deductibles nd coinsurnce for smll bills, nd for the fct tht historiclly insurnce developed first for inptient doctor nd hospitl chrges, where bills re the lrgest. 4. Reltionships between insurers nd providers The medicl cre system is network, with ptients, monies nd informtion flowing from one prty to nother. The informtion flow to insurers, however, is not so rich tht they cn gurntee tht only cost-effective cre will be provided. Their monitoring difficulties provide the motivtion for cost-shring in insurnce policies. But cost shring hs limited vlue: Ptients do not mke the most costly decisions, the Hippocrtic Oth does not extend to conserving society's resources, nd risk spreding considertions severely limit wht chrges cn be imposed. Return now to Figure 1, the Medicl Cre Trid. Working solely on the left side of the tringle, the demnd side, these rguments suggest tht pssive insurers re unlikely to be ble to limit utiliztion ppropritely. Recognizing this, insurers lso work the right side of the tringle - the supply side. Incresingly, insurers ttempt to provide incentives for providers to limit spending. The incentives my be imposed t rm's length, s Medicre does with its DRG system: tret simple hert ttck, nd hospitl gets pid flt 26 This includes the expenses of pying bills s well s mrketing. Divisions between these sources of dministrtive expense re not very precise. 27 Of course, individuls must lso ber some costs in pying bills on their own, so it is not self evident which method of pyment, individully or through insurnce, is cheper. But most people implicitly ssume tht insurers hve dditionl trnsctions costs for pying bills beyond wht individuls fce. Thus, there is likely to be net trnsctions cost to purchsing insurnce. There re lso trnsctions costs ssocited with selling the policy, but they do not vry with the mgnitude of clims.

29 - Ch. 11: The Antomy of Helth Insurnce UU 8 ) Q. 6 4 n HMO io POS E PPO [ Mnged FFS l Unmnged FFS Yer Figure 4. Chnges in helth pln enrollment. The smple is people with privte (employer or individul) insurnce. Source: Dt re from Lewin-VHI. mount, roughly $5,. Or the insurer my form contrcting llince with providers, s it does sy with network HMOs. At the extreme, insurers nd providers merge into single entity. Uniting disprte orgniztions in this wy enhnces monitoring possibilities nd better ligns incentives, but it lso cretes the potentil for diseconomies of scope, e.g., requiring nother lyer of mngement when cre is delivered. The sweeping nture of insurer-provider interctions is indicted by Figure 4 [see lso Glied (2)]. In 198, over 9 percent of the privtely insured - i.e., employeror self-pid - popultion in the United Sttes ws covered by "unmnged" indemnity insurnce. By 1996, tht shre hd shrunk to mere 3 percent. Tble 6 provides txonomy of different insurnce-provider rrngements. The most limited rrngement is "mnged" indemnity insurnce policy. It bundles trditionl indemnity policy with limited utiliztion review, for exmple requiring tht nonemergency hospitl dmissions be precertified. At the most intrusive, insurers cn seek to monitor cre on retil bsis through tissue review committees, or on sttisticl, wholesle bsis by monitoring physicin or hospitl's overll utiliztion. Such reviews cn be used to refuse or reduce pyment. Such intrusiveness by insurers my be unhelpful nd, coming fter-the-fct, my be ineffectul. It certinly is not welcome

30 592 D.M. Cutler nd R.J. Zeckhuser Tble 6 Key chrcteristics of insurnce policies Dimension Indemnity Mnged cre insurnce PPO IPA/network Group/stff HMO HMO Qulified providers Almost ll Almost ll Network Network (network) Choice of providers Ptient Ptient Gtekeeper Gtekeeper (in network) (in network) Pyment of providers Fee-for-service Discounted FFS Cpittion Slry Cost shring Moderte Low in network; Low in network; Low in network; High out of network High out of High/ll out of network network Roles of insurer Py bills Py bills; Py bills; Provide cre Form network Form network; Monitor utiliztion Limits on utiliztion Demnd-side Supply-side (price) Supply-side Supply-side (price, quntity) (price, quntity) to physicins. As Figure 4 shows, mnged indemnity insurnce, though non-existent in 198, climed 41 percent shre by 1992, but hs fllen to 22 percent tody. Preferred Provider Orgniztions (PPOs), second type of mnged cre, form network of providers, including physicins, hospitls, phrmceuticl purveyors, nd others, nd control costs by securing discounts from them. The quid pro quo for the discounted fee is tht insureds re steered to in-network providers. Out-of-network providers my get reduced coverge or no coverge t ll. More typiclly, the ptient's coinsurnce or copyment rtes re merely set lower for in-network providers. In 1991, for exmple, the typicl PPO hd n in-network coinsurnce rte of 1 percent nd n out-of-network coinsurnce rte of 2 percent. PPOs usully impose preuthoriztion requirements s well, though they re rrely especilly strict. As Figure 4 shows, PPO enrollment, zero in 198, now mkes up bout one-qurter of the privtely insured popultion. Full integrtion cretes the strongest link between insurnce nd provision. In the United Sttes, these merged entities re clled helth mintennce orgniztions (HMOs). They sell their services directly to employers or individuls on n nnul fee bsis, nd then they deliver cre. There re three mjor types of HMOs. Within group/stff HMO - the most common form, with Kiser being the best known exmple - physicins re pid slry nd work exclusively for the HMO. The HMO my hve hospitls on contrct, or my run its own. HMOs employ rnge of mechnisms to limit utiliztion. They reflect the trditionl economic instruments of regultion, incentives, nd selection of types. HMOs frequently regulte physicins' prctices, for exmple limiting the referrls they cn

31 Ch. 11: TheAntomy ofhelthinsurnce 593 mke or the tests they cn order. But the efficiency benefits of HMOs rise much more from ligning the incentives of provider nd insurer, rther thn through direct regultion. Some group/stff HMO physicins re slried; s result, they hve weker incentive to provide mrginl cre thn their fee-for-service counterprts. Moreover, HMOs monitor the services tht physicins provide. They my rewrd prsimonious resource use directly with compenstion, though more likely with perks or subsequent promotion. Extrvgnt users re kicked out of the network. Finlly, since physicins differ substntilly in their tretment philosophies, HMOs cn select physicins whose nturl inclintion is towrd conservtive tretment. Given the bility of HMOs to limit utiliztion on the supply-side, price-relted demnd-side limittions cn be less severe. Cost-shring to enrollees is generlly quite low - typiclly bout $5 to $1 per provider visit, lthough other forms of demnd-side limittion survive (for exmple, ptients my hve to get pprovl from their internist before seeing specilist). Independent Prctice Associtions (IPAs), or Network Model HMOs, represent more recent innovtion in mnged cre. 28 These plns neither employ their own physicins nor run their own hospitls. Insted, they contrct with providers in the community. By limiting the size of the network, the plns secure lower costs from willing providers. In ddition, these plns employ stringent review procedures. For exmple, ptients my need pprovl to receive prticulr tests. Finlly, IPAs often provide finncil incentives to limit the cre tht they provide. For exmple, some plns py physicins on "cpitted" bsis. The physicin receives fixed pyment per ptient per yer. Out of this cpitted stipend, the physicin must py for ll necessry medicl services, possibly including hospitl services nd prescription drugs. The physicin's incentives for cost control become even more significnt when ll expenditures come out of his own pocket. In mny HMOs, ptients cn go outside of the network nd still receive some reimbursement. This is termed Point of Service (POS) option. But reimbursement out-ofnetwork is not s generous s reimbursement within. Use of non-network services, for exmple, frequently requires deductible followed by 1 to 4 percent coinsurnce pyment. As Figure 4 shows, HMO enrollment of ll forms (including POS enrollment) hs incresed from 8 percent of the popultion in 198 (then predominntly group/stff model enrollment) to nerly hlf of the privtely insured popultion tody. This verticl integrtion in mnged cre, with insurers nd providers linked or united, is virtully unherd of in insurnce of other types. Auto insurnce, for exmple, is n indemnity policy. People choose wht coverge they will hve, wht deductibles will be in force, etc. When there is crsh, the insured nd the djuster get together, perhps t the repir shop, to negotite the cost of the repir. The insured or the repir shop, entities hving no prticulr reltionship to the insurer, re pid tht mount, less 28 Some IPAs re older, but their form gined populrity only recently.

32 594 D.M. Cutler nd R.J. Zeckhuser ny deductibles, which re the responsibility of the insured. After mjor crshes, costineffective repirs re voided by declring the cr totl loss, giving the wreck to the insurnce compny nd reimbursing the owner. But such contingent clims system could not work with helth cre. The clims re more frequent nd uncertinties much greter, mking costs much hrder nd more expensive to estimte. "Scrpping" humn body is rrely n inexpensive or pltble proposition. The burgeoning links between insurers nd providers in helth cre, we believe, re response to the priori difficulty of writing contingent clims contrcts in the medicl sector. Verticl integrtion is lso importnt becuse it cn elicit price discounts. Mnged cre prtly represents price club. In exchnge for n up-front fee, the ptient gets to purchse goods t significnt discount. The discounts re secured through bulk purchse brgining, or by directly hiring the sellers. In exchnge for lower prices, ptients precommit to receive cre from limited set of providers, or to py hrshly for the privilege of going elsewhere. Finlly, verticl integrtion is importnt becuse it fundmentlly trnsforms the principl-gent conflicts in the medicl system. Physicins no longer look out for the interests of just their ptients, or perhps their ptients' interests nd their own. Now, physicins must wtch out for the insurer s well. And ptients must be more ttuned to the incentives their physicin is under. We note the integrtion of insurnce nd provision s the second lesson of helth insurnce: Lesson 2: Integrtion of insurnce nd provision. With medicl cre, unlike other insurnce mrkets, insurers re often directly involved in the provision of the good in ddition to insuring its cost. The integrtion of insurnce nd provision, intended to lign incentives, hs incresed over time. Mnged cre, where the functions re united, is n extreme version. Under it, doctors hve dul loylties, to the insurer s well s to the ptient Equilibrium tretment decisions in mnged cre One cn understnd the impcts of mnged cre using frmework similr in spirit to wht we described for ptient cost shring, only the physicin's choices re trgeted. A typicl physicin pyment, for exmple, is Pyment = R + r Cost. (13) Here, R is the prospective mount nd r is the retrospective mount. A fully cpitted system sets r = nd R >, while fully retrospective system sets R = nd r > 1. Thus, the cpitted system focuses solely on incentives; the retrospective system removes ll risk from the doctor. Chnging to cpitted system might ffect tretment decisions in severl wys. One effect is to rise the physicin's "shdow price" for providing tretment - physicins might require greter expected helth benefit before providing cre under mnged

33 Ch. 11: The Antomy of Helth Insurnce Dollrs 595 Supply P c.,o/- Q*s Price to providers I \ Ptient cost-shring Demnd Q*D Quntity of Tretment Figure 5. Conflict in quntities desired between providers nd ptients. cre thn under trditionl indemnity insurnce [Frnk, Glzer, nd McGuire (1998), Keeler, Crter, nd Newhouse (1998)]. This effect is prticulrly strong when the physicin is cpitted, nd thus bers the mrginl cost for providing dditionl cre. In ddition, mnged cre might hrmonize tretment decisions cross ptients. Protocols in mnged cre, for exmple, encourge or require physicins to tret ptients with the sme condition similrly. In both of these circumstnces, the physicin's views bout optiml tretment my differ from the ptient's. Doctors my wnt to limit cre while ptients my wnt more. This divergence is prticulrly likely if ptients py little t the mrgin for medicl cre, s they do in mny mnged cre plns (t lest for in network services). The conflict of incentives between physicins nd ptients in mnged cre contrsts with the sitution in trditionl indemnity insurnce, where the incentives of ptients nd physicins re generlly ligned (lthough both differ from the incentives of insurers). Figure 5 shows potentil conflict; t the prices ech fces, the ptient demnds much more cre (QD) thn the physicin wnts to provide (Q). 2 9 Which level of cre will ultimtely be provided? Knowing how tretment decisions will be mde in such n environment is difficult, s economic nlysis of rtioned goods in generl does not 29 We hve drwn the physicin's supply curve s upwrd sloping. This needn't be. It could be verticl or bckwrd bending. Our point would crry through, nevertheless.

34 596 D.M. Cutler nd R.J. Zeckhuser rech uniform conclusions. The sitution is prticulrly severe in the medicl cre mrket becuse ptients do not py substntil mounts t the mrgin for medicl cre; thus, willingness to py is not n ccurte wy of guging individul vlue of services. There re severl possible outcomes. One possibility is tht the short-side principle, pplies, which predicts tht the equilibrium quntity will be the lesser of demnd nd supply. This is shown s the thickened line in Figure 5 nd corresponds to sitution where tretment decisions in mnged cre re mde predominntly by physicins. The shortside principle underlies much of the work on mnged cre [see, e.g., Bumgrdner (1991), Rmsey nd Puly (1997), Puly nd Rmsey (1998)]. But the short-side principle ssumes ptient wishes ply no role when demnd exceeds supply. Tretment decisions my come out of "brgining" process tht blnces the wishes of physicins nd ptients [Ellis nd McGuire (1986)]. One cn interpret this brgining either s n explicit process between the prties, or s the physicin blncing his own self-interest (or the insurer's profits) with the best interests of the ptient. The ctul level of service delivered is likely to vry with the prticulr medicl sitution. Ptients with chronic conditions my know gret del bout their tretment options; the outcome my thus be close to the ptient's demnd. In emergency situtions, the opposite my be true. The effectiveness of mnged cre in limiting medicl spending my thus differ cross settings Evidence on supply-side pyment nd medicl tretment A substntil literture exmines the role of supply-side pyment systems in influencing medicl tretments. A chnge from retrospective, or cost-bsed reimbursement, to prospective reimbursement is typiclly nlyzed. Tble 7 presents studies on this topic. It documents the impct of prospective pyment on four spects of hospitl cre: the number of dmissions nd trnsfers; verge length of sty or other inputs; hospitl profits; nd qulity of cre. Prospective pyment might increse or decrese hospitl dmissions. On the one hnd, sick people might be less likely to be dmitted to hospitl under prospective pyment, since reimbursement for these individuls flls short of expected cost. On the other hnd, hospitls might be more eger to dmit helthy ptients, for whom reimbursement exceeds costs. As Tble 7 shows, dmissions generlly declined with the implementtion of prospective pyment. While one might worry bout whether cre for the sick is excessively rtioned in such system, the literture on whether ptients re being "dumped" under prospective pyment (e.g., sent to public hospitls) is not prticulrly cler. A loose consensus is tht there is some dumping of ptients under PPS, but the mgnitude is not prticulrly gret [Morrisey, Slon, nd Vlvon (1988), Newhouse (1989), Newhouse (1996)]. Studies exmining the effect of prospective pyment on verge lengths of hospitl sty nd other inputs find nerly uniformly tht verge hospitl stys fell with the reimbursement chnge. This is wht theory predicts: hospitls no longer pid for ech dditionl service will cut bck on mrginl cre, which is expensive reltive to helth benefits. The effect of prospective pyment on hospitls stys is uniformly strong nd

35 Ch. 11: The Antomy of Helth Insurnce 597 C) C 4) s8 g.2 O CO 2.~."~" ~6C)*1 CO CO~,B z C) CO. C) C) C) ~ E CO o C) 5- Id 2I. Q K ril Q51 4: bs.. :CS_ CO I - C O CO. o C i.cz- 2 _ > t Q ; I e- K t - C I o tl ~.C) -.6. I) ). r) 3< 2.E v. ) ) 1. t-. I ID 8.-. o *t C) 'In e- e o c = S 4. = - o E C '* o 8cS - C CO C Q S )CE r. E O C,;c? 9 CO~ =;: QC o,c I < o P~ r to ON oo. C. E E¼ C)o Q C ) j c < o CO 9.. C oo Ecm 9 oo ZN '-' C - oo N 5 z C 8 u - EN

36 598 D.M. Cutler nd R.J. Zeckhuser oii E.t 9, P o o ( P S.o ạ o ' oo E,. I. Eo o ~ -,c m u O c,- O c M, t~ O S *o -.~ -t 4 E~~~~~' c c c ~~ o "Soo ~ ~ o" o r I E.'.' v l - ~ -1 ; c O; 1.-i -J-- N ~ - ~i ~ bl ~ - P E 2,, B n r-. m E c '4-. (4-7 s: s i :r E - o S5 2 ; : -z F4b, < E c ) P H r t Z ~ &~. vi~~, ~~ ~ ' ' $ < -;i -- ' o c ut_ ~ ~ ~ () ~- 4-c

37 Ch. 11: The Antomy of Helth Insurnce 599 Q I Z CD, -~~ ~ ~? CC~ ~~~e,~ c. ~~ r. d ) P I 'c q, P.,~ o. so ~ C-C 4c w O :I'.-,,,~ 6 P, C-'S C C R 7i I~ Ao: I f - -c g, 2, o r V U C 4, - O.. S!, _ r- : ~ c O EP. - - o E E c- ' o ạ OE o rs E i V, C- 4- C yoc '.k> U m -C Ct, o I =C~ ONCC mr,, -A - 1 C B < Z C- ~,i ''C'i 9 - B- >R ) -~~~~ ~ - Uj > 9 -co CC - os 7) "' E Ol.2 oo = zi to~o I ) c. U ON

38 6 D.M. Cutler nd R.J. Zeckhuser ~ Z -G, ' I *v t- C 1 O Iq ^ - o O'O.6 CC ezco, C-. > CO k lo. 'tcoo I C - ~ 2 o -~ C te io i E CO 6 CO D C) ' D 'e O G " li : -o CD 2 C. ONi NU.~.lo ON~ ~ ' 6 - = - - C o- Z r,.o N~~ :g d c C' C CC C ~, O N t12. om = L ' C-C CC A C -O t=v 'O 4 ' u P. o C. P c -O -O "C~~~~ ~=~ ~ C PO..- m I= u - ' 5 ' C 5C - : S o-c- - ON ON O O EC. 5 o ON COC - O - C C C O" "CO ~ CO -o _ u ON,, F ON n s Ct r. ' ON ' lz. N ~CC -.4, to to ONl ōv C.

39 Ch. 11: The Antomy of Helth Insurnce 61 o ~ oo?~ o~~~~ -S ' n ' 14 2t 4> o 4> I O_ "B i:~~~~~~~~~~~~~~~( 4> g -O -Y O 5 M 5 - c 4,.-I I. N o -. Z3I3 : s: :z..2z ' f I> i E 4 2 5, ~ 8. ~~~~~, di 5-4>, ~ z,.s o ~~~ 8,...- l o,o; 5 bo c.9 = -o ': -)x -n o F-, e m E 4) 4- H -C 4.2 o n _ 8 L(.BP i i to u I 4 4e.=) 4 2 ~c. 4) 4 O ~E~ = o t - o e e $. 8~ so c o It ~, occ t., o --'C.)= o.5! < 8 m =, ' t P, q d i > - 55 I I= d < 'Cu-,t4 o 4> e 9 I ".C q,, N 1ur 3s 2 I8 Ilc " Il-I _ u to, 4> -e " ' -C r7 15 "~, O zz p < o c - 4 ' 4 5 _,- o4 :. 44,- 4~ i 1 o 9._ 8 5- u

40 62 D.M. Cutler nd R.J. Zeckhuser It : C 3,. 8 C U o 2 ;4, C), m - o 2 ~e zti B I = :; E, Q C) R CO 4 ~, 1CO ~ 1 t h PO O C, A o) U P 4- t-co COOr lo. 2, O C CO~ C-, C- C) Or ld I I,-.6 -, C ~Q o rc z r-~. ȯ o t - Q I, U = UD~f o t C5 V) ' O E t. s._ 1 CO C) \ ~-~8 C., Co,,4 < C) 8 m. o -' 2C UOC) IUE, N CO, VO <, O 1) C CO ~g- r~ Ft U C) OC. C) C) ON = c CZ 'P C) m N. C,.) ',,

41 Ch. 11: The Antomy of Helth Insurnce 63 el o Eo S E o "rl E. o E.- reo m O. 5 t e cn. - ;4;, " 8 ri - I o. C- e -.t 2 - r! " 5, toi o s v o 25- m 8N 'o." 7 o ' p r" z " V-: - -e I o " m -d B 9 Z b. P c -9.o. E m O ) C. E1 " - ' 'd~.,4.? e O ) " -"~ r _t i - r ; u!~. " n~~~~~n " +, J 7 O N N C - < O o O O t m ;-o O -bb c.c m 4 - c ~ d., m o s ~8 " Of " CN I- :: _ t m ; ON ON C-v, b5,- 'i i " O - c O 9. ON = -tt CI r.c

42 64 D.M. Cutler nd R.J. Zeckhuser impressive; mny studies find reductions of 2 to 25 percent over period of 5 yers or less. These studies provide mong the clerest evidence tht supply-side reimbursement chnges do ffect medicl tretments. Despite the reduction in verge lengths of hospitl sty, number of studies find tht profit mrgins fell under prospective pyment. This reduction in profits cme lrgely from reduction in revenues. As the reduction in length of sty indictes, costs fell with the introduction of prospective pyment. In ddition to exmining the effect of prospective pyment on qulity, the literture hs lso exmined how mnged cre s whole ffects medicl spending. Studies of this question re summrized elsewhere, including in this Hndbook [Miller nd Luft (1997), Congressionl Budget Office (1992), Glied (2)]; we discuss it only cursorily here. Virtully ll studies find tht mnged cre insurnce reduces medicl spending in comprison to trditionl indemnity insurnce. The consensus estimte would be tht ptients under mnged cre spend bout 1 percent less thn ptients in indemnity plns, djusted for differences in the underlying helth of the two groups. The effect is somewht greter for inptient hospitl spending, but is offset by some dditionl outptient utiliztion in mnged cre insurnce. Overll, therefore, incentives on the physicin side clerly hve n effect on overll utiliztion. 5. Optiml mix of demnd- nd supply-side controls Given the vilbility of both demnd- nd supply-side controls, which should be employed? A first pss suggests tht supply-side limittions re preferble, since providers re reltively less risk verse thn re ptients. In prctice, however, plns with both types of limittions re sold, nd indeed most plns vilble hve mix of demndnd supply-side cost continment fetures (for exmple, cpittion with high cost shring on out-of-network use, or indemnity insurnce with utiliztion review). 3 Both demnd- nd supply-side controls my be desirble in the presence of the other. First, ptients nd providers my control different fetures of the medicl interction. For exmple, the Rnd Helth Insurnce Experiment found tht ptient cost shring hd substntilly greter impct on the probbility tht ptient uses services thn on the level of services provided conditionl on use [Newhouse et l. (1993)]. One cn interpret this s sying tht cost shring ffects insureds, but not their physicins. The evidence cited bove shows tht mnged cre cn limit the level of services provided, however. An insurer or provider fcing this sitution might then wnt to combine demnd- nd supply-side cost shring, the former to limit the initition of visits nd the ltter to control the intensity of tretment provided within visits [M nd McGuire (1997)]. 3 The coexisting prevlence of both types of plns my be trnsitionl, since mnged cre is still reltively new. But mnged cre plns hve incresingly been incorporting more consumer choice nd cost shring (for exmple, in out-of-network use). This suggests the combintion is not just trnsitionl.

43 Ch. 11: The Antomy of Helth Insurnce Dollrs 65 Xx P DX l. I r i ~ I I Q*M Q'M Q Q*s Q's Quntity of Tretment Figure 6. Demnd nd supply side expenditure controls. Combining demnd- nd supply-side controls cn lso promote flexibility in types of tretment. Consider the sitution in Figure 6 [Bumgrdner (1991), Rmsey nd Puly (1997), Puly nd Rmsey (1998)]. There re two types of ptients: those who re modertely ill (denoted M), nd those who re more seriously ill (denoted S). 31 Modertely ill ptients demnd less medicl cre t ny price thn severely ill ptients. We ssume the insurer cnnot distinguish the two groups, however; thus, cost shring or quntity restrictions must pply eqully to the two. Given price of medicl cre P, the optiml mounts of medicl cre to receive re Q4 nd Q* respectively for the modertely nd severely ill. With coinsurnce policy tht requires the ptient to py c for ech unit of cre, the equilibrium will be medicl cre levels of QM nd Q'. Becuse of morl hzrd, medicl cre demnd will be too high. Insurers might lterntely dopt fixed quntity constrint, for exmple Q for ech ptient. 32 At Q, the right mount of medicl cre is provided in totl, but not for ech ptient; the modertely ill ptient will receive too much medicl cre, while the severely ill ptient will not receive enough. Thus, neither demnd- nor supply-side cost continment by itself yields n optiml lloction. 31 Note tht this my pply conditionl on dignosis. For exmple, the conditions could be severe nd moderte hert ttcks. 32 We ssume tht mnged cre fetures this type of restriction.

44 66 D.M. Cutler nd R.J. Zeckhuser Combining demnd- nd supply-side cost continment cn improve the sitution, however. For exmple, strting from Q, rising coinsurnce will discourge utiliztion by the modertely ill person before the severely ill person (becuse the mrginl vlue of cre is much lower for the former). If the coinsurnce rte necessry to deter low vlue utiliztion is smll, the risk spreding loss from such coinsurnce will be smll, nd the net welfre consequences of deterrence will be positive. The bility to limit demnd by the modertely ill person, in turn, llows n increse in Q, since this constrint pplies only to the severely ill person. Indeed, if demnd for the modertely ill person is fully constrined by the cost shring, Q could be incresed to the optiml level of cre for the severely ill person. More generlly, coinsurnce nd constrints cn be combined to enble rtioning in more thn one dimension when there is heterogeneity of optiml tretment. A combintion of the two systems my be superior to using either system lone. A third rtionle for combining demnd- nd supply-side controls is to limit selection behvior by providers. Providers pid on cpitted bsis will hve incentives to ttrct helthy ptients nd "dump" sick ones, since the provider's pyment is the sme with the two ptients but the costs re much greter in treting the sick ptient. Incorporting ptient cost shring into the insurnce policy cn relx the supply-side constrints nd thus limit the incentives to dump ptients [Ellis (1998)]. We return to this type of dverse selection in the next section. Theoreticl results to dte generlly suggest combintion of demnd- nd supplyside controls my offer significnt dvntges. Moreover, with so mny differing incentives in the medicl cre system, optiml reimbursement schemes undoubtedly differ cross specilties (for exmple, in response to morl hzrd propensities) nd groups of providers (for exmple, if the bility to ber risk differs with group size), which increses the potentil for working both sides of the mrket. The wy demnd- nd supply-side systems interct with ech other, however, is not well understood; neither is the trdeoff between fine-tuned system nd system tht is simple nd comprehensible. Rel world structures suggest simplicity hs its virtues. It is noteworthy, for exmple, tht virtully ll coinsurnce opertes t flt rte between the deductible nd ny stop loss mount Mrkets for helth insurnce: pln choice nd dverse selection To this point, we hve tlked of the design of single helth insurnce pln. Most privte insurnce in the United Sttes is offered on menu bsis, however, with different insureds selecting different plns. Helth insurnce choice is nturl wy to meet differing individul preferences. Some people will prefer mnged cre insurnce, which 33 Simplicity nd trnsprency my be hndicp. Conceivbly insureds nd doctors, not understnding wht they will be respectively chrged or pid for something, my behve more resonbly. For exmple, low but complex coinsurnce rte might be the best wy to discourge utiliztion. It imposes less finncil risk thn, sy, higher flt rte, but might be just s effective in controlling use.

45 Ch. 11: TheAntomy of Helth Insurnce 67 limits utiliztion but costs less, while others will opt for more open-ended indemnitystyle policy. Within indemnity insurnce policies, some will be willing to ber more finncil risk thn others. Hving these preferences reflected in mrket outcomes is beneficil. In ddition, helth insurnce choice is importnt to promote efficiency. Customers shopping for the lowest prices drive costs to their lowest level. Moreover, product chrcteristics will be shifted nd new products introduced to meet consumer demnds. These benefits of competition for helth insurnce re nlogous to the benefits competition yields in other mrkets. But helth insurnce is fundmentlly different from other mrkets in wys tht crete hrmful side effects from competition. The key problem is tht with helth insurnce, unlike other services or commodities, the identity of the buyer cn drmticlly ffect costs. Insuring 6 yer old costs 3 times s much s insuring 3 yer old, nd mong 3 yer olds, some will hve fr higher costs thn others. Whom one pools with in helth insurnce drmticlly ffects wht one hs to py. Generlly, the sick re drwn to more generous plns thn the helthy. Those expecting to use more services will, ll else equl, wnt more generous policies thn those expecting to use fewer services. If plns could chrge individuls their expected cost for enrolling in ech pln, the mrket would efficiently sort people. Such chrges re generlly not imposed, however, since it is widely believed tht it is not fir to mke people py lot more just becuse they re sick. Knowing the individul-specific prices my lso not be techniclly fesible. When plns cn only chrge verge prices, generous plns will disproportiontely ttrct sicker people, nd more moderte plns will disproportiontely ttrct helthier ones. This phenomenon is termed dverse selection [Akerlof (197), Arrow (1985)]. As result of dverse selection, generous plns will hve to chrge premiums bove moderte plns not only becuse they offer more benefits but lso becuse they ttrct worse mix of enrollees. These premium differentils, if pssed on to insureds, will tilt unfirly ginst generous plns. 3 4 Adverse selection into more generous plns leds to two fundmentl difficulties. First, people will choose to be in less generous plns, so tht they cn void pying for the higher costs of very sick people. Second, plns will hve incentives to distort their offerings to ttrct the helthy nd repel the sick. Since no pln would like to enroll the sickest people, ll plns will find it profitble to distort their benefits. Indeed, even innovtions tht improve qulity of helth cre my be unttrctive to plns even if they come without dditionl cost, if they ttrct the wrong people. The distortion in pln provisions resulting from dverse selection is vriously termed pln mnipultion, skimping [Ellis (1998)], or stinting [Newhouse (1996)]. 34 This would hppen, for exmple, if employers mke fixed dollr contribution to the premiums of ech pln offered to their employees. The converse is lso true; if employers hevily subsidize the difference between pln costs, employees will choose the generous pln too often.

46 68 D.M. Cutler nd R.J. Zeckhuser Tble 8 Benefits nd costs for HIGH nd LOW risk individuls Generous pln Moderte pln Bsic pln Benefits Costs Benefits Costs Benefits Costs HIGH risk $33 $16 $2 $4 $14. $2.8 LOW risk $6 $4 $5 $1 $3.5 $.7 The consequences of these undesired side effects of competition re felt in mrket equilibrium. The equilibrium with dverse selection my be inefficient; it my not even exist. We express this s the third lesson of helth insurnce: Lesson 3: Competition when consumer identity mtters. When consumer identity ffects costs, competition is mixed blessing. Allowing individuls to choose mong competing helth insurnce plns cn llocte people to pproprite plns nd provide incentives for efficient provision. But it cn lso bring with it dverse selection - the tendency of the sick to differentilly choose the most generous plns. Adverse selection induces people to enroll in less generous plns, so they cn be in helthier pool, nd gives plns incentives to distort their offerings to be less generous with cre for the sick. Mny models of dverse selection hve been developed. We strt with simple models nd then present more dvnced models Equilibrium with dverse selection - the bsics To understnd the ptterns in dverse selection, we strt with the simplest possible sitution [Rothschild nd Stiglitz (1976), Wilson (198)]. Assume there re two individuls, one HIGH risk nd one LOW risk, nd two plns, generous pln nd moderte pln. Tble 8 gives the hypotheticl benefits nd costs for the generous nd moderte plns. We suppose tht the generous nd moderte plns re wht HIGH nd LOW respectively would design for themselves, ssuming tht ech hd to py his own costs. 3 5 Note tht HIGH costs more in either pln nd both people use more services in the generous pln thn in the moderte pln. Equilibrium. Efficiency requires people to be in the generous pln if the dditionl benefits of tht pln to them re greter thn the dditionl costs they incur. In this cse HIGH should be in the generous pln, nd LOW should be in the moderte pln, since the dditionl vlue to HIGH of the generous pln ($13) reltive to the moderte pln is greter thn its dditionl cost ($12), while the converse is true for LOW ( benefit 35 This ssumption of respective optimlity fcilittes exposition, but is not required.

47 Ch. 11: The Antomy of Helth Insurnce 69 of $1 compred to n dditionl cost of $3). The efficient outcome thus seprtes the insureds. Were seprtion to hppen, the premiums would be $16 for the generous pln (the cost of HIGH) nd $1 for the moderte pln (the cost of LOW). At these prices, however, HIGH would select the moderte pln; the $15 svings re greter thn the $13 loss. Of course, once HIGH joins the moderte pln costs esclte, but they re still only $2.5 (the verge of 4 nd 1). HIGH's cost svings by enrolling in the moderte pln ($13.5) re still greter thn his loss in benefits ($13). LOW will lso prefer the moderte pln. The mrket equilibrium will thus hve both individuls in the moderte pln, pooling equilibrium. This is not efficient, however. The reson this inefficiency rises is tht individuls do not py their own costs in ech pln, but rther the verge cost of the pln. Hence, HIGH mimics LOW so tht he cn shre his costs with LOW. There re vriety of wys to struggle bck towrds efficiency. Two logicl cndidtes, ssigning people to plns or chrging people on the bsis of expected cost, re undesirble becuse they respectively override free choice or scrifice risk spreding. 3 6 Two dditionl possibilities would be to cross-subsidize the generous pln by the moderte pln [Cve (1985)], or to distort the pln offerings [Rothschild nd Stiglitz (1976)]. Cross-subsidy. Suppose the moderte pln is txed n dditionl $1.25 per cpit, which is used to offset the premium of the generous pln. In the seprting equilibrium, the premiums in the two plns will be $14.75 nd $2.25, nd HIGH will now prefer the generous to the moderte pln. Both insureds re better off with the subsidy thn without. HIGH clerly prefers subsidy to no subsidy. LOW lso prefers the subsidy, becuse he pys only $1.25 subsidy, compred to n dditionl $1.5 premium if he pooled with HIGH in the moderte pln. Pln mnipultion. A second mechnism to induce seprting equilibrium is to replce the moderte pln with something stingier. When fced with stingier pln, HIGH might choose the generous pln over pooling with LOW. Mking the moderte pln stingier is diststeful to LOW, but the cost to HIGH is substntilly greter. This disprity in costs is wht llows "hurting" the pln to produce seprtion. Consider pln clled bsic, lso detiled in Tble 8, which gives both HIGH nd LOW 7 percent of the benefits nd costs they would receive from the moderte pln. Thus, LOW would receive benefits of $3.5 t cost of $.7 were he in the bsic pln nd HIGH would receive benefits of $14, incurring cost of $2.8. If bsic nd generous were the two plns offered, LOW would select the bsic pln. If HIGH selects the bsic pln s well, his premium, i.e., verge cost, would be $1.75. He'd prefer the generous pln, which offers n dditionl $19 in benefits, but would cost only $14.25 more. LOW 36 Prtil mesures re possible. For exmple, mny employers "crve out" mentl helth benefits from ll plns nd provide those services using one insurer. Adverse selection is one rtionle for this [Frnk, McGuire, nd Newhouse (1995)].

48 61 D.M. Cutler nd R.J. Zeckhuser prefers the bsic pln to pooling with HIGH in the moderte pln. Pln mnipultion scrifices efficiency, since LOW genertes more net benefits in the moderte pln. In prctice, pln mnipultion cn tke mny forms. Aerobics progrms, for exmple, will ttrct the vigorous helthy while spinl cord injury or high-tech cncer cre fcilities pull in the costly sick. There re generlly more opportunities to trim high cost-ttrcting service thn to dd erobics equivlents. 3 7 Thus, we expect plns to be ungenerous with services for conditions tht will predictbly hve high costs. Mrket competition will led to the mnipulted equilibrium. Assume tht the moderte nd generous plns were the only offerings. All prticipnts would pool in moderte. Introducing the bsic pln would then ttrct LOW, HIGH would go off to generous, nd the moderte pln would be bndoned. 3 8 In prctice, pln mnipultion nd cross-subsidy of premiums cn be combined to promote seprtion. The mrket equilibrium will hve two plns. One will be the optiml pln for HIGH, given whtever subsidy he is receiving. The other pln, which will enroll LOW, will be the pln s close s possible to moderte whose combintion of subsidy nd mnipultion just mkes HIGH prefer his optiml pln. We show this grphiclly in Figure 7(), ssuming there is continuous choice of plns. 39 We rry the plns in Figure 7() from lest to most generous - in this cse vribility mong plns is due to differences in the percent of expenses covered. The figure shows the expected utility of LOW (the upper two lines) nd HIGH (the lower two lines) t ech possible level of generosity, nd for both the pooling nd seprting equilibri. LOW does better thn HIGH, since he hs lesser chnce of incurring the cost of sickness. HIGH is better off pooling thn seprting for it llows him to shed costs; the opposite is true for LOW. For both LOW nd HIGH, their optiml seprting equilibrium offers less thn full insurnce. This might be becuse of morl hzrd or dministrtive costs; without these fctors ech in isoltion would wnt the most generous policy. We show HIGH s wnting full insurnce in the pooled equilibrium; in our exmple, the benefits from the subsidy in tht pln re greter thn the morl hzrd or dministrtive cost loss. In the lest generous pln (no insurnce), both HIGH nd LOW re indifferent between pooling nd seprting equilibri. In the most generous pln (full insurnce) the two py the sme price nd get the sme utility in the pooling equilibrium. Consider the sitution if HIGH nd LOW re initilly t A, the full insurnce pooling equilibrium. An insurer tht offered pln with generosity Gi would ttrct LOW, 37 However, the Hrvrd University Group Helth Pln - n option for Hrvrd fculty - offers $5 wellness pyment, which cn be used sy for snekers, s n ttrctor. 38 The efficiency costs of seprtion produced through pln mnipultion my be smll. Tht is becuse the moderte pln ws designed for LOW. Assuming smoothness, the costs of moving wy from the optiml pln re initilly trivil. But the costs to HIGH, who is lredy fr from his optimum, my be gret. This disprity llows chep distortion to produce trget efficiency [Nichols nd Zeckhuser (1982)]. 39 The clssic digrmmtic presenttion of pln mnipultion (dting from Rothschild nd Stiglitz) uses indifference curves. We present this in the Appendix.

49 Ch. 11: The Antomy of Helth Insurnce Expected Utility 611 () Expected Utility Generosity of Pln (Percent of Expenses Covered) (b) Generosity of Pln (Percent of Expenses Covered) Figure 7. Reduction in insurnce to seprte HIGH nd LOW. () Stble seprting equilibrium. (b) Unstble seprting nd pooling equilibri. since LOW prefers G 1 to A. HIGH would then move to G 1, becuse E is preferred to C, the seprting equilibrium if only HIGH is in the generous pln. As the pooled policy becomes less generous, its ttrctiveness to HIGH flls. Policy G 2 mkes HIGH just indifferent between pooling with LOW nd the seprting equilibrium t C. The

50 612 D.M. Cutler nd R.J. Zeckhuser stble equilibrium will thus hve two policies: LOW will be t point L with policy G2 nd HIGH will be t point C. With slight chnges in the curves, however, the sitution t G 2 my not be stble either. Consider the sitution in Figure 7(b), drwn for the cse where the risk difference between HIGH nd LOW is less thn in Figure 7(). Here LOW's preferred pooling equilibrium is superior to his best sustinble seprting pln, SL. Thus, the seprting equilibrium t G 2 will be broken by the pooling equilibrium t G 1. But the converse is lso true; the pooling equilibrium t G 1 is broken by pln sy t G 3, with price just low enough to ttrct LOW t F, wheres HIGH would prefer to stick with the premium nd coverge t E. Once LOW went to F, however, the premium t E would hve to rise, nd HIGH would chse LOW to G 3. Thus, there is no stble equilibrium in Figure 7(b). The model underlying Figure 7 ssumes frictionless world, where individuls shuttle costlessly between plns nd there re no costs involved in estblishing new plns. If such costs ply role, they my enble otherwise brekble equilibri to survive. For exmple, if estblishing pln entils high fixed costs, but individuls' trnsit costs remin low, p* becomes stble, since breking pl with G 3 is costly but yields only temporry profits. Interestingly, greter trnsit costs for individuls my promote instbility, since temporry period for ttrcting individuls to n unstble equilibrium my lst longer, nd therefore be more ttrctive despite the fixed costs of estblishing pln. Even in this simple model, the ultimte outcome of mrkets with dverse selection is uncertin Equilibri with multiple individuls in risk group The simple model of dverse selection hd single HIGH nd LOW risk. The lumpiness of movement implied by this specifiction is n importnt limittion of the model. With multiple individuls of given risk type, there cn lso be third clss of equilibri, "hybrid" equilibrium, to join the pooling nd seprting equilibri. We now show this equilibrium. Imgine tht there re now mny HIGHs nd LOWs, with similr tstes for insurnce within ech group. 4 Our exmple uses the prmeter vlues from Tble 8, with the $33 benefit for HIGH under the generous pln chnged to $34. Suppose we strt in the seprting equilibrium, with HIGHs in the generous pln nd LOWs in the bsic pln. The expected utility in this equilibrium is shown by the points A nd B in Figure 8. Recll tht the LOWs ll prefer the moderte pln to the bsic pln. Imgine tht they ll enroll in tht pln. Now suppose tht insted of ll the HIGHs choosing the moderte pln, only shre of them choose it. Figure 8 trces expected utility for HIGHs nd 4 A more generl formultion would llow individuls within cost clss to differ on such fctors s risk version, or in tstes for plns. Then the division of HIGHs between the moderte nd generous plns would reflect the individuls' preferences.

51 Ch. 11: The Antomy of Helth Insurnce Net Benefits of Insurnce (Dollrs) 613 $19. $1 8. HIGHs in moderte pln E HIGHs in generous pln _ B $4. $2.8 LOWs in moderte pln A D C LOWs in bsic pln % H* (5%) 1% Shre of HIGHs in moderte pln Figure 8. Hybrid equilibri with dverse selection. Note: Dshed lines ssume ll LOWs choose the moderte pln. The figure uses the vlues in Tble 9, ssuming the benefits to the HIGH risks in the generous pln is $34 insted of $33. LOWs s greter shre of the HIGHs choose the moderte pln. Once H* of the HIGHs hve enrolled in the moderte pln - the number is 5 percent for our prmeters - HIGHs will be indifferent between the two plns. No dditionl movement of HIGHs will occur. The LOWs in the moderte pln re worse off pooling with some of the HIGHs thn they would be if they hd the moderte pln to themselves. But tht does not indicte whether the LOWs prefer to seprte themselves in bsic. Indeed, in Figure 8, expected utility for the LOWs given shre H* of HIGHs in the moderte pln (point D) is greter thn expected utility in the bsic pln (point C). The equilibrium with ll of the LOWs 4 1 nd shre H* of the HIGHs in the moderte pln - wht we term the "hybrid equilibrium" - is stble. The hybrid equilibrium need not be stble, however. If the HIGHs re sufficiently costly, the LOWs will prefer the seprting equilibrium to the hybrid equilibrium (point C will be bove point D) nd thus the two groups would seprte completely. 41 The LOWs will never end up split between the bsic nd moderte pln. Sy the bsic nd moderte plns were eqully ttrctive with frction of the LOWs in the moderte pln. As more LOWs moved to the moderte pln it would become more ttrctive. Hence, the equilibrium would tip ll the LOWs into the moderte pln.

52 614 D. M. Cutler nd R. J. Zeckhuser A Dltth\ 7(S) P(s) p P" (s) SFigure 9. Enrollment consequences of dverse selection. Figure 9. Enrollment consequences of dverse selection Continuous risk groups Our two-risk-types model suggests tht t lest some high risks will enroll in their most preferred pln while low risks my be distorted into less generous plns. In situtions with more thn two risk groups, however, this sitution my be reversed; the low risks my be in their preferred plns but the high risks my not. We show this using model developed by Feldmn nd Dowd (1991), Cutler nd Reber (1998), nd Cutler nd Zeckhuser (1998). The model ssumes there re two pre-estblished pln types. Suppose there is continuous distribution of risks in the popultion, denoted by s. For simplicity, we normlize s to be the person's expected spending in the generous policy. There re two plns, one generous nd one moderte. The vlue of more generous insurnce to n individul is V(s), where V' > (the sick vlue generous policies more thn the helthy). Figure 9 shows V(s). At ny dditionl cost for choosing the more generous policy, people will strictly divide into plns. If s* is the sickness level of the person indifferent between the two policies, people with s > s* will choose the generous policy, wheres people with s < s* will choose the moderte policy. Averge sickness in the generous policy is SG = E[s s > s*], nd verge sickness in the moderte policy, is SM = E[s s < s*]. Pln premiums, in turn, depend on who enrolls. We ssume people in the moderte policy cost frction ( < 1) of wht they would cost in the generous policy. 4 2 In competitive insurnce mrket, premiums will equl costs: PG = SG, nd PM = SM. The premium difference between the two plns is therefore: AP(s) = PG - PM = (1 - )SM + [SG - SM]. (14) 42 The literture reviewed bove suggests tht r e.9 for n HMO reltive to n indemnity policy.

53 Ch. 11: The Antomy of Helth Insurnce 615 The first term in the finl expression is the cost svings the moderte pln offers to its verge enrollee. The second term is the difference in the verge sickness level in the two plns; it is the consequence of dverse selection. As mrginl people move from the generous to the moderte pln, the verge sickness in ech of the plns will rise. Depending on the distribution of s, the price difference between plns my widen or nrrow. Becuse medicl spending in prctice is significntly right-skewed (Tble 2), it is nturl to conjecture tht the premium in the generous pln will rise by more thn the premium in the moderte pln. Figure 9 reflects this expecttion s n upwrd sloping AP(s) curve. The guideline for efficiency is tht the price differentil must be pproprite for the individul t the mrgin in choosing between plns. All other people would be pproprite sorted, with sicker people choosing the generous pln nd helthier people choosing the moderte pln. 4 3 The price for the mrginl individul is given by: Apmrnrg() = (1 - )s, (15) where s is the person for whom Eqution (15) holds. We show this schedule in Figure 9 s lying below the AP(s) line. optimlly delinetes people in the moderte nd generous plns. Compring Equtions (14) nd (15) shows tht only by coincidence will the equilibrium be efficient. Suppose tht the efficient lloction previled. From Eqution (14), the price difference between the two policies will differ from this mount for two resons. The first term in Eqution (14) is generlly below the efficient differentil; it represents the svings from the moderte pln for the verge person in the moderte pln, not the mrginl person in the pln, for whom the svings would be greter. Working in the opposite direction, dverse selection (the second term in Eqution (14)) will rise the premium in the generous pln reltive to the premium in the moderte pln. Depending on the distribution of medicl expenditures, the mrket differentil could thus be bove or below the efficient level. The right skewness of medicl spending suggests tht the dverse selection effect will tend to predominte. This is the sitution shown in Figure 9 (by virtue of the fct tht the AP(s) line is bove the Apmrg(s) line). The premium differentil for the generous pln will then be bove the efficient differentil, nd too few people will enroll in the generous pln. Becuse of dverse selection, smll devitions in price cn drive lrge differences in lloctions, nd indeed, the generous pln my fil to survive. Strting from, suppose the generous pln is priced too high. Mrginl enrollees will deprt, driving prices up still further, inducing new deprtures, nd so on. The finl equilibrium my be quite fr from the efficient point. Indeed, Figure 9 lso shows the possibility tht the entire generous pln is depopulted. If APlt(s) described the cost differentil, then V(s) would not 43 If preferences s well s sickness level ffect the vlue of the generous pln, then ech individul must py his personl cost differentil, AP' (s) = (1 - )s i.

54 616 D.M. Cutler nd R.J. Zeckhuser intersect tht line nd the equilibrium would hve no enrollment in the generous pln. 44 The disppernce of generous plns s result of dynmic processes of dverse selection is termed "deth spirl". In such sitution, high risks end up in less generous plns thn is optiml, while low risks get their preferred policy Evidence on the importnce of bised enrollment A substntil literture hs exmined dverse selection in insurnce mrkets. Tble 9 summrizes this literture, breking selection into three ctegories: trditionl insurnce versus mnged cre; overll levels of insurnce coverge; nd high versus low option coverge. Most empiricl work on dverse selection involves dt from employers who llow choices of different helth insurnce plns of vrying generosity; minority of studies look t the Medicre mrket, where choices re lso given. Within these contexts, dverse selection cn be quntified in vriety of fshions. Some uthors report the difference in premiums or clims generted by dverse selection fter controlling for other relevnt fctors [for exmple, Price nd Mys (1985), Brown et l. (1993)]. Other ppers exmine the likelihood of enrollment in generous pln conditionl on expected helth sttus [for exmple, Cutler nd Reber (1998)]. A third group mesure the predominnce of known risk fctors mong enrollees of more generous helth plns compred to those in less generous plns [for exmple, Ellis (1989)]. Regrdless of the exct mesurement strtegy, however, the dt nerly uniformly suggest tht dverse selection is quntittively lrge. Adverse selection is present in the choice between fee-for-service nd mnged cre plns (8 out of 12 studies, with 2 findings of fvorble selection nd 3 studies mbiguous), in the choice between being insured nd being uninsured (3 out of 4 studies, with 1 mbiguous finding), nd in the choice between high-option nd low-option plns within given type (14 out of 14 studies). Figure 1 shows prticulrly slient exmple of dverse selection, tken from experience t Hrvrd University. 45 The Hrvrd experience is nice becuse dverse selection ws driven by policy chnge, nd thus one cn view the beginning of dverse 44 Whether deth spirl ctully occurs will depend on the distribution of risk levels, nd the strength of the risk-preference interction. The ftter the upper til, the stronger the interction, the more thretening is the possibility of spirl. A numericl exmple illustrtes this possibility. Suppose tht the highest cost person hs expected spending of $5, nd tht the verge costs of the whole popultion in the moderte policy (with or without this person, if he comprises smll prt of the totl risk) is $3,. Suppose further tht the high cost person vlues the generous policy t $2, more thn the moderte policy, nd tht he spends only $5, less in the moderte policy thn with the generous policy (for exmple, 1 percent svings if the plns re n indemnity policy nd n HMO). Efficiency demnds tht he should be in the generous policy; the dditionl vlue of tht policy ($2,) is greter thn the dditionl cost he imposes there ($5,). If the high cost person were the only person in the generous policy, however, the cost of tht policy would be $47, more thn the cost of the moderte policy, which would led him to opt for the moderte policy. 45 See Cutler nd Reber (1998) nd Cutler nd Zeckhuser (1998).

55 Ch. 11: The Antomy of Helth Insurnce 617 P o C) z rcc) 2 o.s1 5 C- P CC C) ~ CC C) C). C)...C M. E -~ C ' e C. C :f. 5 r C- C) CC CC.. C) 8 " DP i 8 E < C) CO C) C C)C= G C C. A m ~oo u9 8 e C.CCC -U. ge 5 _ C) o. e : =., Ce C) m. Co).C C P 'C.. r- 1111Y icc I c x C) C o g CC.~ 4 F o. 2~~ ~ E 8 3 -, C -B i ' CC C._,, vc D5 cs, i ~ -". C C ) C -CC-.. + C ; 5 5 Pe) = o ~b CC< E~8 = ou C- C) E c g C) C C C -~ o. E C) o C C 3 OO C.) ). _ P. o -O C) EC cr E o 5.W U u o C C) I C) E C) CE I.2 =.M z' C; RCC 5 C -CZ~. CC C).E C- 'b C -. -Sg E CC - CCO -E C) CC EC 5C CC C ) C C -x C- C- ~ 4 r/ 1CC O ' ~ N )..C - CdC CC ~. \4 'N C) ~~~~ -p, ~ - CC t- e ".. C)... ~ C ) C - C ) O ~~~~~~~~~~~~~~~~~~~~~~~~C B C C C -B O C C.C C. C - C,_e o >-) = C 4 -..~. A. C. "I Z! Z! -Zz oz 'z: icc C)- Cn 91L U,x, r5 o V n C) CO. * 5 b C C 8 to ' w c : C)'-o

56 618 D.M. Cutler nd R.J Zeckhuser r.2 =~~~~ > >E ~ > u ~~ ~ ~~~~~~~~~~~ r- ~9 " o r-, Ee C, h5 ~~ yi f) E1 42'~~~~~~~~~2 Q --,- i : ie E m ~~ 8~~ 8 _. Z I~ m ~ ~ ~ oo~ '"~~~- $ 2-7 FS o C- l c O U > -~~~~~~~~~~ ~~~~~~~U o ~ 8 ~~~~~~~~~8 ~~~~~~1 M U U o l Q cl, t 8.. ru > ~ c ~ "e U~~~~~ o c.z N~. ~ E N E ~~~~~~~ - - d ~~. 1 ~~b u~~~~~' 8 <.t 8

57 Ch. 11: The Antomy of Helth Insurnce 619,Z:: uc) C B n = m.i P = to CO- CO COS CO C O O M m I B~~~~~~~~~~~~~~C so. s d. " o '. o.~ -~e " 8"ICCO. *=P~C)C COO.C C )o O ) CC)C o to 4 I<EC)~p C).. CO I CO.' C)CO." C) C "OC) CO-4-..o5~ COOCO3 4-Soo >l ~9. ~, S't5~S~ E ~5C CC COCOCO 5s~ ' 'CO. - C)4 4,r COO5oC. "~~i.c 3 E.''" o ) o C C) 'O - -O I- C) ~ Co ON C)i o M =S.S tu ' 14. O e -. - C3 Ac - C on 'oc 4.- C C). 'C 'O CO O P->.. S o~ C); Q 5 4-' o 5 C) 3 " e- OC Sj CO 4 "C O.2. C O. 5.5E 4-~ Ic o~ COi C). Cfl OC o nc O 4,, t o C C - c: m C Z C.>CO.,. CIO " lg~~~~~~~~f 4- COC C S S9C 5 " c. 4- _o 4 - s C, C n c c" m~t C ) o ~ c -6i c lr,,~~~~~e 4~ Cr O ' o. S.C % B,~~~ O -: l OE Cs'C 2 R " og CO Y_ O S >H Y O. O CO ) ' l C.5.t 3 CO P.C _ Q

58 62 D.M. Cutler nd R.J. Zeckhuser C ' E) C) C) C) C) t > d - ' C) Cv > > > t - - C)~~~~~~1 I ~.., O, C C).. ti, ~; $ ~e ~ '.t z ~ C) C A C~ C ) $ C d od ",-).3~~~~~~~~~~~~~~~~~ C C~ ~,, C5-C, C " ~ ~, 5 t 42F~ : 3, 5 - C ) C, C C - S M 4- - C)~~~~4 C,~ C ) ~ --, ~ g" g C)m5C C)C-8t CC) C, r,' E:~~ 5C, Pw, ~C n~ I C C), 5C) - C), U,. C) O\ C -5 H - U S 4 -c - 5 C C C) C )la 'C, C ) - 3 Cr i 32 C C) B, C, C) ~ 42 C), p.v - 4--s U o - oc.5 It, SC g 'ii Pz r C)I C >o C) C) C, o C 3 C 4 C C ", 5 D C C CC)C) 4-- C -C c C C, t H i;. -C) -) r. ~Z U, ) C1t 4 oo g on Z- r- r C r _5 W co

59 ..~ Ch. 11: TheAntomyofHelthInsurnce 621 C C C " " ~ " o s. E o o. C o 8 E - -; S G ~ ~ o C -C t to U ) C e to C >C 5 C" C - C. > is E " C to -fp.c C C C C i C~ CC O C " z uc.u C C S C fl... CC, o C Co S o(i C, >c t-~ t CC C C w CP C c3 C 5 CC 5" E c" E 2 'So 5 C Ce C C c c - o " e, ~ C o C t C~~~ 5 CC C C CO ~ 5 C C to c- C. C O C O S. ). = C C Oc t C. -" " c.. 5 CE C E = U zc" Q > ~ ~ ~ ~ ~ " "C >~ cc- ~ c e C P. ~ ~ ~ ~ ~ -

60 622 D.M. Cutler nd R.J. Zeckhuser 9$3, sn"" $2,5 e$2, e--- lollment _ r\ix\e / 2% I l 1% ~~------~~~~~~~~... xl r 5% Yer () PPO Enrollment nd Employee Chrge $9.9 $7,9 7, I t S6,5 E A ~/. $6. $5,5 $5, ;i _ i I J _I J Yer (b) Totl Premium for PPO nd HMOs I Figure 1. Adverse selection t Hrvrd University. Note: Dollr figures re for fmily policy. Source: Cutter nd Reber (1998).

61 Ch. 11: The Antomy of Helth Insurnce 623 selection nd its subsequent effects. In the erly 199s, Hrvrd University offered its employees two types of helth insurnce plns: generous PPO nd number of HMOs. The University pid bout 9 percent of ech pln's premium; thus, the employee cost of the PPO, shown in Figure 1(), ws reltively modest $5 per yer. To trim costs, Hrvrd in 1995 moved to more competitive helth insurnce system. Under the new system, the University pegged its contribution t fixed percentge of the lowest cost pln. Employees pid the entire mount bove this for the pln of their choice. The hope ws tht competition mong plns would drive down premiums nd thus sve the University money. When the new system ws introduced, the cost of the PPO rose, nd PPO enrollment fell. As Figure 1() shows, bout one-qurter of PPO enrollees left the pln between 1994 nd These enrollees were disproportiontely the younger nd helthier employees in the PPO, however. As result of the bised disenrollment, the PPO lost money in 1995; in 1996, it hd to rise its premium by nerly $1,. This led to further decline in PPO enrollment; over hlf the remining PPO enrollees left the pln fter Agin, these employees were disproportiontely younger nd helthier thn those tht remined in the PPO. Thus, the PPO premium lost money gin in 1997 nd would hve hd to increse premiums substntilly in 1998, just to prevent losses. In fct, the required premium increse would hve been too lrge for the insurer nd Hrvrd to ber. The PPO ws disbnded before tht yer. Adverse selection thus produced deth spirl, nd did so very quickly. The disppernce of the PPO is welfre loss to employees who would hve chosen it t their individul-specific cost. Cutler nd Reber estimte the size of the welfre loss t 2 to 4 percent of bseline premiums. The importnce of dverse selection hs hd direct impcts on policy. For exmple, Brown et l. (1993) found tht Medicre enrollees who enroll in mnged cre pln would hve spent 1 percent below verge if they hd been in the trditionl system. Since Medicre pid only 5 percent less to mnged cre compnies for enrolling these people, Medicre lost money s HMO enrollment incresed. In 1997, Federl legisltion reduced pyments to HMOs by n dditionl 5 percent, to void these continuing losses Evidence on the importnce of pln mnipultion There re substntilly fewer empiricl studies on pln mnipultion thn on dverse selection. Plns, of course, differ gretly in their generosity. But it is difficult to know, nd plns do not wnt to revel, the extent to which the observed vrition in pln benefits reflects mnipultion by the plns to ttrct helthy risks s opposed to the selfinterested choice of insurnce rrngements mong people lredy enrolled in the plns. Adverse selection side, plns with sicker enrollees probbly should be more generous. Though evidence on pln structures is mbiguous, the mrketing of mnged cre plns shows cler efforts to promote fvorble selection. Mibch et l. (1998) document the mrketing prctices mnged cre plns use to ttrct helthy Medicre enrollees, including television ds tht show seniors engged in physicl nd socil c-

62 624 D.M. Cutler nd R.J. Zeckhuser tivities nd mrketing seminrs held in buildings tht were not wheelchir ccessible. Whether such prctices extend to the types of benefits these plns offer is unknown The trdeoff between competition nd selection In weighting the consequences of competition, losses from dverse selection must be blnced ginst the gins, if ny, from lower premiums tht competition induces. The Hrvrd University study discussed bove [Cutler nd Reber (1998)] shows such trdeoff. As Figure 1(b) demonstrtes, premiums for the HMOs fell by over $1, when the University moved to flt-rte pricing. The svings to Hrvrd from these lower premiums ws estimted t 5 to 8 percent of bseline helth spending. This cost svings is greter thn the 2 to 4 percent loss from dverse selection noted bove. Thus, the net effect of competition in the Hrvrd circumstnce ppers to be beneficil, lthough the dverse selection losses were quite lrge. With few exceptions [Wholey et l. (1995), Feldmn nd Dowd (1993), Bker nd Corts (1995)], few studies hve exmined how competition ffects helth insurnce premiums. It is often difficult to gther dt on premiums, since most insurers chrge different groups different mounts. In ddition, premiums need to be djusted for differences in the qulity of benefits, but the mny dimensions of qulity re very difficult to control for. Thus, the trdeoff between cost svings nd dverse selection in other situtions is generlly unknown Risk djustment The fundmentl question bout helth insurnce design is how to chieve the benefits of competition while contining the costs of dverse selection. A nturl solution is suggested by the model bove. Suppose tht individuls were not chrged the full difference in premiums between plns, but tht insted the employer or government entirely running the insurnce system offset some of the difference. For exmple, if the generous pln hs bove verge risks in the mount E[sls > s*] - E[s], the government would give the pln per cpit subsidy equl to this mount. The subsidy would be finnced by tx on the moderte pln, which hs below verge risks, by the mount E[s Is < s*] - E[s]. The contribution from the plns wouldjust mtch, 46 so there would be no net cost to the government. In competitive mrket, plns tht receive subsidies (or re forced to py txes) would pss these subsidies on to consumers. Therefore, the premium for the generous pln would fll to PG = sg - subsidyg = E[s], nd the premium for the moderte pln would rise to PM = sm + txm = E[s] - (1 - )SM. The djusted premium difference between the plns, which individuls would fce, would thus be APdj - PM)s. = (PG - (16) 46 This is becuse, tking expecttions, (E[sls > s*] + E[sls < s*])/2 = E[s].

63 Ch. 11: TheAntomy of Helth Insurnce 625 This quntity is the svings for the verge person in the moderte pln. It is closely relted to the optiml price difference in Eqution (15), which is the svings for the mrginl person in the moderte pln. Pln choices mde on the bsis of the price difference in Eqution (16), though not optiml, re likely to be more efficient thn pln choices mde on the bsis of undjusted price differences. This form of differentil pyment is termed "risk djustment" [Vn de Ven nd Ellis (2)]. Risk djustment must be crried out by some entity tht cn require individuls to insure or convince them to do so through subsidies. Otherwise, low cost individuls would choose not to prticipte. One possibility would be for the government to impose risk djustment, whoever is the pyer. But employers providing subsidized helth insurnce cn do the job just s well. Employers hve n incentive to risk djust since it promotes efficiency nd thus lowers the overll cost of providing helth coverge. 4 7 Empiriclly, risk djustment cn be crried out in four wys. Plns cn py or receive pyments bsed on: (1) demogrphic vribles (for exmple, more for tking on older people); (2) medicl conditions (for exmple, more for people with dibetes); (3) pst medicl expenditures, which help predict future expenditures; or (4) ctul experience in yer (for exmple, $5, extr for ech orgn trnsplnt ptient). The first three pproches ttempt to predict experience; the lst is fter-the-fct reinsurnce. The trdeoffs between these different forms of risk djustment re relted to the bility of helth plns to mnipulte the risk djustment system. Informtion bout dignosis, pst clims, nd ctul use increse the bility to mesure differentil enrollment, but re susceptible to distortion by the plns. For exmple, plns my code borderline people s hving dibetes if risk djustment is done on the bsis of the number of dibetics. Plns might cretively ssign costs to high cost cses, when such cses re lrgely reimbursed. Even if risk djustment is done on prospective bsis, plns hve n incentive to exggerte current sickness nd expenditure levels, since the vst mjority of insureds stick with their plns from yer to yer. A finl, t lest theoreticl, concern bout risk djustment is tht it my diminish plns' incentives to mintin their enrollees' helth. Keeping people helthy disqulifies the pln from receiving dditionl risk djustment pyments, thus reducing the vlue of the helth investment. Becuse so few employers or governments hve used forml risk djustment systems, the reltive dvntges nd drwbcks of different risk djustment methodologies re unknown. New efforts my provide some of this informtion, however. In Jnury 1999, in mjor inititive, the federl government nnounced its intention to employ risk djustment on the bsis of pst dignoses to py HMOs tht enroll individuls in Medicre. Evluting the impct of this system is mjor reserch priority. 47 Some employers hve mde second-best efforts to implement risk djustment, t times indvertently. The hevy subsidy of premiums - mny employers py 85 percent or more - in effect covers 85 percent of cost differentils due to vrying mixes of insureds. Als, hevy subsidies lso significntly diminish the incentives of insureds to shop round, hence of helth plns to hold down their costs.

64 626 D.M. Cutler nd R.J. Zeckhuser 7. Person-specific pricing, contrct length, nd premium uncertinty Adverse selection is problem of symmetric informtion - individuls know their likely medicl cre utiliztion but insurers either do not, or re not llowed to use this informtion. Incresingly, however, informtion is becoming equlized. Insurers question individuls or monitor their pst utiliztion to forecst their future costs. Equipped with such knowledge, insurers my know more bout expected costs for the groups they re insuring thn the members of the groups do themselves. Insurers cn use this informtion to set premiums. While such "experience rting" is rre t the individul level, it is common t the group level. Most privte helth insurnce in the United Sttes is t lest prtly experience rted. The bigger the group purchsing insurnce, the more likely is experience rting. Hence, older nd sicker groups re chrged more per cpit for the sme coverge. But experience rting cretes its own set of problems, prticulrly when crried out t the individul level. When people fce premiums tht depend on their sickness, they re denied form of insurnce - the bility to obtin the sme insurnce premiums s their peers t the sme price. The welfre loss cn be significnt. Consider, for exmple, sitution where individuls re insuring themselves, dibetes is the only disese, nd both people nd plns know who is dibetic. Plns would offer full insurnce to everyone but would chrge dibetics more thn non-dibetics; fter ll, no one who is not dibetic would be willing to py extr to insure the dibetics. Given the distribution of dibetics nd non-dibetics, the higher premiums chrged to dibetics crete distributionl issue. Dibetics py more, nd non-dibetics py less reltive to level premiums. But from n ex nte perspective, before nyone knows who will contrct dibetes, the distributionl issue represents n efficiency loss. Suppose tht before n individul knew if she would be dibetic or not - potentilly before birth - she ws offered insurnce ginst the risk tht she would become dibetic nd thus fce higher insurnce premiums in the future. Full insurnce would gurntee tht if she developed dibetes, the policy would give her sufficient income ech yer to cover the higher dibetes premium she would then fce. The benefits would be finnced by pyments from non-dibetics. Individuls would be willing to purchse this insurnce were it sold t fir odds; they get reduction in finncil risk t no expected cost. In rel-world mrkets, however, such insurnce ginst flling into worse risk clss is not offered. Some of the insurnce would hve to be purchsed before birth. People obviously cnnot do this, nd even their prents might be unble to buy it for them, if there is genetic predisposition towrds disese. Other insurnce could wit until mid-life for the unpredictble infirmities of old ge. The key is to contrct for insurnce before the risk is resolved. While long-term nticiptory insurnce is possible, helth insurnce in ctul mrkets is rrely sold for over one yer. People consequently lose welfre ex nte; there is n insurnce policy they wnt but cnnot obtin. This loss t first my seem counterintuitive: everyone hs full informtion nd everyone gets full insurnce every yer. Where is the source of the loss? The welfre

65 Ch. 11: The Antomy of Helth Insurnce 627 loss derives from missing mrket for insurnce ginst one's risk type. Risk-verse individuls would like to insure ginst the possibility of being discovered to be high risk. There is no mrket where they cn do so, however. Given tht mrket is missing, there is no gurntee tht efficient pricing on the bsis of known informtion s opposed to level pricing (s if ignornt) will enhnce welfre. This illustrtes the theory of the second-best. The mrket filure might lso be thought of s recontrcting filure. We recontrct for helth insurnce nnully despite the fct tht we lern bout expected future helth costs during the yer. Such periodic recontrcting breks the contrctul rrngements tht would chrcterize optiml insurnce. This problem hs vriously been termed the problem of renewble insurnce or the problem of intertemporl insurnce [Puly, Kunreuther, nd Hirth (1995), Cochrne (1995), Cutler (1996) nd Zeckhuser (1974)]. It is likely to grow in importnce in helth insurnce mrkets s our bility to predict medicl spending rises, s it will, for exmple, through dvnces in genetic screening. We note this s the fourth lesson of helth insurnce: Lesson 4: Informtion nd long-term insurnce. More informtion bout individul risk levels llows for more efficient pricing of risk, but portends welfre loss from incomplete insurnce contrcts. Might mrkets develop to del with this problem? Some possibilities suggest themselves. People might purchse insurnce for their lifetime rther thn nnully. If insurnce choices were mde erly enough (or high-cost people were compensted when insurnce choices were mde), people would not suffer from knowledge gined over time. Long-term purchses, such s those ssocited with whole life insurnce, re mde in this fshion. Individuls buy level premium life insurnce when they re young nd helthy; they will wish to retin it, even if reltively helthy, when they grow old nd nnul risks esclte. In theory, helth insurnce could be sold for the long term on level premium bsis. In prctice, mtters will be more complex. Much helth insurnce is now bundled with the provision of cre. If n individul left geogrphic region, he might hve to chnge provider, nd no new provider/insurer would wnt to tke him own t his old level rte. Portbility is but one problem. Once individuls purchse lifetime medicl insurnce, why should n insurer strive for efficiency when people re stuck in his pln? This problem is excerbted since the insurer must gree to py for or provide chnging level of services. Helth insurnce policies optimlly chnge from yer to yer, s medicl technology improves nd knowledge bout optiml tretments expnds. Finlly, with future medicl costs so unpredictble, insurers cnnot tke on the risk, which would pply to ll policies, tht costs will esclte beyond expecttion. With life insurnce, by contrst, portbility, chnging service mix, nd vrying costs re not problems. A second pproch to long-term helth insurnce would be to develop policies offering insurnce ginst lerning one is high cost [Cochrne (1995)]. Imgine tht people purchse two insurnce policies in yer; one to cover their medicl costs tht yer, nd second to cover ny increse in premiums they my fce in the future. The second

66 628 D.M. Cutler nd R.J. Zeckhuser policy - the "premium insurnce" policy - might look like stndrd helth insurnce policy: people py in money nd if they lern they re likely to hve high costs in the future they receive money bck. Full premium insurnce would give people n mount of money equivlent to the discounted expected increse in their future medicl spending they lern bout during the yer. 48 Why don't we observe premium insurnce? Severl fctors hve been identified. Morl hzrd (people with premium insurnce would tke insufficient cre of their helth) nd dverse selection (people expecting declines in helth would more likely tke up the insurnce) re possibilities. The ggregte risk phenomenon provides still third explntion [Cutler (1996)]. Full premium insurnce would hve to insure person ginst the risk tht the medicl policy tht representtive individul will need in the future will cost more then thn it is forecst to cost tody. But future medicl costs re not known. For exmple, hlf century go, the cost of treting crdiovsculr disese ptients ws miniml with little prospect for rpid increse. Bypss surgery, ngioplsty, nd the like unexpectedly incresed the cost of treting crdiovsculr disese. Diversifying such risk of significnt cost increses for common ilment is not possible. It is wht is termed n ggregte s opposed to n idiosyncrtic risk, where the ltter pply to individuls one t time. Insurers generlly eschew ggregte risks. By contrst, insurers ccept risks redily when they cn len comfortbly on the Lw of Lrge Numbers to spred them, s they cn with idiosyncrtic risks. They generlly refuse to write insurnce for risks tht re unpredictble or nondiversifible since they could bnkrupt the compny. Cost increses ssocited with future medicl cre suffer both disqulifictions. The result is tht even though improved insurer informtion my reduce dverse selection over time, problems in insurnce mrkets my grow. If people re incresingly chrged on the bsis of their individul risk chrcteristics, the efficiency losses could be severe. Does employer-bsed insurnce, where individuls choose from menu of options, help? Under such plns, there is rnge of potentil costs individuls cn fce for choosing more generous insurnce. At one extreme such plns re fully subsidized; people py the sme mount for ech pln. At the other extreme there is no subsidy; people py the expected cost in ech pln on group or individul bsis. A system of risk djustment lies in between; people py the verge cost of more generous plns ssuming the mix of insureds is constnt cross plns. We hve stressed the efficiency spects of risk-djusted premiums, but such system my not spred risks to sufficient extent. Even in the perfect risk-djusted equilibrium, the sick will py more thn the helthy, since they will be more ttrcted to the generous pln. People would presumbly like to insure some of even this efficient price difference. There is, in terms of our erlier discussion, trdeoff between morl hzrd nd risk shring. Risk spreding considertions suggest tht people should py nothing 48 This is relted to the solution in Puly, Kunreuther, nd Hirth (1995). They propose pying lrge premium in the first yer, which is used to finnce dditionl cre for those who become sick in lter yers.

67 Ch. 11: TheAntomy ofhelthinsurnce 629 dditionl for selecting more generous plns, ssuming risk level ws the driving fctor in their choice. Efficiency dicttes tht they should py the expected dditionl cost they incur by choosing more generous cre. The optiml differentil lies between the two extremes, t the point where the mrginl costs in terms of mislloction of people cross plns exctly offsets the mrginl benefits of incresed risk shring. Of course, price setting to this level of refinement my not be possible. 8. Insurnce nd helth outcomes Our empiricl nlysis to this point hs focused on the impct of helth insurnce on medicl spending. Ultimtely, people cre bout helth insurnce becuse they re concerned bout their helth. A centrl reserch issue is therefore how lternte insurnce rrngements ffect helth. Much policy rhetoric expounds on the effects of not hving insurnce on helth. Evidence on this issue shows tht the effect of being without insurnce cn be lrge. See Weissmn nd Epstein (1994) for review. For our purposes, however, we re interested in how vritions mong the set of insurnce plns ffect helth. One might expect n ttenuted version of the sme finding - tht people crrying less generous insurnce, either indemnity insurnce with high cost shring or mnged cre insurnce, would suffer worse helth outcomes thn people with more generous insurnce. This might be prticulrly expected since medicl tretment differs cross insurnce ctegories. But severl fctors work in the other direction. Some of the dditionl cre provided under more generous insurnce my be itrogenic (hrmful to the ptient), conceivbly provided by physicins to increse their income. Perhps more importnt, mnged cre policies my improve outcomes. One feture of mnged cre is tht it stndrdizes the cre tht is received by clsses of ptients. These stndrds, if bsed on sound science nd crefully crfted to ptient chrcteristics, my be superior to wht physicins conclude on their own. In ddition, mnged cre usully involves less cost shring for primry cre, preventive services, nd prescription drugs thn does indemnity insurnce. Greter use of these services my improve helth outcomes. Evidence on the effect of different insurnce rrngements on helth outcomes generlly suggests very little difference in helth produced cross plns. The clerest findings on the impct of differing levels of demnd-side cost shring emerge from the Rnd Helth Insurnce Experiment [Newhouse et l. (1993)]. The Rnd study mesured brod rry of helth indictors. For most people, outcomes did not differ cross plns. This is true even though spending differed cross plns by up to one-third. Insurnce did hve smll effect on the helth of the sick poor: poor people chieved better outcomes in more generous plns with blood pressure control, vision correction, nd filling decyed teeth. Of course, the Helth Insurnce Experiment lsted for only few yers, which my hve tilted the test ginst more generous plns. Incresed primry nd preventive cre, even if strongly beneficil, my not be so importnt in such short period of time.

68 63 D.M. Cutler nd R.J. Zeckhuser Mny studies hve exmined the impct of supply-side cost shring on medicl outcomes. Such studies must djust for differing popultion mixes cross plns, which is difficult chllenge. Importnt evidence comes from the implementtion of prospective pyment for hospitl dmissions covered by Medicre. At the time of the chnge, the critics of the new prospective pyment wrned tht ptients would be dischrged from hospitls "quicker nd sicker." Severl ppers exmined this question, s shown in Tble 7. The most detiled studies re the ppers grouped under Khn et l. (199), which exmined ptient medicl reviews before nd fter prospective pyment ws implemented to mesure chnges in helth. Tht reserch found no increse in dverse outcomes for the verge ptient fter prospective reimbursement, lthough it did find tht with prospective pyment more ptients were dischrged from the hospitl in n unstble condition. The lck of significnt dverse effect on qulity of cre ws lso found by Deshrnis, Chesney, nd Fleming (1988). Some ppers hve found evidence of dverse outcomes resulting from prospective pyment. Fitzgerld et l. (1987, 1988) found tht ptients dmitted to hospitl in the midwest with hip frcture were dischrged sooner fter prospective pyment but were more likely to be in nursing home 6 months nd 1 yer fter the hip frcture. In response, mny other reserchers hve exmined this question, finding tht length of sty for hip frcture ptients fell but there ws no effect on nursing home residence, functionl sttus, or mortlity fter 1 yer [Gerety et l. (1989), Plmer et l. (1989), Ry, Griffin, nd Bugh (199)]. Two studies hve looked t the impct not of the prospective pyment system, but of the revenue chnges stemming from prospective pyment [Cutler (1995) nd Stiger nd Gumer (1995)]. These studies compred ptients dmitted to hospitls tht lost revenue with ptients dmitted to hospitls tht gined revenue. The former ptients experience compression of mortlity into the period just fter the hospitl dmission in comprison to the ltter; some clsses of ptients tht formerly survived severl months fter being hospitlized did not live s long fter revenues fell. The effect diminished over the succeeding yer, however. For ptients who survived yer or longer, there ws no increse in mortlity. 49 The uthors conclude tht price chnges hve smll dverse effect on the very sick, but little effect on others. A second set of evidence exmines the effect of mnged cre on helth. Miller nd Luft (1997) summrize 35 studies compring medicl outcomes in mnged cre nd indemnity insurnce. They find no cler difference; some studies find tht mnged cre does worse, while n eqully lrge number find it does better. Mny find no difference in outcomes. 5 One is tempted to conclude from these findings tht mnged cre is superior to trditionl insurnce - it sves money without substntil dverse effects. Such conclusion 49 After phse-in period, hospitl pyments in totl were not substntilly ffected by prospective pyment, so these results re consistent with the Khn et l. (199) finding of no chnge in helth for the verge ptient. 5 See lso Cutler, McClelln, nd Newhouse (1998).

69 Ch. 1]: TheAntomyofHelthInsurnce 631 is premture, however, until long-term evidence on the effect of mnged cre hs been obtined. We note the focus on helth nd lck of conclusive results s the fifth lesson of helth insurnce. Lesson 5: Helth insurnce nd helth. The primry purpose of helth insurnce nd delivery is to improve helth. Unfortuntely, conclusive results re not in on which insurnce nd provision rrngements do this most effectively. 9. Conclusions nd implictions Helth insurnce hs complex ntomy. The lens of economics brings mny of its criticl fetures - incentives, risk spreding nd symmetric informtion - into shrp focus. The understnding thus gined, however helpful, does not solve ll of the problems. Indeed, the primry messge of this chpter is tht helth insurnce design is chllenging exercise in the second-best. On ech of vriety of dimensions, gols must be trded off ginst ech nother, since first principles re in conflict. Our lessons bout helth insurnce, highlighted in Tble 1, re instructive in this respect. We strt with single insurer. Lesson 1 stresses the trdeoff between efficient risk spreding nd excessive utiliztion. Optiml risk shring puts ll the burden on the risk-neutrl insurer, but this induces morl hzrd (excess consumption of services) nd possibly supplier-induced demnd (excessive provision). Lesson 2 finds tht integrtion of insurnce nd provision of services, which is bsent in other insurnce contexts, my be desirble to lign producer nd insurer incentives in the delivery of medicl cre. Lessons 3 nd 4 highlight second-best problems in the helth insurnce mrketplce. Lesson 3 shows tht competitive mrkets, the trditionl lodestr of economics, my hve undesirble side effects in helth insurnce. Most importnt, competition induces dverse selection, hence the mislloction of people to plns nd the incentive for insurers to trim their offerings to deter the sick. In theory t lest, risk-djustment methods, which re just now being tried in prctice, cn counter these phenomen. Lesson 4 lerts us, however, tht even if we sly the drgons of dverse selection nd pln mnipultion, fierce risk remins. Since insurnce is written on n nnul bsis, individuls re denied crucil protection ginst becoming sick nd hving their premiums esclte substntilly in the future. Lesson 5 reminds us tht the ultimte gol of helth insurnce does not involve the usul economic concepts of prices, incentives nd costs. Rther, the centrl objective of helth insurnce is to mintin nd enhnce our helth. The pyoff question, therefore, is wht cn we get for lterntive levels of expenditure? The contribution of economics is to enble us to sketch the production function. Helth insurnce is service in society, like hircut or tennis lesson. Why then does helth insurnce cuse so mny more problems thn the other two? Both the insurnce spect, nd its re of ppliction, helth, produce problems. In ny insurnce sitution, morl hzrd nd dverse selection plgue outcomes. In the cse of helth insurnce, the problems re mgnified, since helth-promoting nd cre-seeking ctions re difficult

70 632 D.M. Cutler nd R.J. Zeckhuser Tble 1 Five centrl lessons bout helth insurnce Lesson 1: Risk spreding versus incentives Lesson 2: Integrtion of insurnce nd provision Lesson 3: Competition nd consumer identity Lesson 4: Informtion nd long-ternm insurnce Lesson 5: Helth insurnce nd helth Helth insurnce involves fundmentl trdeoff between risk spreding nd pproprite incentives. Incresing the generosity of insurnce spreds risk more brodly but lso leds to incresed losses becuse individuls choose more cre (morl hzrd) nd providers supply more cre (principl-gent problems). Medicl cre is unlike other insurnce mrkets in tht insurers re often involved in the provision of the good in ddition to insuring its cost. The integrtion of insurnce nd provision, intended to lign incentives, hs incresed over time. Mnged cre, where the functions re united, is n extreme version. Under it, doctors hve dul loylties, to the insurer s well s the ptient. When consumer identity ffects costs, competition is mixed blessing. Allowing individuls to choose mong competing helth insurnce plns cn llocte people to pproprite plns nd provide incentives for efficient provision. But it cn lso bring with it dverse selection - the tendency of the sick to prefer the most generous plns. Adverse selection induces people to enroll in less generous plns, so they cn be in helthier pool, nd gives plns incentives to distort their offerings to be less generous with cre for the sick. More informtion bout individul risk levels llows for more efficient pricing of risk, but portends welfre loss from incomplete insurnce contrcts. The primry purpose of helth insurnce nd delivery is to improve helth. Unfortuntely, conclusive results re not in on which insurnce nd provision rrngements do this most effectively. to monitor, nd it is widely believed to be unfir to chrge people more if they contrct diseses tht re not their fult. Moreover, the pyoff from helth insurnce, unlike sy life insurnce, is quite vrible, nd subject to humn choice mde fter the contrct is written. In ddition, for justifible resons, helth cre is written on n nnul bsis, though tody's chnce outcomes often hve cost implictions tht stretch for decdes. Finlly, helth hs privileged position bove other goods nd services. For rnge of philosophicl nd morl resons, societies cre deeply tht their citizens receive helth cre, even if tht is not wht they would buy were they given the money. These fundmentl issues surrounding the equitble nd efficient provision of helth insurnce mke government involvement inevitble, nd in mny contexts desirble. The rnge of government involvement in helth cre nd helth insurnce is enormous. At one end, mny governments provide medicl cre directly; they rise money through

71 Ch. 11: The Antomy of Helth Insurnce 633 txes, hire doctors nd run public hospitls. Less extreme re countries where the government is the sole insurer, but provision of services remins privte. More mrketoriented systems such s the United Sttes hve most of the popultion in privte insurnce nd most of the provision of medicl cre done by privte providers. Even there, though, government plys sizeble role, refereeing the plying field nd insuring those who the mrket would leve behind. Thus, the federl government insures people through Medicre nd Medicid, provides tx subsidies to privte insurnce, defines permissible structures for supplementry Medicre insurnce, nd requires insurers to cover people who recently lost or chnged jobs. Moreover, mny sttes mndte tht prticulr benefits be prt of ny helth insurnce pln. Discussions of medicl cre reform in the United Sttes nd elsewhere often led to extreme positions. Advoctes t one end believe tht the problems with mrkets in helth cre re so severe tht government control, t lest of expenditures, is necessry. The Cndin system - tx-supported, privtely provided, but publicly regulted - is held up s n exemplr. The climed merits re tht one insurer elimintes dverse selection, tight supply restrictions mnge costs, nd tx finncing enbles everyone to be insured. Of course, in such system competition between insurers plys no role in promoting efficiency. At the other extreme re free-mrket dvoctes, who believe tht mrket institutions, if guided correctly, would produce superior outcome. The government should sty out of the insurnce business, but implement risk djustment system, directly or t rm's length, so tht people fce efficient prices. Moreover, the government should remove the tx subsidy fvoring employer provision of insurnce, which would led to trimmed pln generosity nd more cost shring by employees. Where necessry, the government should give high cost individuls risk-relted subsidies tht enble them to buy helth insurnce in the mrketplce. The fundmentl difference between the public nd privte pproches to medicl cre reform is indictive of the enormous problems in medicl cre mrkets nd the centrl role tht helth plys in our utility. Cn risk djustment work well enough to deter pln mnipultion nd crem skimming? Without subsidies, would employers provide insurnce? If they stopped doing so, how mny more people would be uninsured, nd how much would their helth suffer? These re questions t the hert of helth insurnce reform. And beyond the question bout orgnizing the helth insurnce system, there remin questions of how plns should interct with providers. Should providers be pid by cpittion or by fee-for-service, or might there be hppy medium? Will providers respond to pyment schedule by either skimping on ptients or driving up costs? Only experience in the future, coupled with delictely blnced wisdom, will enble us to nswer these questions. Economics does not offer robust conclusions bout the virtues nd libilities of mrkets in second-best situtions. Hence, it is not surprising tht the debte on who should provide helth insurnce nd how it should best be structured rges on, even mong economists. Ultimtely, of course, mny of the issues cnnot be nswered on the bsis

72 634 D.M. Cutler nd R.J. Zeckhuser of first principles, much less the dogm tht is too often brought to the debte. They require empiricl investigtions. An impressive rry of dt hs been brought to ber one-to-one on centrl issues in helth insurnce, but the grnd synthesis needed for effective prescription wits us. Which medicl system round the world is best, nd wht would mke it even better? Might the best system for Germny or Jpn differ significntly from tht for the United Sttes? To understnd the ttrctiveness of lterntive helth insurnce structures, not unlike much of medicl cre itself, mny consequences must be weighed, nd mny side effects considered. This chpter provided n ntomy to help orgnize those investigtions. Appendix This ppendix shows the clssic tretment of equilibrium with dverse selection nd two individuls, from Rothschild nd Stiglitz (1976). For simplicity, ssume tht spending when sick, m, is the sme for HIGH nd LOW, i.e., there is no morl hzrd. HIGH is more likely to be sick. Figure A(1) shows the indifference curves for these two people. LOW's indifference curve is steeper thn HIGH's, since LOW is not willing to give up s much money when helthy to get dollr when sick. With no morl hzrd, both LOW nd HIGH would optimlly wnt full insurnce, if chrged their fir price for it. Points A nd B represent their respective efficient levels of insurnce when purchsed t cturilly fir rtes. Figure A(2) shows the potentil pooling equilibrium. The fir odds line tht is shown is the verge premium for the two together. At point C, both LOW nd HIGH purchse full insurnce t this price. But this equilibrium cnnot previl. If n insurer entered the mrket offering policy D, which hs incomplete coverge but lower premium, he would ttrct LOW but not HIGH. LOW prefers the policy becuse he gets the cost svings from not pooling with HIGH, which more thn mkes up for his loss of full insurnce. This is prllel to wht hppens with the introduction of the bsic pln in our numericl nlysis, which breks the pooling equilibrium t moderte. Figure A(3) shows the equilibrium with pln mnipultion. HIGH receives full insurnce (point A). To seprte himself out nd thereby reduce his pyments, LOW insures incompletely, t point G. Point G mkes HIGH just indifferent between stying in the full insurnce pln nd enrolling in the less generous, but less expensive, policy. Though optimlity requires tht both groups insure fully, only HIGH does so. Figure A(4) shows how the seprting equilibrium my be broken. We show two fir odds line for the verge of HIGH nd LOW - one where costs for the two re fr prt nd one where they re closer together (for simplicity, we show only one indifference curve for HIGH). In the cse where HIGH nd low hve very different costs, the pooled fir odds line will not ttrct LOW; they do not wnt to py the dditionl mount for more generous coverge becuse doing so necessittes pooling with HIGH. If the costs re closer together, in contrst, the verge fir odds line for the two s whole

73 _..... Ch. 11: TheAntomyofHelthInsurnce 635 (1) Indifference Curves Dollr Low-risk indifference curve 45 rnce Dollrs when helthy (2) Pooling Equilibrium Doll Dollrs when helthy Dshed lines re indifference curves through no insurnce, point E Figure A. Adverse selection nd pln mnipultion.

74 636 D.M. Cutler nd R.J Zeckhuser (3) Seprting Equilibrium Dollrs when helthy (4) Potentil Non-Existence of Seprting Equilibrium Doll Low-risk indifference curve Dollrs when helthy Figure A. (Continued.)

75 Ch. I1: The Antomy of Helth Insurnce 637 will be close to the fir odds line for LOW. Reltive to points A nd G, there my be point such s H tht will be preferred by LOW to the seprting equilibrium. It will lso be preferred by HIGH, who benefits from pooling with the helthier group in the popultion. It will thus undermine the seprting equilibrium. With no stble pooling equilibrium nd no stble seprting equilibrium, the mrket will not rech n equilibrium. References Akerlof, G. (197), "The mrket for 'Lemons': qulittive uncertinty nd the mrket mechnism", Qurterly Journl of Economics 74: Altmn, D., D.M. Cutler nd R.J. Zeckhuser (1998), "Adverse selection nd dverse retention", Americn Economic Review 88(2): Arrow, K. (1963), "Uncertinty nd the welfre economics of medicl cre", Americn Economic Review 53(5): Arrow, K. (1965), Aspects of the Theory of Risk Bering (Yrjo Jhnssonin Stio, Helsinki). Arrow, K. (1985), "The economics of gency", in: J. Prtt nd R. Zeckhuser, eds., Principls nd Agents: The Structure of Business (Hrvrd Business School Press, Cmbridge, MA) Bker, L.C., nd K.S. Corts (1995), "The effects of HMOs on conventionl insurnce premiums: theory nd evidence", NBER Working Pper No Bumgrdner, J. (1991), "The interction between forms of insurnce contrct nd types of technicl chnge in medicl cre", Rnd Journl of Economics 22(1): Beck, R.G. (1974), "The effects of co-pyment on the poor", Journl of Humn Resources 9(1): Berk, M.L., nd A.C. Monheit (1992), "The concentrtion of helth expenditures: n updte", Helth Affirs 11(4): Bhttchry, J., W.B. Vogt, A. Yoshikw nd T. Nkhr (1996), "The utiliztion of outptient medicl services in Jpn", Journl of Humn Resources 31(2): Bice, T.W. (1975), "Risk vulnerbility nd enrollment in prepid group prctice", Medicl Cre 13(8): Blomqvist, A.G. (1997), "Optiml non-liner helth insurnce", Journl of Helth Economics 16(3): Brown, R.S., et l. (1993), "The Medicre risk progrm for HMOs - Finl summry report on findings from the evlution", Finl Report under HCFA Contrct No (Mthemtic Policy Reserch, Inc., Princeton, NJ). Buchnn, J.L., E.B. Keeler, J.E. Rolph nd M.R. Holmer (1991), "Simulting helth expenditures under lterntive insurnce plns", Mngement Science 37(9): Buchmueller, T.C., nd P.J. Feldstein (1997), "The effect of price on switching mong helth plns", Journl of Helth Economics 16(2): Crdon, J., nd I. Hendel (1996), "Asymmetric informtion in helth cre nd helth insurnce mrkets: evidence from the Ntionl Medicl Expenditure Survey", mimeo. Crroll, N.V., nd W.G. Erwin (1987), "Ptient shifting s response to Medicre prospective pyment", Medicl Cre 25(12): Cve, J. (1985), "Subsidy equilibrium nd multiple-option insurnce mrkets", in: R. Scheffier nd L.F. Rossiter, eds., Advnces in Helth Economics nd Helth Services Reserch. Bised Selection in Helth Cre Mrkets, Vol. 6 (JAI Press, Greenwich, CT) Cherkin, D.C., L. Grothus nd E.H. Wgner (1989), "The effect of office visit copyments on utiliztion in helth mintennce orgniztion", Medicl Cre 27(7): Cochrne, J. (1995), "Time consistent helth insurnce", Journl of Politicl Economy 13(3):

76 638 D.M. Cutler nd R.J. Zeckhuser Colle, A.D., nd M. Grossmn (1978), "Determinnts of peditric cre utiliztion", Journl of Humn Resources 13(Suppl.): Conrd, D.A., D. Grembowski nd P. Milgrom (1985), "Adverse selection within dentl insurnce mrkets", in: R.M. Scheffier nd L.F. Rossiter, eds., Advnces in Helth Economics nd Helth Services Reserch, Vol. 6 (JAI Press, Greenwich, CT) Congressionl Budget Office (1992), "The effects of mnged cre on use nd costs of helth services", mimeo. Cutler, D.M. (1991), "Estimting the effect of reimbursement policy on medicl outcomes", Doctorl disserttion (Msschusetts Institute of Technology, MA). Cutler, D.M. (1995), "The incidence of dverse medicl outcomes under prospective pyment", Econometric 63(1):29-5. Cutler, D.M. (1996), "Why don't mrkets insure long-term risk?", mimeo. Cutler, D.M., M. McClelln nd J.P. Newhouse (1998), "Wht does mnged cre do?", mimeo. Cutler, D.M., nd S.J. Reber (1998), "Pying for helth insurnce: the trdeoff between competition nd dverse selection", Qurterly Journl of Economics 113(2): Cutler, D.M., nd R.J. Zeckhuser (1998), "Adverse selection in helth insurnce", in: A. Grber, ed., Frontiers in Helth Policy Reserch, Vol. 1 (MIT Press, Cmbridge, MA) Dvis, K., nd L.B. Russell (1972), "The substitution of hospitl outptient cre for inptient cre", Review of Economics nd Sttistics 54(2): De Mez, D. (1983), "Helth insurnce nd the demnd for medicl cre", Journl of Helth Economics 2(1): DesHrnis, S.I., J. Chesney nd S. Fleming (1988), "Trends nd regionl vritions in hospitl utiliztion nd qulity during the first two yers of the prospective pyment system", Inquiry 25: DesHrnis, S.I., R. Wroblewski nd D. Schumcher (199), "How the Medicre prospective pyment system ffects psychitric ptients treted in short-term generl hospitls", Inquiry 27: Dimond, P. (1998), "Optiml income txtion: n exmple with U-shped pttern of optiml mrginl tx rtes", Americn Economic Review 88(1): Dowd, B., nd R. Feldmn (1985), "Bised selection in twin cities helth plns", in: R.M. Scheffler nd L.F. Rossiter, eds., Advnces in Helth Economics nd Helth Services Reserch, Vol. 6 (JAI Press, Greenwich, CT) Eggers, P.W. (198), "Risk differentil between Medicre beneficiries enrolled nd not enrolled in n HMO", Helth Cre Finncing Review 1: Eichner, M.J. (1998), "Incentives, price expecttions nd medicl expenditures: n nlysis of clims under employer-provided helth insurnce", mimeo. Eichner, M.J., M. McClelln nd D. Wise (1998), "Insurnce or self-insurnce?: Vrition, persistence, nd individul helth ccounts", in: D. Wise, ed., Inquiries in the Economics of Aging (University of Chicgo Press, Chicgo, IL) Ellis, R.P. (1985), "The effect of prior-yer helth expenditures on helth coverge pln choice", in: R.M. Scheffler nd L.F. Rossiter, eds., Advnces in Helth Economics nd Helth Services Reserch, Vol. 6 (JAI Press, Greenwich, CT) Ellis, R.P. (1989), "Employee choice of helth insurnce", Review of Economics nd Sttistics 71(2): Ellis, R.P. (1998), "Creming, skimping nd dumping: provider competition on the intensive nd extensive mrgins", Journl of Helth Economics 17(5): Ellis, R.P., nd T.G. McGuire (1986), "Provider behvior under prospective reimbursement: cost shring nd supply", Journl of Helth Economics 5(2): Ellis, R.P., nd T.G. McGuire (1996), "Hospitl response to prospective pyment: morl hzrd, selection, nd prctice-style effects", Journl of Helth Economics 15: Eze, P., nd B. Wolfe (1993), "Is dumping socilly inefficient? An nlysis of the effect of Medicre's prospective pyment system on the utiliztion of Veterns Affirs inptient services", Journl of Public Economics 52:

77 Ch. 1]: TheAntomyofHelthInsurnce 639 Frley, P.J., nd A.C. Monheit (1985), "Selectivity in the demnd for helth insurnce nd helth cre", in: R.M. Scheffler nd L.F. Rossiter, eds., Advnces in Helth Economics nd Helth Services Reserch, vol. 6 (JAI Press, Greenwich, CT) Feder, J., J. Hdley nd S. Zuckermn (1987), "How did Medicre's prospective pyment system ffect hospitls?", New Englnd Journl of Medicine 317(14): Feldmn, R., nd D. Dowd (1991), "Must dverse selection cuse premium spirls?", Journl of Helth Economics 1(3): Feldmn, R., nd B. Dowd (1993), "The effectiveness of mnged competition in reducing the costs of helth insurnce", in: R.B. Helms, ed., Helth Policy Reform: Competition nd Controls (AEI Press, Wshington, DC) Feldmn, R., M. Finch, B. Dowd nd S. Cssou (1989), "The demnd for employment-bsed helth insurnce plns", Journl of Humn Resources 24(1): Feldstein, M.S. (197), "The rising price of physicins' services", Review of Economics nd Sttistics 52(2): Feldstein, M.S. (1971), "Hospitl cost infltion: study of nonprofit price dynmics", Americn Economic Review 6: Feldstein, M.S., nd B. Friedmn (1977), "Tx subsidies, the rtionl demnd for insurnce nd the helth cre crisis", Journl of Public Economics 7(2): Feldstein, P.J. (1964), "Generl report", Report of the Commission on the Cost of Medicl Cre, Prt 1 (Americn Medicl Assocition, Chicgo). Fisher, C.R. (1992), "Hospitl nd Medicre finncil performnce under PPS, ", Helth Cre Finncing Review 14(1): Fitzgerld, J.F, L.F Fgn, W.M. Tierney nd R.S. Dittus (1987), "Chnging ptterns of hip frcture cre before nd fter implementtion of the prospective pyment system", Journl of the Americn Medicl Assocition 258(2): Fitzgerld, J.F, P.S. Moore nd R.S. Dittus (1988), "The cre of elderly ptients with hip frcture: chnges since implementtion of the prospective pyment system", New Englnd Jouml of Medicine 319(21): Follnd, S., nd R. Kleimn (199), "The effect of prospective pyment under DRGs on the mrket vlue of hospitls", Qurterly Review of Economics nd Business 3(2):5-68. Frnk, R.G., nd J.R. Lve (1986), "The effect of benefit design on the length of sty of Medicid psychitric ptients", Journl of Humn Resources 21(3): Frnk, R.G., nd J.R. Lve (1989), "A comprison of hospitl responses to reimbursement policies for Medicid psychitric ptients", RAND Journl of Economics 2(4): Frnk, R.G., nd T. McGuire (1998), "Economic functions of crve-outs", Americn Journl of Mnged Cre 4(SP):SP31-SP39. Frnk, R.G., T.G. McGuire nd J.P. Newhouse (1995), "Risk contrcts in mnged mentl helth cre", Helth Affirs 14(3):5-64. Frnk, R.G., J. Glzer nd T.G. McGuire (1998), "Mesuring dverse selection in mnged helth cre", NBER Working Pper no. 6825, December. Fuchs, V.R., nd M.J. Krmer (1972), "Determinnts of expenditures for physicins' services in the United Sttes, ", Ntionl Bureu of Economic Reserch Occsionl Pper Series, No Gumer, G.L., E.L. Poggio, C.G. Coelen, C.S. Sennett nd R.J. Schmitz (1989), "Effects of stte prospective reimbursement progrms on hospitl mortlity", Medicl Cre 27(7): Gerety, M.B., V. Soderholm-Diftte nd C.H. Winogrd (1989), "Impct of prospective pyment nd dischrge loction on the outcome of hip frcture", Journl of Generl Internl Medicine 4(5): Glied, S. (2), "Mnged cre", in: A.J. Culyer nd J.P. Newhouse, eds., Hndbook of Helth Economics (Elsevier, Amsterdm) Chpter 13. Goldmn,, nd M. Grossmn (1978), "The demnd for peditric cre: n hedonic pproch", Journl of Politicl Economy 86(2):

78 64 D.M. Cutler nd R.J. Zeckhuser Griffith, M.J., N. Bloff nd E.L. Spitzngel (1984), "Utiliztion ptterns of helth mintennce orgniztion disenrollees", Medicl Cre 22(9): Gutermn, S., S.H. Altmn nd D.A. Young (199), "Hospitls' finncil performnce in the first five yers of PPS", Helth Affirs 9(1): Gutermn, S., nd A. Dobson (1986), "Impct of the Medicre prospective pyment system for hospitls", Helth Cre Finncing Review 7(3): Hdley, J., S. Zuckermn nd J. Feder (1989), "Profits nd fiscl pressure in the prospective pyment system: their impcts on hospitls", Inquiry 26: Hodgkin, D., nd T.G. McGuire (1994), "Pyment levels nd hospitl response to prospective pyment", Journl of Helth Economics 13:1-29. Hurley, J. (2), "An overview of normtive economics of the helth sector", in: A.J. Culyer nd J.P. Newhouse, eds., Hndbook of Helth Economics (Elsevier, Amsterdm) Chpter 2. Jckson-Beeck, M., nd J.H. Kleinmn (1983), "Evidence for self-selection mong helth mintennce orgniztion enrollees", Journl of the Americn Medicl Assocition 25(2): Jub, D.A., J.R. Lve nd J. Shddy (198), "An nlysis of the choice of helth benefits plns", Inquiry 17: Khn, K.L., et l. (] 99) (series), "The effects of the DRG-bsed prospective pyment system on qulity of cre for hospitlized Medicre ptients", Journl of the Americn Medicl Assocition 264(15): (eight rticles). Keeler, E.B., J.P. Newhouse nd C.E. Phelps (1977), "Deductibles nd demnd: theory of the consomer fcing vrible price schedule under uncertinty", Econometric 45: Keeler, E.B., G. Crter nd J.P. Newhouse (1998), "A model of the impct of reimbursement schemes on helth pln choice", Journl of Helth Economics 17(3): Kotowitz, Y. (1987), "Morl hzrd", in: New Plgrve Dictionry of Economics. Lngwell, K.M., nd J.P. Hdley (1989), "Evlution of the Medicre competition demonstrtions", Helth Cre Finncing Review 11(2):65-8. Lve, J.R., R.G. Frnk, C. Tube, H. Goldmn nd A. Rupp (1988), "The erly effects of Medicre's prospective pyment system on psychitry", Inquiry 25: Long, S.H., R.F. Settle nd C.W. Wrightson (1988), "Employee premiums, vilbility of lterntive plns, nd HMO disenrollment", Medicl Cre 26(1): Luft, H.S., J.B. Truner nd S.C. Merki (1985), "Adverse selection in lrge, multiple-option helth benefits progrm: cse study of the Cliforni Public Employees' Retirement System", in: R.M. Scheffiler nd L.F. Rossiter, eds., Advnces in Helth Economics nd Helth Services Reserch, Vol. 6 (JAI Press, Greenwich, CT) M, C.A., nd T. McGuire (1997), "Optiml helth insurnce nd provider pyment", Americn Economic Review 87(4): Mibch, E., K. Dusenbury, P. Zupp et l. (1998), "Mrketing HMOs to Medicre Beneficiries: An Anlysis of Four Medicre Mrkets" (Kiser Fmily Foundtion, Menlo Prk, CA). Mnning, W.G., nd M.S. Mrquis (1996), "Helth insurnce: the trdeoff between risk pooling nd morl hzrd", Journl of Helth Economics 15(5): Mrquis, M.S. (1992), "Adverse selection with multiple choice mong helth insurnce plns: simultion nlysis", Journl of Helth Economics 11(2): Mrquis, M.S., nd C.E. Phelps (1987), "Price elsticity nd dverse selection in the demnd for supplementl helth insurnce", Economic Inquiry 25(2): McAvinchey, I.D., nd A. Ynnopoulos (1993), "Elsticity estimtes from dynmic model of interrelted demnds for privte nd public cute helth cre", Journl of Helth Economics 12(2): McGuire, T.G. (1981), "Price nd membership in prepid group medicl prctice", Medicl Cre 19(2): McGuire, T.G. (2), "Physicin gency", in: A.J. Culyer nd J.P. Newhouse, eds., Hndbook of Helth Economics (Elsevier, Amsterdm) Chpter 9.

79 Ch. 11: TheAntomyofHelthInsurnce 641 Menke, T. (199), "Impcts of PPS on Medicre Prt B expenditures nd utiliztion for hospitl episodes of cre", Inquiry 27(2): Merrill, J., C. Jckson nd J. Reuter (1985), "Fctors tht ffect the HMO enrollment decision: tle of two cities", Inquiry 22(4): Miller, R.H., nd H.S. Luft (1997), "Does mnged cre led to better or worse qulity of cre?", Helth Affirs 16(5):7-25. Mirrlees, J.A. (1971), "An explortion in the theory of optimum income txtion", Review of Economic Studies 38: Morrisey, M.A., F.A. Slon nd J. Vlvon (1988), "Medicre prospective pyment nd posthospitl trnsfers to subcute cre", Medicl Cre 26(7): Newhouse, J.P. (1989), "Do unprofitble ptients fce ccess problems?", Helth Cre Finncing Review 11(2): Newhouse, J.P. (1996), "Reimbursing helth plns nd helth providers: efficiency in production versus selection", Journl of Economic Literture 34(3): Newhouse, J.P., nd the Insurnce Experiment Group (1993), Free for All? Lessons from the RAND Helth Insurnce Experiment (Hrvrd University Press, Cmbridge, MA). Newhouse, J.P., nd D.J. Byrne (1988), "Did Medicre's prospective pyment system cuse length of sty to fll?", Journl of Helth Economics 7(4): Newhouse, J.P., nd C.E. Phelps (1974), "Price nd income elsticities for medicl cre services", The Economics of Helth nd Medicl Cre (John Wiley & Sons, New York), ch. 9, Newhouse, J.P., nd C.E. Phelps (1976), "New estimtes of price nd income elsticities of medicl cre services", The Role of Helth Insurnce in the Helth Services Sector (Ntionl Bureu of Economic Reserch, New York), Chpter 7, Nichols, A., nd R. Zeckhuser (1982), "Trgeting trnsfers through restrictions on recipients", Americn Economic Review 72(2): Plmer, R.M., R.M. Sywell Jr., T.W. Zollinger, B.K. Emer, A.D. LBov, D.A. Freund, J.E. Grber, G.W. Mismore nd FB. Throop (1989), "The impct of the prospective pyment system on the tretment of hip frctures in the elderly", Archives of Internl Medicine 149(1): Puly, M. (1968), "The economics of morl hzrd: comment", Americn Economic Review 58: Puly, M. (1974), "Overinsurnce nd public provision of insurnce: the roles of morl hzrd nd dverse selection", Qurterly Journl of Economics 88(1): Puly, M. (1986), "Txtion, helth insurnce nd mrket filure", Journl of Economic Literture 24(2): Puly, M., H. Kunreuther nd R. Hirth (1995), "Gurnteed renewbility in insurnce", Journl of Risk & Uncertinty 1(2): Puly, M., nd S. Rmsey (1998), "Would you like suspenders to go with tht belt? An nlysis of optiml combintions of cost shring nd mnged cre", mimeo. Phelps, C.E. (1973), "The demnd for helth insurnce: theoreticl nd empiricl investigtion", RAND Reserch Pper Series, No. R-154-OEO. Phelps, C.E., nd J.P. Newhouse (1972), "Effect of coinsurnce: multivrite nlysis", Socil Security Bulletin Phelps, C.E., nd J.P. Newhouse (1972b), "Effects of coinsurnce of demnd for physicin services", RAND Reserch Pper Series, No. R-976-OEO. Phelps, C.E., nd J.P. Newhouse (1974), "Coinsurnce, the price of time, nd the demnd for medicl services", Review of Economics nd Sttistics 56(3): Plto, The Republic. Price, J.R., nd J.W. Mys (1985), "Bised selection in the Federl Employees Helth Benefits Progrm", Inquiry 22(1): Rmsey, S.D., nd M. Puly (1997), "Structurl incentives nd doption of medicl technologies in HMO nd fee-for-service helth insurnce plns", Inquiry 34(3):

80 642 D.M. Cutler nd R.J. Zeckhuser Ry, W.A., M.R. Griffin nd D.K. Bugh (199), "Mortlity following hip frcture before nd fter implementtion of the prospective pyment system", Archives of Internl Medicine 15(1): Rodgers, J., nd K.E. Smith (1996), "Is there bised selection in Medicre HMOs?", Helth Policy Economics Group Report (Price Wterhouse LLP, Wshington, DC). Roos, N.P., E. Shpiro nd R. Tte (1989), "Does smll minority of elderly ccount for mjority of helth cre expenditures? A sixteen-yer perspective", Milbnk Qurterly 67(3-4): Rosenthl, G. (197), "Price elsticity of demnd for short-term generl hospitl services", in: H.E. Klrmnnn, ed., Empiricl Studies in Helth Economics (Johns Hopkins Press, Bltimore, MD) Rosett, R.N., nd L. Hung (1973), "The effect of helth insurnce on the demnd for medicl cre", Journl of Politicl Economy 81(Mrch/April): Rothschild, M., nd J.E. Stiglitz (1976), "Equilibrium in competitive insurnce mrkets: n essy on the economics of imperfect informtion", Qurterly Journl of Economics 9(4): Russell, L.B., nd C.L. Mnning (1989), "The effect of prospective pyment on Medicre expenditures", New Englnd Journl of Medicine 32(7): Sger, M.A., D.V. Esterling, D.A. Kindig nd OW. Anderson (1989), "Chnges in the loction of deth fter pssge of Medicre's prospective pyment system", New Englnd Journl of Medicine 32(7): Scitovsky, A.A., nd N. McCll (1977), "Coinsurnce nd the demnd for physicin services: four yers lter", Socil Security Bulletin Scitovsky, A.A., N. McCll nd L. Benhm (1978), "Fctors ffecting the choice between two prepid plns", Medicl Cre 16(8): Scitovsky, A.A., nd N.M. Snyder (1972), "Effect of coinsurnce on use of physicin services", Socil Security Bulletin Shw, G.B. (1911), The Doctors Dilemm. Sheingold, S.H. (1989), "The first three yers of PPS: impct on Medicre costs", Helth Affirs 8(3): Sheingold, S.H., nd T. Buchberger (1986), "Implictions of Medicre's prospective pyment system for the provision of uncompensted hospitl cre", Inquiry 23(4): Slon, F.A., M.A. Morrisey nd J. Vlvon (1988), "Medicre prospective pyment nd the use of medicl technologies in hospitls", Medicl Cre 26(9): Smith, A. (1776), The Welth of Ntions. Spence, M., nd R. Zeckhuser (1971), "Insurnce, informtion, nd individul ction", Americn Economic Review 61(2): Stiger, D., nd G.L. Gumer (1995), "Price regultion nd ptient mortlity in hospitls", mimeo. vn de Ven, W.P.M.M., nd R.P. Ellis (2), "Risk djustment in competitive helth pln mrkets", in: A.J. Culyer nd J.P. Newhouse, eds., Hndbook of Helth Economics (Elsevier, Amsterdm) Chpter 14. vn de Ven, W.P.M.M., nd R.C.J.A. vn Vliet (1995), "Consumer surplus nd dverse selection in competitive helth insurnce mrkets: n empiricl study", Journl of Helth Economics 14(2): Wgstff, A., nd E.K.A. vn Doorsler (2), "Equity in helth cre finnce nd delivery", in: A.J. Culyer nd J.P. Newhouse, eds., Hndbook of Helth Economics (Elsevier, Amsterdm) Chpter 34. Welch, W.P. (1989), "Restructuring the Federl Employees Helth Benefits Progrm: the privte sector option", Inquiry 26(3): Weissmn, J., nd A. Epstein (1994), Flling Through the Sfety Net: Insurnce nd Access to Medicl Cre (Johns Hopkins University Press, Bltimore, MD). Wholey, D., R. Feldmn nd J.B. Christinson (1995), "The effect of mrket structure on HMO premiums", Journl of Helth Economics 14(1): Willims, A., nd R. Cookson (2), "Equity in helth", in: A.J. Culyer nd J.P. Newhouse, eds., Hndbook of Helth Economics (Elsevier, Amsterdm) Chpter 35. Willke, R.J., W.S. Custer, J.W. Moser nd R.A. Muscchio (1991), "Collbortive production nd resource lloction: the consequences of prospective pyment for hospitl cre", Qurterly Review of Economics nd Business 31(1):28-47.

81 Ch. 11: The Antomy of Helth Insurnce 643 Wilson, C. (198), "The nture of equilibrium in mrkets with dverse selection", Bell Journl of Economics 11(1): Wrightson, W., J. Genurdi nd S. Stephens (1987), "Demogrphic nd utiliztion chrcteristics of HMO disenrollees", GHAA Journl Zeckhuser, R. (197), "Medicl insurnce: cse study of the trdeoff between risk spreding nd pproprite incentives", Journl of Economic Theory 2(1): Zeckhuser, R. (1974), "Risk spreding nd distribution", in: H.M. Hochmn nd G.E. Peterson, eds., Redistribution Through Public Choice (Columbi University Press, New York) Zweifel, P., nd W.G. Mnning (2), "Morl hzrd nd consumer incentives in helth cre", in: A.J. Culyer nd J.P. Newhouse, eds., Hndbook of Helth Economics (Elsevier, Amsterdm) Chpter 8.