Fundamentals of Insurance (Part 2): The Bad (Moral Hazard)

The previous post explained the basic purpose of insurance (and should be read first). There are two limitations on how well this can be accomplished. The first of these is addressed here.

Spending Other People's Money

While insurance is great at smoothing out random expenses, it runs into trouble if those expenses are not entirely random. With health insurance, patients have some control over the outcome. In particular, we can choose how a particular health issue is treated, which could drastically affect how much the treatment costs.

Of course, in our other consumer activities, we make choices like this all the time. When we want seafood, do we buy fish sticks? Salmon? Lobster? We certainly think about the quality difference, but we also consider the price difference. In the end, we will buy whatever gives us the greatest net benefit (value minus price).

Generous insurance coverage stops us from thinking that way. It's like we are spending other people's money, so why should we deny ourselves the lobster? We choose the option that gives the greatest benefit, completely ignoring the costs. Suppose I cut my finger while woodworking (a pure hypothetical :-), and I need stitches. If I pay the same copay whether I am sewn up by an ER doc or a hand specialist, I'm going to choose the specialist — even if it costs my insurance company ten times as much and even if it is unlikely to have any effect on the quality of the stitch.

Unfortunately, many insurance plans have exactly this type of effect. Insured patients pay for a tiny fraction of the actual cost, and thus have very little incentive to compare the relative costs of various options to their relative benefits. (We economists label this problem moral hazard.)

It occurs in other ways as well. If our insurance company is picking up the bill, we have very little reason to shop around for the best price (such as with prescription drugs). Did you know that different pharmacies have dramatically different prices for the same drug? For most insured Americans, probably not. 88% of us pay the same copay at any pharmacy — while our insurer picks up the rest.

Wasteful Medical Spending?

You can fight moral hazard in one of three ways.

(1) Reduce coverage, by which I mean leaving the insured person responsible for a larger fraction of the medical bill. If a person has a personal stake in controlling the cost, surprise surprise, he will start thinking about the cost! The downside is that this leaves people exposed to more of the shocks of life (i.e. insurance won't fully smooth out the bumps). The upside is that insurance will be much less expensive.

So it's a balance between the value of insurance and the costs of moral hazard. My own academic research suggests that it doesn't take much to get patients cost-conscious — perhaps as little as 20% out of pocket. But it gives remarkable cost reduction — drug prices could fall as much as 50%! And it encourages the most effective use of medical resources.

(2) Deny coverage, by which I mean, the insurer inspects every treatment you intend to receive and decides whether you've made the right choice. If they think not, they refuse to cover it. This feature seems to be the most common source of hatred for private insurers, but don't think it disappears in government-run programs. Ask anyone on Medicare, or anyone in Britain. This is the main weight that governments use to keep costs from ballooning into the stratosphere.

This is where worries about choice start cropping up. Will I be able to pursue the medical treatment that my doctor and I feel are appropriate? The more we use option (1), the answer is yes. Your preferred treatment may be expensive, and you'll be paying a chunk of it, but not all of it. The more we use option (2), the answer is no. Your preferred treatment may be expensive, and if you still want it, you'll have to pay every cent of it. (Under HillaryCare back in the 90s, even that wouldn't have been an option. You would not have been allowed to circumvent your government-appointed HMO, even on your own dime.)

(3) Do nothing. We could just let everyone choose the lobster. But it's going to be expensive. And the insurance company will have to charge a premium that assumes you will choose the lobster. And with expensive premiums, many people (who don't think they need the lobster) will prefer to go uninsured.

The other problem is that it is wasteful. Many conditions can be treated almost as effectively in a much less expensive way. A friend of mine who is uninsured recently needed a medical issue examined and had a CAT scan. Because my friend asked about the cost, the doctor leveled with him, saying that the much more expensive MRI would provide very little additional information. Lobster isn't always best!

Of course, Obama routinely criticizes wasteful medical spending, but he usually just blames it on greed. That's not fair at all — it's all about moral hazard. Patients have no incentive to consider the costs, and certainly doctors don't either. Only the insurance company can intervene, and when they do, they get demonized for reducing coverage.

Unfortunately, government intervention almost certainly will do worse. Governments rarely encourage option (1); it's not popular to make people pay for their government goodies. Governments may lack the political will to even do (2). But rest assured, the moral hazard problem would exist in a "public option" just as much, if not more, than in private insurance. After all, they are spending other people's money.