Over-Utilization, Under-Utilization How Would One Spot an Excessive Health Care Treatment

Over-utilization, Under-utilization… How would one spot an excessive health care treatment if it walked by?

Dahlia K. Remler, Ph.D.

School of Public Affairs Baruch College The City University of New York and NBER

Kamiar Khajavi**, JD, MD

Formerly of Department of Public Health Weill Cornell Medical College and presently in the private sector

Work in Progress Do not cite or circulate without the authors’ permission

October 20, 2008

Note: Khajavi has not seen recent drafts, which have substantial changes. Thus, Remler, and not Khajavi, bears responsibility for some portions of this current draft.

**Khajavi’s work was done primarily while he was at Cornell; he is now in the private sector.

We thank Diane Gibson, Marthe Gold and participants in seminars at the Cornell Department of Public Health, Pfizer Pharmaceutical Outcome Group and the 2005 International Health Economics Association meeting for comments on earlier drafts. We also thank Karl Kronebusch and many seminar participants for comments on a closely related paper. We thank Joe Newhouse for inspiring the title in a very different context. Khajavi gratefully acknowledges funding from Pfizer Pharmaceuticals. All responsibility for the content and opinions in the paper resides with the authors and no endorsement or responsibility for the funder or commentators is implied.

2 Abstract:

We frequently hear about over-utilization of health care—excessive health care—as a primary culprit of our health care cost crisis. Some advocate cost-sharing and policies based on it, like consumer driven health plans, as a solution. We also frequently hear about under-utilization of health care. Others, on the opposite side of the fence, advocate less cost-sharing and more insurance coverage, as a solution. Of course, we may have both problems simultaneously, but among different groups. However, implicitly, perhaps even unconsciously, the different sides have different definitions of excessive care. At one extreme, a health care treatment is deemed excessive if the recipient is unwilling to pay out of pocket. Nyman (2003, 2007) has challenged what he describes as the traditional analysis of health insurance, finding it accords with the extreme view above. At the other extreme, any health care treatment expected to have any positive benefit is deemed not excessive, no matter how great its cost. This view ignores economic (and political) reality. To the extent a middle view is articulated, it is usually based on some form of cost-benefit analysis (CBA). A clear conceptual definition of what constitutes excessive care would help prevent both sides talking past one another and support a constructive health care policy debate about cost containment. We extend Nyman’s work in several ways. First, we develop a simple contingent claims contract (CCC) view of the value of health insurance that is accessible to a wide policy audience. In it, if consumers are willing to pay the higher premium needed to ensure coverage of care under particular circumstances, then that care is not excessive. Second, we illustrate how the identification of the term “market” with out-of-pocket payment is misguided, because it ignores the health insurance market and the inter-relatedness of health care and health insurance. Third, we illustrate, with specific medical examples, the extent to which the value of a specific medical treatment depends on a tremendous clinical detail and the consequences for cost containment practices. Fourth, we contrast the CCC model with CBA, to which it is related. We find that CCC model fits better with an individualistic and market-based society because: (a) it does not require all benefits be expressed in dollars; (b) it is individualistic, rather than collectivist.

3 I. Introduction

“[T]here’s a systemic problem. Health-care costs are on the rise because the consumers are not involved in the decision-making process. Most health-care costs are covered by third parties. And therefore, the actual user of health care is not the purchaser of health care. And there’s no market forces involved with health care.” -- President George W. Bush, Third Bush-Kerry Debate of 2004 Presidential Campaign, October 13, 2004. (http://www.debates.org/pages/trans2004d.html)

“Market forces”, individual choice, consumerism and other such terms have figured prominently in the health policy debates of the last decade. Moreover, the policies identified with those terms, such as health savings accounts (HSAs) and consumer driven health care (CDHC), are supposed to increase out-of-pocket payment by patients at the point of service and reduce payments by insurers (Atlas 2005). The policies are often described as creating “more skin in the game.” 1 Supporters envision greater competition in the health care services market, driven by empowered and informed patient/consumers. This market rhetoric, however, blurs the distinction between consumer choice and market forces at the level of health care and consumer choice and market forces at the level of health insurance. These are not the same and are often in conflict (Remler, Brown and Glied). Enthoven’s (1980) original managed competition vision was based on market competition at the health insurance plan level, driven by ordinary individuals who might or might not end up using health care services. Enthoven’s vision has been partially realized in managed care, but the ensuing backlash against managed care fueled interest in cost-sharing based CDHC. Thus, interest in tradeoffs at the patient level, rather than at the insurer level, increased. Underlying the out-of-pocket based proposals is the widely taught and widely repeated moral hazard rationale: With insurance, patients pay only a fraction (if any) of the cost of health care services. Therefore, they choose to consume health care treatments whose marginal benefits (to the patients) exceed the marginal costs (to society). Such care is deemed excessive. It is said to make society worse off than if only care the patient would choose to purchase out of pocket were consumed. In the tradition story, the

1 Remler and Glied (2006) have shown that current HSA policies and proposals actually do not represent a significant increase in cost-sharing and that very substantial increases in cost-sharing would be needed to reduce expenditures.

4 magnitude of such excessive care is assumed to be large and a significant contributor to our health care crisis. I will term both the policies based on this perspective and their supporters “out-of-pockets.” The traditional excessive care story, however, ignores the perspective of those purchasing insurance. The basic value of insurance comes partially from financial protection in the event of illness but also from increasing the use of beneficial medical care beyond what patients would or could purchase if they had to pay entirely out of pocket. Nyman (2003, 2007) has shown and stressed that the widely taught form of traditional model has simplifications that preclude the second value of health insurance, which he has termed the access value. In effect, the traditionally taught model compares the benefits to the patient to the costs to society. It ignores the ex ante perspective, the desirability of transferring money to unhealthy states in order to increase health care usage—a major reason that health insurance is valuable. In the standard simplified model, the optimal level of health care services is that which would be purchased with no insurance whatsoever and payment being entire out of pocket; anything else is “excessive” and an undesirable side-effect of the financial protection role of insurance. While many commentators today, including Fuchs and Emanuel are decrying our “perfect storm of over-utilization” (2008), others are decrying our tremendous problems of under-utilization (XX cite). Of course, it is possible to have both problems simultaneously among different groups, with under-utilization being present among the uninsured. However, some of the different perspective is probably among the same people. Much of the current under-utilization is said to be due to precisely the kind of cost-sharing advocated by the “out-of-pockets.” Some of those who decry under-utilization are what Glied (1997) has termed medicalists: they believe that there are well-defined health care needs and everyone has a right to have those needs provided. Implicitly, if not always explicitly, many medicalists hold a belief at the opposite end of the spectrum from the “out-of-pockets.” Specifically, they reject the notion of any role for costs and believe that any health care treatment expected to have any positive value should be covered by insurance. They further believe that everyone should insurance to cover all such care is a right that everyone should have.

5 Thus, no health care treatment with an expected positive value, no matter how small, is excessive. I will term these advocates and the policies they support the “at any costs.” While attractive, this opposite extreme ignores both economic and political reality. Funding everything effective for everyone is beyond our means, certainly on a global scale and probably on a national scale. Trying to come close would require taking funds away from other valuable sectors, such as education and infrastructure, to fund less valuable aspects of health care. Politically, trying to come close requires far more redistribution that United States citizens have been willing to do and a level of redistribution that Europeans are moving away from. Cost-effectiveness analysis (CEA) provides the only explicit definition of excessive care which takes an intermediate position and avoids both the “out-of-pocket” and “at any cost” extremes. CEA trades off the costs to society of health care with the benefits to the society as a whole—the benefits to ordinary citizens who might or might not get a particular condition (Gold et al 1996). While specific uses of CEA have major informational and technical problems, the conceptual definition of excessive care is clear and intuitive. CEA is widely used to make coverage decisions by the National Health Service in Britain and in some other countries (Pearson and Rawlins 2005). However, CEA has made few inroads in the US, although its rise is both advocated and predicted (e.g., Garber 2004). Some allege that the resistance to CEA in the US is based on opposition to “rationing” (any limitations on effective health care) but Gold et al 2007 have some evidence that this is not so. We contend that part of the difficulties CEA has in gaining acceptance in the US is its collectivist perspective that is at odds with American’s emphasis on individualism, markets and choice. Managed competition implicitly contains an intermediate definition of excessive care, but it suffers from the lack of explicitness. Managed competition envisions consumers trading off the premiums of plans (their costs) with the benefits they would provide in health circumstances that might or might not occur (Enthoven 1980). The benefits encompass both the quality of the care and the breadth of coverage. This intermediate perspective, however, gives neither consumers nor plans any guidance about how to make specific tradeoffs. Indeed Eddy (1991a, 1991b) advocates that plans use

6 CEA to make coverage decisions. While the backlash against managed care has many causes, a critical one is that the plans were trying to skimp on care to save money (Enthoven and Singer 1998). Americans did not like the idea of some big anonymous entity trying to save money, even though they also prefer plans with lower premiums. The lack of transparency and the anonymity of the tradeoff are certainly problematic. However, a significant problem is that plans lack language with which to articulate what coverage limitations might be legitimate, unless the care is shown to be utterly ineffective (Garber 2004). We contend that managed competition would be more acceptable if limits in coverage could be presented to Americans as choices that they freely and knowledgably made.2 Currently in the US, health care policy discussion often consists of the two extreme views, the “at any costs” and “out-of-pockets”, talking past one another without common language or paradigms. They use terms like over-utilization and under- utilization but they share no common definitions. The one conceptually clear intermediate definition, CEA, is based on a collectivist paradigm. Managed competition, another intermediate perspective, has no clear definition of excessive care, and no way to teach consumers about how to make tradeoffs. Productive discussion of health care policy requires a conceptual definition of excessive care that all sides can accept and that fits with US political, philosophical and economic norms. To create such a definition, we extend and simplify Nyman’s (2003, 2007) work. We develop a simple contingent claims contract (CCC) model and use it to create a conceptual definition of excessive care that is accessible to a wide policy audience. Specifically, our proposed definition is that if consumers are willing to pay the higher premium needed to ensure coverage of care under particular circumstances, then that care—that coverage-- is not excessive. We rush to stress that we do not believe that plans could articulate every coverage situation—indeed we stress the overwhelming impossibility of this. We are even more sure that consumers could not understand all the contingencies. Nonetheless, we contend that the conceptual definition helps a great deal. It helps avoid the extremes and provides 2 Tradeoffs in choice of doctor and hospital, as well as coverage for some kinds of treatment, are currently made in precisely this way. However, choices about coverage of particular forms of care under particular medical circumstances, the venue of utilization review, are not made this way or even conceptualized this way.

7 intellectual clarity for a center vision. It can provide legitimacy to CEA and managed competition. The paper is structured as follows. In section II, we develop the contingent claims contract (CCC) model of health insurance and illustrate the value of health insurance. The model inevitably makes a variety of simplifications but we develop it fully enough to make all of those simplifications explicit. In section III, we illustrate why health insurance inevitably causes genuinely excessive care, along with desirable increases in care, and illustrate the definition of excessive care. In section IV, we discuss the effect of relaxing some of the model’s simplifications and how that complicates applying our definition of explicit care. In section V, we discuss the relationship of the CCC model to CEA. In section VI, we return to the big picture of health care policy, discussing how CCC furthers managed care and fits into the big picture of health care perspectives. Our proposed definition and its value can be understood without extensive discussion of the history of thought about moral hazard in health care. However, that history has shaped policy and parts are likely to be familiar to readers. Therefore, in an appendix, we relate our model to the history of the use of the term moral hazard in health care and to Nyman’s work.

II. Contingent Contracts: Realizing the Value of Health Insurance The purpose of our model is to support our proposed definition for excessive care caused by insurance: are you willing to pay the higher premium needed to provide coverage under particular circumstances? If so, it’s not excessive. Obviously, such a definition neglects many philosophical and technical issues. In this section, we lay out the basic contingent claims contract (CCC) model of health insurance in some detail.3 In order to make the assumptions clear and allow comparison to other models, it is more technical than is essential. We also provide an accessible simple numerical example to support the definition. Our model builds on and simplifies Nyman’s model (1991a, 1999b, 2001, 2003, 2004, 2007) and in the appendix, we discuss the relationship of our

3 The contingent claims model of health insurance extends back to Arrow (1963) and has been implicit in several theoretical economic treatments of health insurance since then. Unfortunately, as discussed in the introduction, the model did not make it into health policy debate. Moreover, the full implications of the clinical complexity of medical decisions, and therefore just how many relevant states there are, were not addressed.

8 model to his. In section V, we address many of the issues neglected due to our assumptions. The CCC model plays multiple roles. First, it captures the essence of what health insurance is and how it works. Second, it illustrates what an ideal health insurance contract, illustrating what we would like to have but cannot, for reasons of medical complexity. Finally, and most importantly, the model provides a conceptual definition of the first-best for health insurance coverage and medical care consumed. With such a definition, we can conceptually disentangle care we would like policies to eliminate or reduce from care that we want policies to enable or promote. We take the traditional perspective of economists: individualistic and utilitarian. So, individual preferences are assumed to be given and we consider how to best pursue those preferences in light of limited resources. Most importantly, our perspective precludes the idea that health care is a “basic human right” and neglects idea of distributive justice. In some sense, the individualistic perspective facilitates inequality However, less restrictive forms of the model which incorporate heterogeneity in wealth allow can address redistribution and mechanisms to accomplish it. We return to the issue of equity in section V.

Formal CCC Model The most restrictive assumptions of our model are that there are no selection in insurance markets or inequalities in wealth and income. Specifically, our model assumptions are as follows: First, individuals are assumed to be identical in income or wealth and identical in their tastes for medical care and other goods. Second, neither behavior nor prior medical care can affect an individual’s risk of illness. Third, medical care is a purely private good, with no externalities: care such as vaccines or mandatory treatment of infectious diseases, which can prevent individuals from infecting others, is not included. Fourth, all individuals are identical in their initial-- or ex ante -- risk of illness. Thus, each person is ignorant ex ante of his medical or family history. Finally, and most importantly, there is no real notion of time: uncertainty does not unfold over time but in one single shot. Thus, insurance does not consist of repeated limited-time

9 contracts but rather consists of a single one-shot contract. We return in section IV to some of these complexities. The model has four periods, illustrated in Figure 1. In period one, everyone is in the same position: no one knows who will stay healthy and who will get sick, or how they will get sick. We assume that everyone is identical, with the same preferences and the same income and wealth. In this stage, all stand behind a veil of ignorance (Rawls) with respect to their personal medical and family histories and the medical future is completely uncertain. In period two, everyone discovers his state of health: some are perfectly healthy, others slightly ill, still others seriously ill. In economists’ jargon, the uncertainty is realized.

Figure 1: Time periods of CCC model of health insurance

Time = 1 Time = 2 Time = 3 Time = 4 Everyone Uncertainty realized: Medical Health and all identical in health Everyone discovers treatment other Ex ante health status provided consumption experiences

Expensive medical treatment can help the ill improve their health, often substantially so. In period three, medical treatment can be provided. In period four, each person is in the state of health that has been revealed in period two, as affected by any interventions made in period three. (Death is one possible such state.) We refer to all goods and services other than medical care, such as housing, entertainment, education and food, as “all other goods.” In this fourth period and only in this fourth period, each person is also able to enjoy all other goods. For those who die, imagine that the other goods are passed to their heirs and that they value their heirs’ consumption.4

4 Thus, these “periods” (the term common in formal economic models) are not really periods of time unfolding, so much as uncertainty unfolding.

10 Medical care is often very expensive, frequently quite beyond the means of an individual.5 The care can also be highly valuable, able to turn certain death into life, pain into comfort, disability into ability. In a world without insurance, everyone is left to try to fund their medical treatment out of pocket. It may be utterly unaffordable given their lifetime income. Alternatively, it might be accessible but at massive cost in terms of foregone consumption of all other goods. Initially, in period one, no one knows whether or not such expensive care will be valuable to them or not, because they do not know their health state yet. Therefore, individuals may want to pool their resources to provide for medical coverage: everyone pays some amount into a fund which is used to cover the costs of medical care of those who get an unlucky draw. At its core, health insurance is about transferring money from good health states, in which medical care is not so valuable, to bad health states, in which medical care can be very valuable. This is the critical insight into why health insurance is valuable (Nyman 2003, 2007).

Numerical Example To make the abstract model more accessible, a simple numerical example is helpful. Imagine that there are only two possible health states: cancer and perfect health. Everyone has a 5% chance of getting cancer and a 95% chance of perfect health. Medical treatment has no value for those in perfect health. For those with cancer, no treatment implies certain death, while medical treatment can reduce the probability of death (conditional on having cancer) to 50%. Medical treatment is the same for all cancer victims and costs $100k. Each individual, however, has only $50k in lifetime wealth. Table 1 Cancer Treatment Probability of Outcome Health Outcome Cost of Care (Conditional on Having cancer ) No Treatment 100% Death $0 Treatment 50% Perfect Health $100k

5 This high expense is intrinsic, not driven by power of providers or any “illegitimate” or avoidable source or market distortion from insurance. While such factors certainly exist, they are not the dominant source of high costs. Rather, it is the inevitable consequence of the time, training, and other resources that go into providing the care (Cutler book).

11 50% Death

What happens in a world with no insurance? Cancer victims could beg, borrow or steal the $50k they need in order to obtain treatment. Otherwise, cancer victims are condemned to die, even though medical treatment could potentially save them. Contrast that fate for cancer victims with their fate in a world with insurance. Everyone pools together, paying insurance premiums. The premiums must be sufficient to cover medical treatment for those who are unlucky enough to become cancer victims. If we neglect administrative costs, the premium necessary is simply the actuarially fair premium (AFP):

AFP = Expected Loss = probability of cancer * cost of cancer treatment = (.05)*($100k) = $5k

Of course, for insurance to work, we need many participants so that the usual law of large numbers applies: the probability that any given individual gets cancer is the same as the share of the population that gets cancer. The need for large insurance pools places some restrictions on possible real world contracts. In evaluating the desirability of insurance, each person must consider whether he wishes to transfer wealth from the state of good health into a state of ill health, i.e. to spend $5,000 against the possibility of getting cancer and wanting $100,000 for cancer treatment. Is it worth giving up $5k in all other goods-- $5k less for housing, education, entertainment and so on—in order to ensure insurance coverage for potentially life- saving medical treatment should one get cancer? If so, then the insurance contract is worth having. If not, then all the ex ante identical (representative) individuals would decide not to enter into the insurance contract. In summary, the basic value of health insurance stems from four sources: (1) there are some states in which health is very bad; (2) in some of those bad health states, medical care can substantially improve health; (3) medical care is often extremely, or even prohibitively, expensive; and (4) those bad health states are relatively rare (i.e., not prevalent), so that affordable financial sacrifice in good health states enables coverage of

12 medical care in the bad states.6 As the example illustrates, the core of health insurance is the transfer of funds from healthy states into unhealthy states. The motivation for such transfers is that funds are more valuable in the unhealthy states because they can be used to purchase expensive medical care. The fact that such insurance causes medical care consumption to rise does not necessarily make such care excessive from a welfare point of view but is a major purpose of insurance.

III. Defining Excessive Care and Excessive Coverage In the simple numerical example, insurance did not cause any excessive care. In that example, insurance coverage should be universal and extend to all the valuable care (the sole cancer treatment!). We can gain insight into excessive care and how insurance, along with contracting problems, can encourage it by extending our simple numerical model. Imagine now that there are two possible cancer treatments: (1) the one described above, the low cost treatment, which for $100k transforms certain death into a 50% chance of death; and (2) a competing treatment, the high cost treatment, which for $200k transforms certain death to a 48% chance of death. As before, the actuarially fair premium for coverage of the low cost treatment is $5k. The actuarially fair premium for the coverage of the high cost treatment is $10k, based on the same 5% chance of cancer and a $200k cost of treatment for cancer victims. The incremental cost of the high cost treatment coverage relative to the low cost treatment coverage is $5000, the difference in the AFP. The incremental benefit, looked at ex post, from the perspective of a cancer victim, is a 2 percentage point decrease in the likelihood of death, from 48% to 50%. However, to make a fair comparison, we have to compare ex ante to ex ante. The incremental benefit of the more expensive coverage is a reduction of the probability of death from 2.5% to 2.4%, a .1 percentage point fall. However, it is hard to think of the benefits of health care from this abstract ex ante perspective. Indeed, that is one of the difficulties people have in understanding CBA. Indeed, we can think of the benefit as a 2 percentage point fall conditional on getting cancer, remembering that cancer occurs with 5% probability.

6 If AFP is likelihood multiplied by cost of care, the AFP for common conditions might be relatively high because of the size of the “likelihood” term.

13 With either method of thinking about benefits, the question is: “ex ante, behind the veil of ignorance (Rawls), would a consumer chose to give up $5000 which could be spent on all other goods, in order to have this benefits (conceptualized as either 0.1 percentage point fall in the probability of dying or a 2 percentage point fall conditional on getting cancer)?” If the answer is yes, then the high cost contract would be preferred to the low cost contract. In that case, the expensive treatment option would not be excessive care. However, if individuals would prefer not to make the additional $5000 sacrifice, preferring to spend those funds for example on education, and instead would prefer the low cost coverage, then the high cost treatment option would represent excessive care. In our simple example, consumers could chose between the low cost coverage and the high cost coverage. In the real world, however, we are often unable to only allow for coverage of low cost treatments and exclude coverage for high cost treatments (Havighurst 1995, Remler 1994). Under such circumstances, if individuals prefer coverage for high cost treatment to no insurance coverage, then part of the treatment allowed by insurance is excessive. Specifically, the increase from the low cost treatment to the high cost treatment represents excessive care, because ex ante individuals would have preferred the contract with the lower premium and less effective care to the contract with the higher premium and more effective care cost care. This provides a clear conceptual definition for excessive care.

Why we can’t stop ourselves from consuming the excessive care Our numerical example had just one disease for which health care was useful, cancer, and just two treatments. Therefore, it is easy to perfectly specify the circumstances under which particular treatments are covered: the optimal CCC is trivial to write and understand. When there are many, many health states and many, many treatment options, however, specifying the contract is vastly more complicated but conceptually the same. The first-best solution to coverage would be a perfect contingent contract written in period one, behind the veil of ignorance. It would specify each possible future health state which might occur in period two and the choice of intervention, if any, for such state in

14 period three. The medical interventions covered are exactly contingent on the health state. Individuals would choose (and pay the AFP for) medical treatments to be received in period three. They would make that choice so that from a period one perspective, there is no way to made better off by transferring resources from one health state to another. The first best insurance contract will equate ex ante the value of the marginal dollar across all health states so that there is no way to make people better off by transferring funds from one state (e.g., minor cold or even good health) to another state (e.g., cancer). It is critical to understand that the term “health state” does not simply refer to a disease or some broad characterization of health. Rather, the term health state refers to every single patient characteristic that might affect the expected benefit of medical treatment, which itself depends on a great deal of clinical detail. Therefore, a health state is not simply something like “heart attack,” but also age, functional status, renal condition, the number of lesions, the significance of the lesions, the extent of blockage and so on. An example will help illustrate the point. MRI scans can be very effective for diagnosing serious medical conditions, such as strokes or tumors. Headache is often a presenting symptom of strokes and tumors. However, the vast majority of headaches are benign and not symptomatic of any serious underlying condition. Distinguishing a serious headache (one that could be a sign of stroke or tumor) from a non-serious one depends on many specific clinical details, including: the intensity and suddenness of onset of the headache; the presence of other neurological deficits, such as paralysis; mental status changes; history of hypertension. A consumer entering an insurance contract might prefer a lower premium with only coverage of MRIs for headache when many of these conditions are clearly met. Or a consumer might prefer a higher premium with coverage of an MRI when any small and still unlikely indication of tumor or stroke is available. However, given that the likelihood of a tumor or stroke can vary dramatically depending on the clinical circumstances, the consumer might well prefer coverage of an MRI for headache under some fairly specific circumstances but not others. It is easy to significantly increase premiums through a lot of MRIs. (American do far more MRIs than other wealthy countries. (Emanuel and Fuchs 2008).) On the other hand, the value of catching a brain tumor early is enormous and

15 worth spending a large amount for. Thus, the consumer might be willing to pay a somewhat higher AFP to ensure coverage of an MRI for headache but only under particular clinical circumstances. The centrality of specifying clinical detail in the CCC has important real world implications and is essential to a meaningful definition of excessive care. We do not want a contract that specifies something simple like “if I have a bad headache an MRI is covered.” Rather, we want a much more complex contract, such as “if I am above a certain age, if the headache is of a certain type and if I have particular risk factors for, or other symptoms consistent with, brain tumors or stroke then an MRI is covered.”7 The value of an MRI for someone with a headache can range from zero to life saving, and the devil is in the clinical details. Specifying each health state would involve specifying not only the disease but an extremely complex set of signs and symptoms. Obviously, no real contract could ever contain such specificity and even if it could no one could comprehend all of it. Making matters even more complicated, these health states are difficult for the insurer to observe and ever-changing as technology provides us new diagnostic and treatment modalities and as new medical conditions occur (e.g. HIV/AIDS, SARS). The real world health insurance contracts we currently use specify ex ante what they cover generally in only the vaguest clinical terms, usually “medically necessary care,” subject to a general list of exclusions such as “experimental therapy” (Havighurst 1995, chapter 5; Bergthold et al 2002).8 With such vague contracts, there is much potential conflict ex post about whether certain treatments are covered or not, giving rise to disputes over utilization review denials.9 Moreover, such contracts make it difficult to exclude coverage for only slightly beneficial but very costly care. The clinical complexity needed for enumeration or enforcement of the contract, even in our abstract model, means that excessive care is an inevitable consequence of health insurance.

7 At least, this is what we want in economic terms. Later, we discuss psychological issues, including bounded rationality and the inability to deal with too much complexity. 8 Aetna is an exception, posting much of the clinical detail for approving coverage on the web. 9 In another paper, Remler and Khajavi (2007) we discuss the law and operation surrounding utilization review and how this model could help shape both.

16 IV. Selection, Cognitive Limitations, Inequality and Other Complexities The simple perfect CCC model of health insurance captured the essence of health insurance but ignored myriad other complexities of the real world. While many of these complexities restrict the forms health insurance can take in the real world10, only some of them are relevant to our definition of excessive care: (1) unfolding risk over time and selection; (2) technological and epidemiological change; (3) cognitive limitations comprehending complexity; and (4) differences in income and wealth. These complexities limit the forms that contracts and the insurance market can take. Some of them make it hard to use of simple definition of excessive care. Our simple model had a single period during which uncertainty about health was resolved. In reality, uncertainty about health evolves over time. Our simple model is more appropriate for life-time insurance or social insurance, not the kinds of time-limited (typically annual) contracts that we have in the US. 11 Because what individuals seek is meaningful insurance over time, selection is a major problem, but a well-studied and well-understood one. Relatively healthy individuals choosing insurance plans have an ex ante (behind the veil of ignorance) perspective. However, individuals with a chronic condition or those with a history of acute conditions at further risk, are no longer in the ex ante position and it is difficult to get a relevant definition of excessive care for them. So, using healthy individuals’ definition of excessive care is, in some sense correct. However, that perspective misses the fact that such individuals might have gotten ill earlier.12 Technological change in medical care, including not only new tests and treatments but also advances in our knowledge about the basis of disease, means that the optimal contract—the contact that individuals would choose ex ante-- changes constantly. New diseases, such as HIV in the early 80s and more recently SARS, emerge, further changing the optimal contract. Obviously, consumers cannot have an opinion about what constitutes excessive care with regard to conditions or treatments that do not yet exist.

10 See Remler and Khajavi (2007) for a further discussion of how real world complexities affect this model. 11 Cochrane (1995) and Pauly et al (XX) have examined how meaningful insurance over time might be implemented, but it is an extremely difficult task. 12 CEA suffers from the same difficulty in getting the right perspective (Gold et al 1996).

17 No insurer could possibly specify the full coverage details or a CCC and no individual could come close to comprehending it. The psychology and behavioral economic literature is filled with examples of how people can be overwhelmed by information and choice, inhibiting beneficial action (Iyengar and Lepper). Our definition of excessive care in terms of contingent coverage is conceptual. Nonetheless, for it to be useful, consumers will need some specific examples and even this may be beyond most cognitive limitations. Finally, our model made all individuals identical in wealth and income. Since much of the debate about heath care policy is about redistribution between different income groups, this would seem to be very problematic. In fact, it is one the most easily relaxed assumptions. Indeed, one motivation for an individualistic definition of excessive care is precisely to allow inequality based on income and wealth. Individuals with different wealth would make different tradeoffs. With the traditional magic wand of economists, concerns about equity can be addressed by redistributing money and concerns about equity in health care can be addressed by redistribution that provides vouchers.13

V. Contingent Claims Contract Definition of Excessive Care vs. CEA Our CCC based definition of excessive care is an individualistic counterpart to the CEA definition of excessive care. Presently, Cost Benefit Analysis (CBA) and CEA offer the only conceptually clear definition of excessive care other than the extremes of the “out-of-pocket” and “at any cost” perspectives. Why is the CCC test of willingness to pay a higher premium for specified contingencies valuable, either instead of or in addition to the CEA definition? How do the two compare? CBA (cite xx) is a standard method of economic analysis designed for public sector decision-making when there are no markets. A particular action is worth taking if its benefits, somehow measured in dollars, exceed its costs. In the context of health care, the issue is whether a particular treatment should be covered by some (generally public) insurer. For health care CBA, there are two critical pieces of knowledge: (1) How much (incremental) health results from the additional health care treatment? (2) How valuable

13 In fact, with regard to definitions of excessive care, such concerns can be addressed, but this is more complicated for actual health insurance markets, because selection complicates matters.

18 (in dollars) is that additional health? Unstated in both questions are two issues: First, who benefits— i.e., whose health? Second, whose value of health and other goods should be used in translating additional health into dollars? CEA (e.g., Gold et al 1996, Weinstein XX, Neumann XX) is essentially derived from CBA. However, CEA tries to skirt some of the difficulties CBA has in placing value on health. It does this by taking the perspective of a government agency that is given a fixed budget and then must allocate that limited budget in the most effective way possible. Thus, CEA breaks the health care decision process into two parts. First, society as a whole sets an overall budget for health care, making the tradeoff between health care and all other goods. Then, CEA itself is used to determine which health care interventions will be funded. It does that by translating all health benefits into an abstract and fungible measure of health, such as “quality-adjusted life-years” (QALYs) and comparing the incremental increase in these health benefits among all possible treatments. Thus, CEA avoids the direct need to translate health benefits into dollars, but only by forcing the cutoff decision to be made elsewhere. Moreover, CEA still requires the translation of all health benefits into some single health metric. Consider the difficulty of translating preventative dental care for small children and life extension for an elderly cancer patient in pain into a single health fungible metric, such as QALYs. The existence of increasingly accepted technical methods to make these translations does not negate the intrinsic difficulties. The incremental cost effectiveness ratio (ICER) is defined as the increase in costs for a treatment divided by the increase in effectiveness (measured in QALYs or some other health unit), both relative to the next best treatment. Really understanding CEA and ICERs is at least a several hour proposition, even for educated and quantitatively literate individuals. Recently, Gold et al (1996) performed a study to assess ordinary citizens’ ability to understand CEA and their acceptance of the legitimacy of its cost-criteria. Study participants were a self-selected group of New York City jury pool members who passed a simple quantitative literacy test. They were taught the most essential ideas of CEA in an hour and 15 minutes and then used some selected ICERs to make hypothetical Medicare coverage decisions based on the CEA. Several results are relevant. First, participants

19 were willing to accept costs as a legitimate concern, at least for a tax-payer funded public program and after thirty minutes of education about the cost problems of Medicare. This suggests that citizens can accept costs as a legitimate basis for coverage decisions. Second, it took over an hour to teach the participants enough about CEA to make tradeoff decisions. On the one hand, this is a relatively short amount of time and thus encouraging for the public debate about CEA. On the other hand, few citizens will have the opportunity or interest to sit through and hour and fifteen minute class. Our CCC-based, single sentence sound bite definition can probably be explained in five minutes. The fuller CCC model is unnecessary. Third, while the participants accepted some of the priorities implied by the ICERs, they also rejected others based on their own notions of priority, responsibility and other factors. This suggests that individuals want to make coverage decisions in ways that are sensitive to the actual treatment and conditions, not simply the single ICER measure. The Oregon Medicaid “rationing” experience illustrates the difficulties the public has in accepting the use of CEA (Kitzhaber 1993, Tengs 1996) and their desire to have other factors influence the decision. In contrast to CEA, our CCC-based criterion for making tradeoffs keeps the health benefits in their most immediate and direct form, the actual treatment covered. This makes the concept accessible to purchasers of health insurance and the general public. CEA is explicitly intended to be relevant to populations, not to individuals (Gold et al 1996). Yet, to be effective in reducing costs, difficult tradeoff decisions must ultimately be applied to individuals. Thus, CEA is used to set coverage policy, particularly in Britain, and those policies do apply to individuals. Thus, it is inevitably a blunt instrument that clumps individuals with significant clinical heterogeneity together. However, many of the relevant margins for cost-containment are sensitive to clinical detail. As discussed in section III, some MRIs for headache are incredibly valuable, others are practically worthless and many are in the complicated middle ground. The same is true for angiograms, particular cholesterol-lowering drugs, hysterectomies and many medical treatment. Empirical studies that use natural experiments show that effectiveness of treatments like invasive heart attack treatments is much lower for marginal sub-groups, who might or might not get the intervention than for all those

20 treated (McClellan, McNeil and Newhouse 1994; Harris and Remler 1998; McClellan and Newhouse 1998). Distinguishing those for whom the treatment is very effective from those for whom it is not so effective requires a great deal of information. Many physicians contend that this is the province of clinical judgment (XX cite; Groopman 2007. It is virtually impossible to perform separate effectiveness studies or separate analysis for every detailed subgroups. Many of the relevant and difficult coverage decisions are currently made as part of utilization review. To get at many of the most relevant margins, we need a much more clinically detailed level, far below the population level decisions currently used for CEA. Of course, CEA could be, and sometime is, done with more finely described clinical detail, but it is rare that studies have the level of complexity demanded. The CCC based definition is not a magical cure for clinical complexity either. All of the relevant clinical conditions (the health states) can’t really be spelled out, but they can be used as examples. CEA is an essentially collectivist visions that require a one-size fits all rationing scheme. It cannot incorporate diversity of tastes. In contrast, the CCC based definition of excessive care is individualistic, not collectivist. It can incorporate diversity of tastes. More controversially, the CCC based definition can incorporate diversity of wealth and income. While some on the left are medicalists, who reject any explicit role for costs in treatment decision, others, particularly in Europe advocate CEA as a means of making treatment decisions sensitive to costs. ICEA is attractive to them precisely because it contributes to equity by putting everyone in the same boat. There is no doubt that health care is different and all but the most radical libertarians believe that equity in health care is more important than equity in other arenas. Yet, we contend that perfect equity in health care, like perfect equity in other areas, is impossible. A market-based vision of individual choice fits more with American norms. We advocate a criterion for excessive care that simply asks individuals if they are willing to pay a premium increase in order to ensure coverage of a particular condition under particular medical circumstances. We suggest that this definition is superior to CEA and should at least be used as a compliment. It is more in tune with the individualistic perspective Americans favor. It is easier to understand. It allows greater

21 sensitivity to features of care or condition that are not captured in effectiveness but which individuals find relevant. It allows far greater sensitivity to clinical detail.

VI. Conclusions Health care’s famously high and rapidly rising costs are widely considered a crisis in their own right. Moreover, they are considered one of the primary culprits behind the uninsured in the US and the largest hurdle to any reforms aimed at reducing the uninsured. There are many worthy targets for cost containment: physician salaries, pharmaceutical prices and other factor prices; administrative costs. Nonetheless, major reductions in health care expenditures probably require reductions in the quantity and choice of health care treatments (Emanuel and Fuchs 2008). Certainly, big reductions in the growth of health care expenditures require affecting actual health care treatments (Newhouse; Glied). The most recent fashion for cost-containment has been CDHC and other out-of- pocket based reforms. These policies and their current prominence are a triumph for a simple model of health care use, first put forward by Pauly in 1968 and widely taught in even more simplified form since.14, 15 When Pauly first introduced that model and even for some decades afterwards, it was the simplification needed for a broad policy audience. Insurance does indeed increase health care use in counter-productive ways to some extent and this was not appreciated in the late 1960s and for many years thereafter. However, the usefulness of that widely taught model, and the reforms it prompted, have little further to contribute. Nyman has illustrated how simplifications obscure the increasingly important access value of insurance. Remler and Glied (2006) have illustrated that policies that most are willing to adopt can have only modest effects on cost. At its foundation, the most recent fashion (e.g., Porter and Teisberg) has a mistaken notion of markets in health care, one that ignored the primacy of insurance markets and health care service markets alone. The identification of the term “market”

14 See Glied and Remler (2003) for a discussion of how the subject is taught in public finance textbooks. 15 Pauly himself in fact holds a more complex and nuanced view of health insurance (e.g., Pauly 1983), but it is the simplified version of the model that permeates the policy debate.

22 with out-of-pocket payment is misguided, because it ignores the health insurance market and the inter-relatedness of health care and health insurance. The “out-of-pockets” ignored an earlier conception of markets in health care, Enthoven’s managed competition. Managed competition is closely related to the CCC model. Managed competition envisages that once the plans have the right incentives they will take care of everything and that people would choose among plans based on their general reputation. In many ways Enthoven’s vision has come to pass, and despite the backlash, it has taken root substantially. Dowd (2005) argues that managed competition and CDHC can coexist and compliment one another. Nonetheless, managed competition, as it now exists, suffers from several major problems. First, people find it hard to judge plans on overall reputation. They prefer substantial choice, particularly choice of provider, at the time of treatment. This has caused the substantial prominence of less stringent forms of managed care, such as point- of-service plans. Second, managed care plans lack any accepted means of making coverage decisions that incorporates costs. According to a survey of medical directors of managed care companies, efficacy overwhelmingly dominates as the criteria for coverage decisions and when cost informs coverage decisions it does so in a limited and non- systematic manner (Bergthold et al 2002; Garber 2004).16 Third, consumers do not presently see a legitimate test for making coverage sensitive to costs. The CCC-based test for excessive care can help overcome all of these: it can provide accessible criteria for justifying coverage decisions. By asking consumers if they would willingly pay a premium higher by a particular amount to ensure coverage, managed care plans would have a way of legitimizing with consumers their coverage limitations. Ultimately, plans might compete on the basis of their explicit coverage policies, just as they now compete on the basis of the doctors and hospitals in their panels. The most obvious, and increasingly advocated, intermediate way to make tradeoffs is CEA (Gold, Sofaer and Siegelberg 2007; Garber 2004). It is widely used by the British National Health Service, and also used in other countries (Pearson and Rawlins 2005). The CCC derived definition of willingness to pay the premium has four

16 The public believes that cost is a major factor (Enthoven and Singer).

23 advantages over CEA. First, our CCC based definition is individualistic, not collectivist as CEA is. It can incorporate diversity of tastes. More controversially, it can incorporate diversity of wealth and income. There is no doubt that health care is different and all but the most radical libertarians believe that equity in health care is more important than equity in other arenas. Yet, we contend that perfect equity in health care, like perfect equity in other areas, is impossible. A market-based vision of individual choice fits more with American norms. Second, CEA is difficult to understand. It involves obscure concepts like the ICER. While the Gold et al (2006) study showed that many ordinary individuals are capable of understanding CEA. Few are likely to be willing to invest the time and others will be unable to understand. Third, the Oregon experience, the Gold et al study and experiences in other countries illustrate that the general public finds some of the priorities dictated by CEA to be unacceptable. They want to bring in other criteria, most easily expressed in terms of the conditions and treatments, not just the effectiveness as measured by studies. Our CCC-based definition makes it easy to incorporate these other concerns. Fourth, CEA studies are generally done on highly aggregated population groups. Therefore, they cannot be sensitive to the clinical detail which has a large affect on the effectiveness of treatments. Our proposed definition of the right amount of care is whatever treatments in whatever circumstances a not yet sick consumer willingly would pay the higher premium to ensure. We advocate that this be widely taught at all levels: in masters courses for public policy and public health, to undergraduates; in think tank reports and academic articles aimed at the policy audience; and finally in newspaper articles, TV shows and web sites aimed at any of the public willing to listen. In this fashion, an intellectually clear definition of excessive care, accessible to a wide audience can start to take root. Such a definition would reduce the extent to which those on different sides talk past one another.

24 Appendix: Alternative views of Excessive Care: a History of the term Moral Hazard in Health Care Readers may have wondered why we have generally avoided the use of the term moral hazard and instead used the term excessive care. As applied to health care, the term moral hazard has become unclear and now causes more confusion than clarity. In this section, we discuss the history of the use of the term moral hazard and the relationship of our model to various earlier models and Nyman’s work. While those knowledgeable about health economics and health policy may find this section interesting and valuable, it is not actually necessary for following the rest of the paper. Standard health policy definitions of moral hazard have emphasized the fact that under insurance one is spending other people’s money and therefore generally ignores the costs of care. The policy discussion has generally leapt from this very real problem to the notion that moral hazard, or excessive care, and the increased medical care utilization stemming from health insurance, are synonymous. However, as Nyman has emphasized, spending other people’s money on health care and the accompanying increase in health care utilization is exactly the point of health insurance. Therefore, we seek to substitute our simple model and its corresponding definition of excessive care for the “sound bite” model currently used in health policy circles. To illustrate how the various conceptual definitions of moral hazard and their accompanying “sound bite models” influence policy, we review the history and various definitions of the term moral hazard, broadly, and as specifically applied to health insurance. In our framework, the moral hazard problem is how to keep those who get a bad health draw from taking too many resources for their medical care from the insurance pool and potentially bankrupting the rest of us. In an insurance contract, the insured is essentially on both sides of the contract: ex ante, he chooses health state-contingent services and pays a premium. Ex ante, he wants to pay the lowest possible premium while simultaneously ensuring coverage for sufficiently valuable care, should he need it. Ex post, when he needs to draw on medical services, his focus is instead on drawing on all services that have any marginal benefit, regardless of marginal cost. The moral hazard conflict is therefore in a sense between me ex ante and myself ex post. It can also be seen as a conflict between “consumers,” the cost-conscious representative individuals ex ante,

25 and “patients” those representative individuals ex post who have gotten a relatively bad draw and want medical care.17 Conceptually, we can define excessive care through this thought experiment. If the representative individual, the consumer, behind the veil of ignorance would not have chosen coverage for this care, then it is excessive. Our definition is akin to Nyman’s “bad moral hazard.” However, we would prefer to reserve the term moral hazard for care that is “bad” from a social welfare perspective. Nyman’s “good moral hazard”, the socially valuable increase in medical care enabled by insurance coverage, is not moral hazard in our definition. In any event, it is certainly not excessive care. Our model is a simpler version of Nyman’s model, more suitable for public policy debate.18 Nyman’s model was necessarily more complex, because he had to illustrate the assumptions implicit in the traditional model.

History of the term moral hazard Moral hazard has had different meanings over time. The term was used in the 19th century fire insurance business to denote the lack of incentive a property owner had to vigilantly guard against fire when his property was fully insured (Baker). With full indemnification of a loss, the property owner might be less concerned about loss from fire and therefore less likely to keep his property safe from fire. The likelihood of fire loss is therefore greater and total payout by the insurer is greater. The classic moral hazard described depends on matters that are largely within the knowledge and control of the insured but not the insurer: the insured knows whether his practices on the property promote or reduce the risk of a fire whereas the insurer generally does not have such knowledge. The modern theoretical definition of moral hazard is based on this informational asymmetry. In an introductory undergraduate textbook, Mankiw defines moral hazard as “the tendency of a person who is imperfectly monitored to engage in dishonest or otherwise undesirable behavior.” (p. 480 Mankiw). In an advanced graduate textbook, Kreps defines moral hazard as a situation “where one party to a transaction may undertake certain actions that (a) affect the other party’s

17 The consumer-patient terminology follows Baumgartner (1991). 18 Nyman needed a model rich enough to incorporate the existing and dominant demand curve formulation in order to make that model richer. We feel that the demand curve formulation is not necessary. Using it requires concepts like compensated demand curve elasticities, not easily usable in widespread policy debate.

26 valuation of the transaction but that (b) the second party cannot monitor/enforce perfectly.” (p.577 Kreps) Both definitions essentially describe moral hazard as a monitoring and/or enforcement problem. As in the case of the fire insurance example, most classic forms of moral hazard in insurance have the insured party influencing the probability of a loss. This is referred to as ex ante moral hazard. The inability to monitor an insured can also affect the size of the loss, resulting in ex post moral hazard (xx cite ??Marshall; Ehrlich and Becker 1972??). Both forms of moral hazard obviously affect the amount that an insurer pays out and thus the actuarially fair premium. Both forms of moral hazard are possible in health insurance. For example, someone who would not engage in high risk sports without health insurance but does engage in those sports with health insurance is exhibiting ex ante moral hazard: the existence of health insurance coverage alters the behavior, namely engaging in high risk sports, and consequently increases the probability of being in a poor health state due to an accident. However, the term moral hazard in health insurance has come to be associated with influencing the size of the loss by affecting the amount of health care consumed, conditional on being in a particular health state, i.e., ex post moral hazard. Most forms of insurance, such as automotive or fire insurance, have limited ex post moral hazard component, because the loss takes the form of a cash payment whose size is well specified contractually. Such contracts are true indemnity insurance. Health insurance as currently available is not true indemnity insurance; true indemnity insurance in the health context would provide a cash payment depending on the health state that one finds oneself in. Rather, health insurance is “price payoff insurance” (Nyman). It promises to cover all “medically necessary” care at a substantially reduced out-of-pocket price of health care, frequently zero.19 Because health insurance takes this form, insureds’ and their physicians’ behavior influences the size of the loss. If health insurance were true indemnity insurance, then ex post moral hazard would not occur.

Pauly’s illustration of moral hazard

19 Note that the term “indemnity insurance” in health insurance does not refer to true indemnity insurance, which would provide cash payment. Rather, it refers to “non managed care” old fashioned, “price payoff” insurance.

27 Health insurance is not true indemnity insurance and almost certainly could not generally take that form, due to medical complexity issues. In 1968, Pauly pointed out that when people are not paying the full cost of their health care resource consumption, because they have insurance coverage, they will consume resources even at levels of marginal benefit to them that are far below the marginal cost of the care they receive, because they are insulated from the real costs by insurance. This consumption could collectively be so gross as to eventually exceed the value of insurance to each individual. He contrasted this moral hazard vision with the perfect contingent contract that essentially underlay Arrow’s 1963 analysis of health insurance. Pauly’s point at the time was that insurance coverage for certain forms of care might be reduce welfare and therefore that government-provided or government-mandated insurance could conceivably reduce welfare on net. An example might make the case clearer. Imagine that among ten people, an MRI scan would be quite valuable for two of them in a particular year. The probability of an MRI being valuable for any person in the group is 2 in 10 or 0.20 in that period. If we assume that an MRI scan costs $1,000, then the AFP for each person in the group is 0.2 x $1,000 = $200. This will be paid into a pool which will eventually pay for the MRIs. For simplicity’s sake, let us also assume no copayments or coinsurance. The cost of an MRI is now zero at the point of service. If more than two people get an MRI scan, the AFP for MRI scans for the next year will be increased. Now what if 5 of the 10 in this group eventually get two MRIs scans each, three of which are of relatively small value. They get the MRIs because they are free and give them peace of mind. Physicians agree to keep on good terms with their patients and because they too are given peace of mind about very small possibilities of mistakes. Next year’s AFP will be (5 x $1000)/10 = $500. The cost of the insurance for MRIs is now equal to half the cost of the service itself. Everyone would be better off if MRIs were paid for out of pocket. The two individuals for whom it is highly valuable would choose to pay out-of-pocket while the other three who might get just in case MRIs will decide that it’s not worth the $1000.

28 This example demonstrates how moral hazard can, if taken to extremes, so increase overall consumption as to actually wipe out the benefit of insurance. Even where it does not actually wipe out the insurance benefit, it might still allow for a great deal of waste,in the sense that it could have been spent on something of greater value. Writing in 1968, in answer to Arrow, Pauly wanted to point out that the welfare gains from universal health insurance are not necessarily obvious, that insurance has the potential of making individuals worse off and therefore that it should not be mandated.

Moral Hazard in health care since Pauly This basic point has become captured in a standard sound bite formulation of the model. It is a basic demand curve formulation in which insurance takes the form of substantially reducing out-of-pocket payment, relative to actual costs of care. The demand curve is assumed to measure the marginal benefit of care. Since out-of-pocket payments are far below the actual marginal cost of care, consumers choose a great deal of care for which the marginal cost exceeds the expected marginal benefit. In this view, any medical care that one would not willingly pay for out of pocket is considered wasteful and there is a great deal of excessive medical care. This view is generally depicted graphically in Figure A1, with the shaded region showing the dead weight loss, taken to be the net social loss. This is the very influential version of moral hazard taught in health economics and public finance courses and discussed among policy analysts. Figure A1:

True Cost

TOS price paid at time of service by patient price

QFC QMH Q

29 Note what is not included in this formulation: different health states. In this formulation, health insurance has no value, and any care that one would not willingly pay for out of pocket is deemed excessive. Indeed, in this model, health insurance looks like a useless, wasteful subsidy, doing nothing but encouraging wasteful medical care. Of course, it has long been recognized that insurance has value in reducing financial risk and that the best one can do is find a “compromise between some risk-spreading and some incentive” (Zeckhauser 1970). Moreover, the literature has long had much more complex views of moral hazard and health insurance with models encompassing the CCC and most of the points discussed here incorporated somewhere (Zeckhauser, Marshall, de Meza, Pauly 1983). However, the insights have not made it into health policy discussions. Instead, the simplistic single demand curve model formulation has made it. Moreover, while most economists’ proposals have not targeted cost-sharing towards catastrophic expenditures and have advocated expanding catastrophic coverage (Pauly 1983, Blomqvist, Newhouse, Feldstein), the policy emphasis on the simple demand curve formulation has engendered the view that if there were only enough out-of-pocket payment, our health care crisis could be solved. Recently, there has been substantial debate about moral hazard in health insurance (Nyman 2003, Blomqvist, etc. up through Nyman HA, Rice) and the implications for the value of cost-sharing. Much of the debate has involved relatively inaccessible concepts such as compensated demand elasticities. We will not recap this debate here except to note that any model which does not incorporate different health states, the wide differences in the value of medical care in those states, income effects on the demand for health care, and the effects and benefits of income transfers among different states, will not capture the value of health insurance. Therefore, a model without those features cannot be used to disentangle worthwhile from non-worthwhile increases in health care due to insurance, what Nyman describes as “good moral hazard” and “bad moral hazard.” The modern theoretical definition of moral hazard (e.g., Kreps) does not fit easily with the way the term moral hazard is usually used in medical care. 20 There is no hidden information in the usual health economics use of the term moral hazard. Viewing the insured influencing the size of the loss as an enforcement problem requires some notion

20 The confusion of students who have been taught moral hazard in the conventional microeconomics sense and are then taught it in the conventional health policy sense dramatically highlights this tension.

30 of what is to be enforced. The demand curve formulation has no such notion, unless it is the level of care that would be chosen if all payment were out-of-pocket, as is the basis for the usual dead-weight loss measurement. A definition of moral hazard that incorporates the value of insurance and fits with the monitoring/enforcement definition requires the CCC formulation. In the CCC-based definition of moral hazard, insurers and consumers have a clear notion of what should be contracted for, but have a real world problem enforcing that contract, largely due to the informational problem of the clinical complexity. If we could write and enforce such a contract, there would be no moral hazard problem. Every entitlement in every possible circumstance would be clear.21 Rather, the moral hazard in such a situation would be patients trying to wrest from the insurer reimbursement for services not originally contracted for. There would also be insurer moral hazard, in which the insurer tries to withhold reimbursement for services that were duly contracted for. In the context of the model in this paper, the notion of moral hazard is that patients and physicians acting as their agents choose amounts of medical care in excess of that which would be chosen by consumers in a perfect contingent contract. That excessive care is costly to insurers but they cannot enforce a perfect contingent contract because the informational detail about patient characteristics is far too great to enumerate, not too mention observe. So, the modern theoretical definition fits, with a bit of a stretch, this paper’s definition of moral hazard in health insurance.

21 The favorable tax treatment of health insurance does mean that there would still be excess medical care relative to the first best (Pauly 1986). However, this is like any other subsidy and is unrelated to the insured nature of or special features of medical care.

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