Question

Graphically illustrate the patient side moral hazard of a low copayment. Note the welfare loss

Answer 1

We describe research on the impact of health insurance on healthcare spending (“moral hazard”), and use this context to illustrate the value of and important complementarities between different empirical approaches. One common approach is to emphasize a credible research design; we review results from two randomized experiments, as well as some quasi-experimental studies. This work has produced compelling evidence that moral hazard in health insurance exists—that is, individuals, on average, consume less healthcare when they are required to pay more for it out of pocket—as well as qualitative evidence about its nature. These studies alone, however, provide little guidance for forecasting healthcare spending under contracts not directly observed in the data.

Typical health insurance contracts are annual and do not specify a constant consumer cost-share. Rather, they specify the consumer cost-sharing as a function of the cumulative (over the covered year) amount of healthcare spending. This function is typically concave. Figure 1 shows a stylized example of a typical contract. This example shows a concave, piece-wise linear schedule with three “arms”. In the first—the deductible range—the individual faces an out-of-pocket price of 100%; every dollar of healthcare spending is paid fully out of pocket. After the deductible is exhausted, which in this example occurs at $500 in total spending, the individual enters the “co-insurance” arm, where she faces a price of 10%; for every dollar of healthcare spending. Finally, once the individual has spent a total of $3,500 out of pocket (or $30,500 in total spending), she reaches the “out-of-pocket maximum” (also known as “stop loss” or “catastrophic coverage”) arm, at which point she faces no cost-sharing and has complete insurance coverage.

A typical health insurance contract in the United States. Figure shows a stylized annual health insurance contract, illustrating the mapping the contract creates from total medical spending to out of pocket medical spending. The x-axis shows total medical spending for the year and the y-axis shows the out-of-pocket medical spending for the year.

Journal of the European Economic Association

Oxford University Press

Moral Hazard in Health Insurance: What We Know and How We Know It

Liran Einav and Amy Finkelstein

Additional article information

Abstract

We describe research on the impact of health insurance on healthcare spending (“moral hazard”), and use this context to illustrate the value of and important complementarities between different empirical approaches. One common approach is to emphasize a credible research design; we review results from two randomized experiments, as well as some quasi-experimental studies. This work has produced compelling evidence that moral hazard in health insurance exists—that is, individuals, on average, consume less healthcare when they are required to pay more for it out of pocket—as well as qualitative evidence about its nature. These studies alone, however, provide little guidance for forecasting healthcare spending under contracts not directly observed in the data. Therefore, a second and complementary approach is to develop an economic model that can be used out of sample. We note that modeling choices can be consequential: different economic models may fit the reduced form but deliver different counterfactual predictions. An additional role of the more descriptive analyses is therefore to provide guidance regarding model choice.

1. Introduction

Empirical work in applied microeconomics is often loosely classified into two categories: “reduced form” or “structural”.1Although this classification is somewhat subjective, surely imperfect, and to some extent artificial—there is a richer spectrum of empirical approaches that could be broken down to many more than two categories—this simple classification is often used to imply two mutually exclusive approaches that are at odds with each other. And the researcher—faced with a question and a data set—is portrayed as needing to make an almost religious choice between the two approaches. In this paper we try to make the simple point—appreciated by many, but perhaps not all—that these two empirical approaches are in fact complements, not substitutes. Each has its own pros and cons. They should often be used in tandem (within or across papers) as scholars embark on answering a specific research question.

To illustrate this point, we use the specific topic of moral hazard in health insurance, on which there is a vast empirical literature (including our own) covering a range of empirical approaches. In the context of health insurance, the term “moral hazard” is widely used (and slightly abused) to capture the notion that insurance coverage, by lowering the marginal cost of care to the individual (often referred to as the out-of-pocket price of care), may increase healthcare use (Pauly 1968). In the United States—the context of all the work we cover in this paper—a typical health insurance contract is annual and concave. It is designed so that the out-of-pocket price declines during the year, as the cumulative use of healthcare increases.

We make no attempt to review the voluminous empirical literature on the topic. Rather, we select only a few specific papers—drawing (grossly) disproportionately on our own work—to illustrate the relationship and complementarities between different empirical approaches used to study the same topic. Our focus is thus not only on describing (some of) what we know, but also on how we know it.

We begin by defining the object of interest: what “moral hazard” means in the context of health insurance, and why it is of interest to economists. We then discuss work on three specific questions related to moral hazard in health insurance. First, we describe work that has tested whether moral hazard in health insurance in fact exists. There is a clear affirmative answer, with much of the most-convincing existing evidence coming from large-scale randomized experiments: Just like almost any other good, individuals increase their healthcare utilization when the price they have to pay for it is lower. Second, we describe work that tries to assess the nature of the consumer response. In particular, we ask whether individuals respond to the dynamic incentives that arise from the nonlinear health insurance contracts. Again, the general finding is positive, with much of the evidence driven by quasi-experimental studies. Finally, we describe work that attempts to forecast what healthcare spending would be under contracts we do not observe in the data. This requires a more complete model of individual behavior.

In the final section, we conclude by returning to our main goal in writing this paper, and discuss the cross-pollination across the methods and approaches used in the three preceding sections. Although all methods were used in the context of the same broad topic, the more specific questions they answer are slightly different. We highlight the value of each approach, and the important interactions between them. In particular, compelling “reduced form” causal estimates of the impact of health insurance contracts on healthcare spending are invaluable for testing specific hypotheses, such as whether there is any behavioral response or whether individuals respond to dynamic incentives. There are settings and questions in which such reduced form estimates may be sufficient. In particular, if the variation used is sufficiently close to prospective policies of interest, one might need to go no further. Yet, many—perhaps most—questions of interest require us to make predictions out of sample, for which economic models that rely on deeper economic primitives are important. These modeling choices should not be made in a vacuum; the descriptive evidence from the reduced form provides general motivation, as well as more specific guidance, as to which modeling choices are more appropriate in a given context.

We are clearly not the first to attempt to highlight the value of combining different empirical approaches in the context of the same question. Very similar views are expressed in Chetty (2009), Heckman (2010), Nevo and Whinston (2010), and Einav and Levin (2010), among others. Although tastes or skill sets of individual researchers may understandably lead them to disproportionately or exclusively pursue one particular style of empirical work, the literature as a whole benefits enormously from attempts to incorporate and cross-pollinate the two, within and across papers. Discussing these issues in the abstract is often difficult, so customizing the discussion to a specific context may be useful. Our modest goal in this paper is to provide such a specific context within which to illustrate this more general point.

2. “Moral Hazard” in Health Insurance

Throughout this paper, we follow decades of health insurance literature and use the term “moral hazard” to refer to the responsiveness of healthcare spending to insurance coverage. The use of the term in this context dates back at least to Arrow (1963). Consistent with the notion of hidden action, which is typically associated with the term “moral hazard,” it has been conjectured that health insurance may induce individuals to exert less (unobserved) effort in maintaining their health. For example, Ehrlich and Becker (1972) modeled health insurance as reducing individuals’ (unobserved) effort in maintaining their health; because health insurance covers (some of) the financial costs that would be caused by poor health behaviors, individuals may have less incentive to avoid them—they may exercise less, eat more cheeseburgers, and smoke more—when they have insurance coverage.

However, this so-called “ex ante moral hazard” has received very little subsequent attention in empirical work from the literature.2This may be because it is not empirically relevant in many contexts—the increased financial cost associated with poor health is not the only cost, and probably not the most important cost of being sick.

The focus of the moral hazard literature has instead been on what is sometimes referred to as “ex post moral hazard”. That is, on the responsiveness of consumer demand for healthcare to the price she has to pay for it, conditional on her underlying health status (Pauly 1968; Cutler and Zeckhauser 2000). In that sense, the use of the term “moral hazard” is a bit of an abuse of the “hidden action” origin of the term. The “action”—that is, the individual’s healthcare utilization—is in fact observed (and contractible), and the asymmetric information problem may be more naturally described as a problem of “hidden information” (regarding the individual’s health status). Yet, to stay consistent with decades of abuse of terminology in the entire health insurance literature, we use the term in a similar way and by “moral hazard” refer to how consumer demand for healthcare responds to the out-of-pocket price the consumer has to pay for that care.

Consumer cost-sharing is the typical name used for determining the out-of-pocket price the consumer has to pay for healthcare. Because the set of healthcare services is broad, and the price of each service could vary, insurers often specify coverage as a percentage share of the total healthcare spending.  The share of total healthcare spending paid by the individual is referred to as “consumer cost-sharing”; the remaining share is paid by the insurer. For example, a 20% consumer co-insurance or cost-share means that for every dollar of healthcare spending, the consumer pays 20 cents out of pocket and the insurer pays 80 cents.

Typical health insurance contracts are annual and do not specify a constant consumer cost-share. Rather, they specify the consumer cost-sharing as a function of the cumulative (over the covered year) amount of healthcare spending. This function is typically concave shows a stylized example of a typical contract. This example shows a concave, piece-wise linear schedule with three “arms”. In the first—the deductible range—the individual faces an out-of-pocket price of 100%; every dollar of healthcare spending is paid fully out of pocket. After the deductible is exhausted, which in this example occurs at $500 in total spending, the individual enters the “co-insurance” arm, where she faces a price of 10%; for every dollar of healthcare spending. Finally, once the individual has spent a total of $3,500 out of pocket (or $30,500 in total sp

A typical health insurance contract in the United States. Figure shows a stylized annual health insurance contract, illustrating the mapping the contract creates from total medical spending to out of pocket medical spending. The x-axis shows total medical spending for the year and the y-axis shows the out-of-pocket medical spending for the year.

Journal of the European Economic Association

Oxford University Press

Moral Hazard in Health Insurance: What We Know and How We Know It

Liran Einav and Amy Finkelstein

Additional article information

Abstract

We describe research on the impact of health insurance on healthcare spending (“moral hazard”), and use this context to illustrate the value of and important complementarities between different empirical approaches. One common approach is to emphasize a credible research design; we review results from two randomized experiments, as well as some quasi-experimental studies. This work has produced compelling evidence that moral hazard in health insurance exists—that is, individuals, on average, consume less healthcare when they are required to pay more for it out of pocket—as well as qualitative evidence about its nature. These studies alone, however, provide little guidance for forecasting healthcare spending under contracts not directly observed in the data. Therefore, a second and complementary approach is to develop an economic model that can be used out of sample. We note that modeling choices can be consequential: different economic models may fit the reduced form but deliver different counterfactual predictions. An additional role of the more descriptive analyses is therefore to provide guidance regarding model choice.

1. Introduction

Empirical work in applied microeconomics is often loosely classified into two categories: “reduced form” or “structural”.1Although this classification is somewhat subjective, surely imperfect, and to some extent artificial—there is a richer spectrum of empirical approaches that could be broken down to many more than two categories—this simple classification is often used to imply two mutually exclusive approaches that are at odds with each other. And the researcher—faced with a question and a data set—is portrayed as needing to make an almost religious choice between the two approaches. In this paper we try to make the simple point—appreciated by many, but perhaps not all—that these two empirical approaches are in fact complements, not substitutes. Each has its own pros and cons. They should often be used in tandem (within or across papers) as scholars embark on answering a specific research question.

To illustrate this point, we use the specific topic of moral hazard in health insurance, on which there is a vast empirical literature (including our own) covering a range of empirical approaches. In the context of health insurance, the term “moral hazard” is widely used (and slightly abused) to capture the notion that insurance coverage, by lowering the marginal cost of care to the individual (often referred to as the out-of-pocket price of care), may increase healthcare use (Pauly 1968). In the United States—the context of all the work we cover in this paper—a typical health insurance contract is annual and concave. It is designed so that the out-of-pocket price declines during the year, as the cumulative use of healthcare increases.

We make no attempt to review the voluminous empirical literature on the topic. Rather, we select only a few specific papers—drawing (grossly) disproportionately on our own work—to illustrate the relationship and complementarities between different empirical approaches used to study the same topic. Our focus is thus not only on describing (some of) what we know, but also on how we know it.

We begin by defining the object of interest: what “moral hazard” means in the context of health insurance, and why it is of interest to economists. We then discuss work on three specific questions related to moral hazard in health insurance. First, we describe work that has tested whether moral hazard in health insurance in fact exists. There is a clear affirmative answer, with much of the most-convincing existing evidence coming from large-scale randomized experiments: Just like almost any other good, individuals increase their healthcare utilization when the price they have to pay for it is lower. Second, we describe work that tries to assess the nature of the consumer response. In particular, we ask whether individuals respond to the dynamic incentives that arise from the nonlinear health insurance contracts. Again, the general finding is positive, with much of the evidence driven by quasi-experimental studies. Finally, we describe work that attempts to forecast what healthcare spending would be under contracts we do not observe in the data. This requires a more complete model of individual behavior.

In the final section, we conclude by returning to our main goal in writing this paper, and discuss the cross-pollination across the methods and approaches used in the three preceding sections. Although all methods were used in the context of the same broad topic, the more specific questions they answer are slightly different. We highlight the value of each approach, and the important interactions between them. In particular, compelling “reduced form” causal estimates of the impact of health insurance contracts on healthcare spending are invaluable for testing specific hypotheses, such as whether there is any behavioral response or whether individuals respond to dynamic incentives. There are settings and questions in which such reduced form estimates may be sufficient. In particular, if the variation used is sufficiently close to prospective policies of interest, one might need to go no further. Yet, many—perhaps most—questions of interest require us to make predictions out of sample, for which economic models that rely on deeper economic primitives are important. These modeling choices should not be made in a vacuum; the descriptive evidence from the reduced form provides general motivation, as well as more specific guidance, as to which modeling choices are more appropriate in a given context.

We are clearly not the first to attempt to highlight the value of combining different empirical approaches in the context of the same question. Very similar views are expressed in Chetty (2009), Heckman (2010), Nevo and Whinston (2010), and Einav and Levin (2010), among others. Although tastes or skill sets of individual researchers may understandably lead them to disproportionately or exclusively pursue one particular style of empirical work, the literature as a whole benefits enormously from attempts to incorporate and cross-pollinate the two, within and across papers. Discussing these issues in the abstract is often difficult, so customizing the discussion to a specific context may be useful. Our modest goal in this paper is to provide such a specific context within which to illustrate this more general point.

2. “Moral Hazard” in Health Insurance

Throughout this paper, we follow decades of health insurance literature and use the term “moral hazard” to refer to the responsiveness of healthcare spending to insurance coverage. The use of the term in this context dates back at least to Arrow (1963). Consistent with the notion of hidden action, which is typically associated with the term “moral hazard,” it has been conjectured that health insurance may induce individuals to exert less (unobserved) effort in maintaining their health. For example, Ehrlich and Becker (1972) modeled health insurance as reducing individuals’ (unobserved) effort in maintaining their health; because health insurance covers (some of) the financial costs that would be caused by poor health behaviors, individuals may have less incentive to avoid them—they may exercise less, eat more cheeseburgers, and smoke more—when they have insurance coverage.

However, this so-called “ex ante moral hazard” has received very little subsequent attention in empirical work from the literature.2This may be because it is not empirically relevant in many contexts—the increased financial cost associated with poor health is not the only cost, and probably not the most important cost of being sick.

The focus of the moral hazard literature has instead been on what is sometimes referred to as “ex post moral hazard”. That is, on the responsiveness of consumer demand for healthcare to the price she has to pay for it, conditional on her underlying health status (Pauly 1968; Cutler and Zeckhauser 2000). In that sense, the use of the term “moral hazard” is a bit of an abuse of the “hidden action” origin of the term. The “action”—that is, the individual’s healthcare utilization—is in fact observed (and contractible), and the asymmetric information problem may be more naturally described as a problem of “hidden information” (regarding the individual’s health status). Yet, to stay consistent with decades of abuse of terminology in the entire health insurance literature, we use the term in a similar way and by “moral hazard” refer to how consumer demand for healthcare responds to the out-of-pocket price the consumer has to pay for that care.

Consumer cost-sharing is the typical name used for determining the out-of-pocket price the consumer has to pay for healthcare. Because the set of healthcare services is broad, and the price of each service could vary, insurers often specify coverage as a percentage share of the total healthcare spending.  The share of total healthcare spending paid by the individual is referred to as “consumer cost-sharing”; the remaining share is paid by the insurer. For example, a 20% consumer co-insurance or cost-share means that for every dollar of healthcare spending, the consumer pays 20 cents out of pocket and the insurer pays 80 cents.

Typical health insurance contracts are annual and do not specify a constant consumer cost-share. Rather, they specify the consumer cost-sharing as a function of the cumulative (over the covered year) amount of healthcare spending. This function is typically concave. Figure 1 shows a stylized example of a typical contract. This example shows a concave, piece-wise linear schedule with three “arms”. In the first—the deductible range—the individual faces an out-of-pocket price of 100%; every dollar of healthcare spending is paid fully out of pocket. After the deductible is exhausted, which in this example occurs at $500 in total spending, the individual enters the “co-insurance” arm, where she faces a price of 10%; for every dollar of healthcare spending. Finally, once the individual has spent a total of $3,500 out of pocket (or $30,500 in total .