qotd: Disentangling moral hazard and adverse selection

National Bureau of Economic Research
January 2016
NBER Working Paper 21858
Disentangling Moral Hazard and Adverse Selection in Private Health Insurance
By David Powell and Dana Goldman

Abstract

Moral hazard and adverse selection create inefficiencies in private
health insurance markets and understanding the relative importance of
each factor is critical for policy. We use claims data from a large firm
to isolate moral hazard from plan selection. Previous studies have
attempted to estimate moral hazard in private health insurance by
assuming that individuals respond only to the spot price, end-of-year
price, expected price, or a related metric. The nonlinear budget
constraints generated by health insurance plans make these assumptions
especially poor and we statistically reject their appropriateness. We
study the differential impact of the health insurance plans offered by
the firm on the entire distribution of medical expenditures without
assuming that individuals only respond to a parameterized price. Our
empirical strategy exploits the introduction of new plans during the
sample period as a shock to plan generosity, and we account for sample
attrition over time. We use an instrumental variable quantile estimation
technique that provides quantile treatment effects for each plan, while
conditioning on a set of covariates for identification purposes. This
technique allows us to map the resulting estimated medical expenditure
distributions to the nonlinear budget sets generated by each plan. We
estimate that 53% of the additional medical spending observed in the
most generous plan in our data relative to the least generous is due to
moral hazard. The remainder can be attributed to adverse selection. A
policy which resulted in each person enrolling in the least generous
plan would cause the annual premium of that plan to rise by $1,000.

From the Introduction

Moral hazard and adverse selection create inefficiencies in health
insurance markets and result in a positive correlation between health
insurance generosity and medical care consumption. The policy
implications are very different, however, depending on the relative
magnitudes of each source of distortion, though isolating the
independent roles of both moral hazard and adverse selection is rare in
the health insurance literature. This paper separates moral hazard and
adverse selection for the health insurance plans offered by a large firm.

The average observed expenditures in the most generous plan are $3,969
more than the per person costs in the least generous plan. We estimate
that if selection were random, that the most generous plan would lead to
$2,117 in more spending than the least generous plan, implying that 53%
of the differential can be attributed to moral hazard. We also estimate
adverse selection without restrictive structural assumptions. We find
that if everyone in the sample were enrolled in the least generous plan
that the premium for that plan would increase by over $1,000.

2.1 Moral Hazard and Adverse Selection

Optimal policy depends on the relative important of adverse selection
compared to moral hazard in explaining the correlation between plan
generosity and medical care costs. The policy implications for moral
hazard are different than those required to confront adverse selection.
Adverse selection typically requires risk-pooling, while distortions
driven by moral hazard would motivate additional cost-sharing.

3.4 Attrition

If we define attrition as individuals enrolled in 2005 but enrolled for
less than 365 days in 2007, the attrition rate in the MarketScan data
(selecting on firms in the data in both 2005 and 2007) is 58.3%. Our
sample has a 58.7% attrition rate.

Conclusion

Understanding moral hazard and adverse selection in private health
insurance is widely- recognized as critical to policy. While the
literature has frequently estimated the effect of price on medical care
consumption, it has typically resorted to parameterizing the mechanism
through which individuals respond to cost-sharing. We show that these
assumptions typically contradict economic reasoning, and we provide
empirical evidence that these specifications perform poorly. In this
paper, we estimate the impact of different health insurance plans on the
entire distribution of medical care consumption using a new instrumental
variable quantile estimation method. These estimated distributions are
the distributions caused by the plans in the absence of systematic
selection into plans. We map these causal distributions to the
parameters of the plans themselves. We can statistically reject that
individuals only respond to the end-of-year price.

We also estimate the magnitude of adverse selection. We find favorable
selection in the least generous plan and adverse selection in the most
generous. We estimate that adverse selection is responsible for $773 of
additional per-person costs in the most generous plan, implying that an
individual considering this plan would pay over $60 per month in
additional premium payments simply to cover the expected costs of the
population selecting into the plan. Similarly, a policy which resulted
in our entire sample enrolling in the least generous plan would cause
annual premiums for that plan to rise by over $1,000.

We estimate that moral hazard is responsible for 53% of the differences
in expenditures between the most and least generous plans. Adverse
selection also plays an important role, accounting for the other 47%. In
the absence of moral hazard, the difference in average medical
expenditures across these plans would be $2,117 instead of $3,969.
Finally, we find that using the previous year's medical expenditures as
a metric of selection greatly overstates the magnitude of selection.

http://www.nber.org/papers/w21858

PDF of full paper (53 pages):
http://www.nber.org/papers/w21858.pdf

***


Comment by Don McCanne

In health insurance, moral hazard occurs when individuals obtain more
health care than they would have if it were not paid for by the insurer.
Adverse selection occurs when individuals with greater health care needs
select plans that provide greater coverage. Both have an impact on
health care spending. This paper estimates the relative impact of each
of these in spending under private health insurance.

Each is responsible for roughly half of the differences of expenditures
between the most and least generous health plans. So enrollees in the
more generous plans pay higher premiums because of both moral hazard and
adverse selection.

Today's standard in insurance coverage is shifting towards lower
actuarial value plans - plans that pay a lower percentage of the total
health care costs. What does this study tell us about premiums for these
less generous health plans? As more people enroll in them, which they
are, the premiums increase to cover the additional expenditures for
those who otherwise would have enrolled in the more comprehensive plans.
The lower actuarial value plans are subject to favorable selection (the
healthy buying less expensive plans in anticipation of not needing
care), but that diminishes as higher cost patients move from the more
comprehensive plans into these cheaper plans.

The insurance actuaries set premiums based partly on anticipated moral
hazard and adverse selection. Though less comprehensive plans
theoretically have less moral hazard and no adverse selection, the lower
premiums are attractive even to those with higher health care needs. As
Powell and Goldman have shown, increased enrollment in the least
generous plans cause premiums for those plans to increase. This likely
goes a long way toward explaining why premium increases this year were
much higher than the overall rate of inflation, even though the rate of
increase in total national health expenditures has slowed.

Under a single payer national health program, adverse selection doesn't
even exist since everyone is in the same plan. Efficiency is an
important goal of health care reform, and wouldn't it be much more
efficient putting these health economists to work designing a simple
single payer financing system, instead of laboring over the complexities
of making a dysfunctional and inequitable market of private health plans
somehow work for us, though not very well?