When moral hazard is good: a critique of the united states health insurance system

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Ashley Gray

Economics Senior Thesis

University of Puget Sound

Spring, 2006

1. Abstract 3
2. Introduction 3
3. Insurance Concepts and Definitions 4

3.1 Moral Hazard
4. Historical Background 8

4.1 History of Health Care in the United States

4.2 Types of Insurance

4.2.1 Publicly Funded Health Insurance Medicare Medicaid

4.2.2 Private Insurance

4.3 Current State of Health Insurance in the U.S.

4.4 A Comparison to Other Industrialized Countries
5. Models of Health Insurance 19

5.1 Social Health Insurance

5.2 Actuarial Health Insurance
6. The Conventional Moral Hazard Critique 22

6.1 The Critique

6.2 Policy Solution

6.2.1 Deductibles

6.2.2 Coinsurance

6.2.3 Co-payments

6.2.4 Terms and Limits

6.2.5 Preexisting Conditions

6.2.6 Health Savings Accounts
7. The Challenge 27

7.1 RAND Corporation Study

7.2 The Distinction

7.3 The New Theory

7.4 Policy Implications
8. Conclusions 34


Health plays an immensely significant role in an individual’s life; it can determine both the quality and the length of a person’s existence. It is therefore no surprise that health care is such a prevalent and controversial topic in the world today. In contrast to the historically public and non-exclusive health insurance in Europe, the health care system in the United States is exclusive and relies heavily on the private market for financing (Geyman 2005). This American preference toward consumer-directed health care is explained by the conventional “moral hazard” theory of health insurance. According to this theory, full insurance encourages individuals to overuse health services because they appear “free” or highly subsidized. New theory, however, indicates that this dominant view of moral hazard is fundamentally flawed, that full insurance is in fact effective and efficient.


The dominance of the United States in health care research is clear. Since 1975, the Nobel Prize in medicine or physiology has been awarded to more Americans than to researchers in all other countries combined. As of 2002, eight of the ten top-selling drugs in the world were produced by companies headquartered in the United States (Ayres 1996). While the U.S. health care market provides excellent incentives for innovation and technological progress, American citizens, in general, have yet to receive good health care outcomes in comparison to citizens in other industrialized nations. In fact, the health insurance system in the United States is often discussed as an explanation for some of these negative effects on health care consumers. Concerns within public discourse regarding the fundamentals of the current health insurance system are not new developments. The U.S. ranks 37th in a current World Health Organization examination of the world’s health care systems (World Health Organization 2000). Modifying the health insurance system offers an especially attractive target for cost-saving reform. Specifically, reforms could be targeted to reduce the incentive to overuse health insurance as a payment mechanism1. Understanding the economic forces at work as well as the strengths and weaknesses of the health insurance system is central to developing policies that will lead to more cost-effective health care and to greater access to health care for those underserved by the current market.

This paper aims to analyze the economic relevance of moral hazard in individual health care decisions, investigating how pertinent the conventional moral hazard argument is to the health insurance industry. First, this paper will examine the notion of health insurance and its history within the United States. This paper will further explore the models and theories surrounding health care, critiquing the conventional theory of moral hazard and proposing a new alternative theory. Ultimately, the purpose of this thesis is to contend that the conventional and dominant theory of moral hazard is not entirely valid in the health insurance industry as it is in other spheres due to the concept of good, efficient health care moral hazard.

Insurance is a significant and widely-discussed topic in modern economics. Automobile insurance provides financial security against the possibility of an accident, home insurance provides financial security against the risk of a fire, flood or other hazards, and life insurance provides financial security to loved ones in case of a death. In each of these examples, the basic principle is the same: in exchange for a fee2, the insurer guarantees that some financial benefit will be supplied if one of these disastrous events occurs. Insurance is a valuable economic commodity for consumers. By giving up some income in the form of a premium, a consumer can avoid the large loss in wealth associated with an unfortunate event. Even if the event does not occur, a consumer still benefits from the reduced uncertainty provided by insurance.

Health insurance was designed with a purpose to pay the costs associated with health care. Health insurance plans pay the bills from physicians, hospitals, and other providers of medical services. By doing so, health insurance protects people from financial hardship caused by large or unexpected medical bills. For example, the cost of a one-day stay in a hospital3 can exceed $1,000 in some parts of the United States. A hospital stay that includes the cost of surgery and other physician services can easily produce bills exceeding $10,000. Health care costs of this magnitude pose substantial risks to many families’ financial well-being.

By combining, or “pooling,” the risks of many people into a single group, insurance can make the financial risks associated with health care more manageable. Through insurance, each person who buys coverage theoretically agrees to pay a share of the group’s total losses in exchange for a promise that the group will pay when he or she needs services. Essentially, individuals make regular payments to the plan rather than having to pay especially large sums at any one time in the event of sudden illness or injury. In this way, the group as a whole funds expensive treatments for those few who need them.

Insurance is generally not needed when there is little uncertainty or when financial risks are small. For example, insurance policies typically do not cover items such as groceries, clothing, gasoline, etc. Few individuals would find such a policy cost-effective. Suppose, for example, that an individual could purchase a grocery insurance policy with a “coinsurance” rate of 25 percent4. An individual with such a policy would be expected to spend substantially more on groceries with the 75 percent discount than he or she would at the full price. However, the insurance company would need to charge a high premium to cover the 75 percent discount on the groceries that the individual would have bought had he or she been paying real price of the product. This represents the inherent inefficiency in the use of insurance to pay for things that have little intrinsic risk or uncertainty. This example also illustrates the broader problem in insurance markets known as moral hazard.

In the past few decades an explanatory theory has developed among prominent American economists, which has also served as a significant justification for the lack of expansion of health insurance. This idea is known as “moral hazard.” Economist Mark Pauly was the first to argue in 1968 that moral hazard plays an enormous role in medicine. Moral hazard refers to the notion that individuals will make different choices when they are covered by an insurance policy than when they are not (Pauly 1974). Moral hazard is a result of asymmetric information; it exists when a party with superior information alters his behavior in such a way that benefits him while imposing costs on those with inferior information. Since most insurance plans reduce the out-of pocket cost of medical care, the behavior of individuals is affected by those reduced prices—this change in behavior is known as the moral hazard. In the same way that people treat water with little care when it is very inexpensive, the conventional theory of moral hazard claims that people also tend to overuse medical care when the out-of pocket costs are small.

The fundamental problem is that the insured individual has far better information regarding his or her health and behavior than the insurer. Therefore, after he has contracted for insurance, the insured can use that informational superiority to alter his behavior in a way that benefits him5. Because the insured’s health care is theoretically being paid by a third party6, he has an incentive to use health care less economically (Rothschild 1976). There are two primary and widely-discussed types of moral hazard resulting from consumers’ actions and behaviors. First, insurance may discourage fully insured consumers to take preventative measures. Insured individuals have less motivation to take care of themselves and lead healthy lifestyles in order to prevent the need of future health care. There is a cost involved in taking precautions to avoid an uncertain loss. However, fully insured persons have no reason to incur the costs of these precautions since their insurance will fully cover the loss; these persons therefore may engage in risky7 behavior. Moral hazard is the health care needed by an insured person because he did not take preventative actions to avoid the care. Second, insurance may encourage consumers to obtain medical care that is not necessary or crucial to his health. For example, this moral hazard occurs when an insured person spends an extra day in the hospital than is required or purchases some procedure that he would not otherwise have purchased. In both situations, health insurance creates a moral hazard problem because insured consumers tend to overuse medical services that, under uninsured circumstances, they would not have. Insurers generally dislike moral hazard because it often results in them paying more out in benefits than they had anticipated when originally setting premiums (Cutler 1998).

Moral hazard results from an asymmetry of information because the actions of the fully insured persons cannot be observed by insurance companies. Insurers therefore do not have complete information about the insured to know why each consumer needs the health care requested and what they intend to do with the care once they receive it. Does the consumer need the health care because he failed to take preventative measures which would have prevented the need for care or was the health situation a result of influences outside of the consumer’s control? This information asymmetry prevents insurers from knowing how financially responsible consumers should be for their personal health care.



The historical background of health insurance coverage in the United States helps explain why it is different from other types of insurance8. Health insurance in the United States is a relatively new phenomenon, dating back to the time of the Civil War (1861-1865). Early forms of health insurance primarily offered coverage against accidents arising from travel, especially by rail and steamboat (Cutler 1999). The success of accident insurance paved the way for the first insurance plans covering illness and injury. The first insurance against sickness was offered by Massachusetts Health Insurance of Boston in 1847. In the late nineteenth and early twentieth century, health insurance tended to cover wage loss rather than payment for medical services (Ayres 1996). This insurance is comparable to present-day disability insurance or workers compensation. Patients were expected to pay all other health care costs out of their own pockets, under what is known as the “fee-for-service9” business model.

The first modern health insurance policy originated in 1929 when a group of teachers in Dallas, Texas, contracted with Baylor University Hospital for room, board, and medical services as needed in exchange for a monthly fee. For an annual premium of $6, the policy guaranteed up to three weeks of hospital coverage (Eggleston 2000). Providing insurance through employers, rather than to individuals, lowered administrative costs for insurers. It also mitigated the problem of adverse selection10 because the insured group was formed without regard to health status. Many life insurance companies entered the health insurance field in the 1930s and 1940s, and the popularity of health insurance grew quickly thereafter. In 1932, nonprofit organizations called Blue Cross and Blue Shield first began to offer policies of group health insurance11 (Cutler 1999). These were the first programs that established contracts directly with health care providers, who would then offer services to subscribers at reduced rates.

In both Europe and the United States, the push for health insurance was led primarily by organized labor. In Europe, the unions worked through the political system, fighting for coverage for all citizens. Health insurance in Europe was public and universal from its origin. Germany introduced the first national health insurance program in 1883 and other industrialized countries adopted government-funded health insurance systems in the early twentieth century (Geyman 2005). In the United States, by contrast, the unions worked through the collective-bargaining system and, as a result, could win health benefits only for their own members. Health insurance in the U.S. has therefore always been a private and selective system with an emphasis on employer-based programs.

Employee benefit plans became a widespread source of health insurance in the 1940s and 1950s. Increased union membership at U.S. factories enabled union leaders to bargain for better benefit packages, including tax-free, employer-sponsored health insurance. Employer-based coverage was also encouraged in the United States by legal provisions during World War II (1939-1945) which allowed employers to compete for employees by offering employee health benefits during a period of wage freezing and price controls (Docteur 2003). Unable by law to attract scarce workers by increasing wages, employers instead enhanced their benefit packages to include health care coverage. In addition, a 1943 administrative tax court ruled that some employers’ payments for group medical coverage on behalf of employees were not taxable as employee income. Exempting premiums paid on employer-provided insurance resulted in lower tax receipts to the Federal government.12 Government programs to cover health care costs began to expand during the 1950s and 1960s. Medicare and Medicaid programs were implemented in 1965. Throughout most of the 1980s and 1990s the majority of employer-sponsored group insurance plans switched from fee-for-service plans to managed care plans (Steinmo 1995).

Figure 1: Types of Health Insurance and Coverage (US Census Bureau 2002)


The United States is the only industrialized nation that does not guarantee access to health care as a right of citizenship. Twenty-eight industrialized nations have single-payer universal health care systems13, while two have a multi-payer universal health care system14 (Bureau of Labor Education 2001). Government-funded national health care in these countries provides health insurance for all citizens. The United States government operates some publicly funded health insurance programs but access is limited to specific groups, such as the elderly and disabled15, the military veterans16, and the poor17. MEDICARE

Government-funded Medicare programs help to insure the elderly18, younger people with disabilities19, and patients with End Stage Renal Disease20 in the United States; Medicare currently provides health care coverage for 41 million Americans (U.S. Census Bureau 2002). Medicare is primarily financed by payroll taxes21 and monthly premiums paid by participants. Medicare has several parts: Hospital Insurance, Medical Insurance (helps cover doctors’ services, outpatient hospital care, and some other medical services that Hospital Insurance does not cover), Medicare Advantage Plans22, and Prescription Drug Plans (2004 Economic Report of the President). The program utilizes premiums, deductibles, and co-payments. MEDICAID

Medicaid in the United States is a program managed by the states and funded jointly by the states and federal government to provide health insurance for individuals and families with low incomes and resources. Medicaid currently provides health insurance coverage for approximately 11 percent of the U.S. Population (U.S. Census Bureau). As originally conceived, any household that fell below the federal poverty level would qualify for Medicaid benefits. In practice, however, budget shortfalls have forced states to vary standards for eligibility, services, and payment (Bureau of Labor Education). State participation in Medicaid is voluntary; however, all states have participated since 1982. In some states Medicaid pays private health insurance companies that contract with the state Medicaid program, while other states pay providers (i.e., doctors, clinics and hospitals) directly to ensure that individuals receive proper medical attention.


In the United States, private organizations have traditionally provided the vast majority of health insurance coverage. Approximately two-thirds of Americans obtain private health insurance coverage through employer-sponsored group plans (U.S. Census Bureau 2002). Americans pay the cost of health insurance in a variety of ways. Workers may pay for private health insurance by authorizing their employers to deduct a specified amount from their paychecks. Alternatively, individuals may work for employers who pay the direct cost of health insurance. People who do not receive health insurance through their employment or through government programs can purchase private health insurance policies by paying premiums directly to an insurance company. Almost ten percent of Americans purchase individual health insurance policies to cover medical costs (U.S. Census Bureau 2002).


The United States has a unique health insurance program. First, most health insurance is provided through employers. As shown in Figure 2, over 60 percent of all individuals in the United States have employer-provided health insurance (U.S. Census Bureau 2002). The central role of employer provision makes health insurance very different from other types of insurance, such as home and automobile insurance programs.

Figure 2: Health Insurance of Adults Under Age 64 (US Census Bureau 2002)

Secondly, health insurance policies in the United States tend to cover many events that have little uncertainty, such as routine dental care, annual medical exams, and vaccinations. For these types of predictable expenses, health insurance plays the role of prepaid preventative care rather than true insurance. If automobile insurance were structured like the typical health policy, it would cover regular maintenance, such as tire replacements, car washes, etc.

Third, health insurance tends to cover relatively low-expense items, such as doctor visits for colds or sore throats. Although often unforeseeable, these expenses would not have a major financial impact on most people. To continue the analogy, this would be similar to car insurance covering relatively small expenses such as replacing worn brakes.

The United States has the most expensive health care system in the world, as measured by health expenditures per capita and total expenditures as a percentage of gross domestic product (GDP). Countries that have national health insurance programs spend 5.5% less on health care as a percentage of their GDP than the United States (2004 Economic Report of the President). As shown in Figure 3, Americans spend approximately $4,887 per capita on health care every year, over twice the amount of the industrialized world’s median of $2,117 (Bureau of Labor Education 2001). The reasons for the especially high cost of health care in the U.S. can be attributed to a number of factors, including the rising costs of medical technology and prescription drugs as well as the high administrative costs resulting from the complex multiple player system in the United States. Administrative costs comprise between 19.3 and 24.1 percent of total dollars spent on health care in the U.S. (Woolhandler 1991). In addition, the high proportion of Americans who are uninsured (15.2 percent in 2002) contributes to expensive health care because conditions that could be either prevented or treated inexpensively in the early stages often develop into health crises (Ayres 1996). Studies have also shown that the uninsured who are not at a point of serious illness still tend to use the most expensive solution for their minor health care needs—they will go to the emergency room when only a visit with a physician is necessary. This is an inefficient use of health care.

Figure 3: Per Capita Spending on Health Care (Bureau of Labor Education 2001)

As shown in Figure 4, most industrialized countries have established systems in which the public sector, which has the greater share of responsibility, works alongside the private sector, both in the funding of health care. The United States is the only country in the developed world that does not provide health care for all of its citizens (Ayres 1996)

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