Economics-1

HEALTH INSURANCE AND MORAL HAZARD

Submitted By : Rajarshi Banerjee

I.D. No : 1835 1st year B.A.,L.L.B. (Hons.)

Submitted on : 12th September ,2010

NATIONAL LAW SCHOOL OF INDIA UNIVERSITY Table of Contents: page no.

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Introduction ..………………………………. 3

Research methodology……………………... 4 Aims and Objectives…………………………………….. 4 Scope and limitations……………………………………. 4 Research Questions and Hypothesis…….................... 5 Sources of Data………………………………………….. 5 Method of writing………………………………………… 5 Mode of Citation………………………………………….. 5

Chapter one : What is moral hazard?.... 6

Chapter two : Mechanism of Moral hazard…………… 9

Chapter three : Empirical Evidence…… 12

Chapter Four : Corrective Measures or Control of Moral Hazard Welfare Loss….. 16

Chapter Five: Divergent Opinion……….. 18

Conclusion……………………………….. 19

Index of Authorities……………………… 20

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Introduction

‘Insurance’ is an instrument used to mitigate the adverse effects of taking risks. It

functions by accumulating the risks faced by the entire number of insured customers of

the particular insurance provider. Theoretically all of the insured customers may claim

but in reality only a few do so. Thus a degree of affordability is gained by insurance

because the cost of providing monetary assistance to an adversely affected individual is

spread over the entire base of insured individuals.

‘Moral hazard’ means that people (or organizations) with insurance may take risks that

are greater than what they would have taken if they did not have insurance because they

know that they enjoy protection(monetary) from the adverse effects that might arise out

of the risky behaviour. So the insurer may face claims that are in excess of the number it

had anticipated and factored into its business plan when selling the insurance.1 The issue

of moral hazard is a cause of heartburn for private insurers as well as public policy

makers since it is supposed to be one of the causes that make insurance (particularly

health insurance) inefficient and create welfare loss for the general public.

1 No particular author’s name mentioned, (ECONOMIC TERMS A-Z ) MORAL HAZARD, available at http://www.economist.com/RESEARCH/ECONOMICS/searchActionTerms.cfm?query=moralhazard, (Last visited on September 8,2010)

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In this paper the researcher will go through the mechanism of creation of a moral

hazard , its attendant effect on the economy, the various methods mooted by economists

to mitigate moral hazard in the health insurance industry and try to arrive at an effective

solution to the problem.

Research Methodology

Aims and Objectives : The purpose of the paper is to provide a detailed analysis of

the mechanism of creation of a moral hazard situation in the health insurance industry

and to determine how a health insurance contract be designed to avoid the ‘welfare loss’

that a moral hazard is supposed to create.

Scope and Limitations: The researcher has made use of a substantial amount of

literature on the subject and has confined himself to giving an overview of the concept of

moral hazard, its creation and an analysis of its effects of welfare loss to society and the

measures adopted by the health industry to contain its effects and their efficacy.

The limitation faced by the researcher while conducting his research was that the seminal

papers on the topic by Nyman, Arrow et al contained mathematical concepts and

derivations that were beyond the level of comprehension enjoyed by the researcher and as

a result a substantial portion of the conclusions arrived at by the esteemed authors in their

writings could not be used by the researcher in this project.

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Research Questions and Hypothesis: The issues that the researcher has attempted to

address in this paper can be stated to be the answers to the following research questions –

1). What is moral hazard as far as the particular issue of health insurance is concerned?

2). What is the mechanism by which moral hazard is created in the course of executing a

health insurance contract?

3). What is the empirical evidence surrounding the issue of moral hazard in health

insurance and the ‘welfare loss’ it creates?

4). What are the measures that can be adopted to mitigate moral hazard and their

respective efficacies?

5). In light of the differing opinions regarding the welfare loss created by moral hazard

what is the best way to address this complex issue?

The conventional theory is that moral hazard creates a welfare loss to society2 as a whole

and that it should be weeded out through the use of innovation when a health insurance

contract is drafted. The paper will investigate into this claim and try to arrive at a

conclusion regarding the same.

Sources of Data: The researcher has used both primary and secondary sources of data

in the course of his research and has made particular use of sources available on the

internet.

Method of Writing: An analytical style of writing has been followed by the researcher

in this paper and in the course of writing a descriptive style has also been used when the

intricacies of the subject matter has been dealt with in the paper.

Mode of Citation: The NLS Citation Guide has been followed in this paper.

2 John A.Nyman, IS MORAL HAZARD INEFFICIENT? THE POLICY IMPLICATIONS OF A NEW THEORY, available at http://www.content.healthaffairs.org/cgi/content/fall/23/5/194, (last visited on September 8, 2010)

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Chapter One : MORAL HAZARD – what is it exactly in the case

of health insurance?

1.1) A General Definition of MORAL HAZARD : “The risk that a party to a transaction has not entered into a contract of good faith, has

provided misleading information about its assets, liabilities ,or credit capacity, or has an

added incentive to take unusual risks in a desperate attempt to earn profit before the

contract expires.”3

Moral hazard occurs when a party insulated from a risk behaves differently than it would

behave if it were fully exposed to the risk.

Elucidation after application of principle to healthcare scenario:

Suppose a person has bought a health insurance plan that provides for reimbursement of

the expenses ( price pay-off mechanism ) he has incurred on his own volition due to

ailment or some other reason connected to his health. The insurance company usually

pays him the money that he has spent when he applies for reimbursement. So far this

seems to be a perfectly normal thing to happen. But behind this entire transaction the

conundrum of moral hazard might be lurking. The person who made use of his insurance

3 No particular author mentioned, DEFINITION OF MORAL HAZARD IN INSURANCE CONTRACT, available at http://www.risk.ifci.ch/glossary.htm

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plan might have indulged in some mode or form of treatment or made some medical

expense that is quite unnecessary and frivolous. An expense that he definitely would not

have incurred if he did not have the insurance coverage that pays for his expenses. It

might be an extra couple of days stay in a luxurious hospital room or even designer

prescription sunglasses. Thus the insurance coverage might have made him behave

differently, with less consideration towards the financial aspects of his actions and thus

incurred a financial wastage for his insurer provider. This is moral hazard in health

insurance in its simplest avatar.

In economic terms moral hazard rears its head when an ‘information assymetry’ exists-

there exists a disconnect between the insurance provider and the insured regarding their

respective intentions and actions. Individual knows the risks that he bears whereas his

insurance provider cannot keep a tab on those risks. Thus the insurance provider is forced

to offer insurance on same terms to everyone.4

A substantial number of health insurance customers indulge in behaviour after taking out

the insurance policy that increases their exposure to health risks and also demand for and

use pricier healthcare services than what is necessary. For example some clients would

engage in a sedentary lifestyle, choosing to forego exercise and wholesome food for the

more easier, subsidised option of medicine and visits to a physician if Thus insurance

companies can protect its customers against risks that arise out of genuine medical illness

strikes. If insurance providers had the means to observe their customers’ actions to the

fullest extent then they could deny coverage to those customers whom they deem to be

indulging in risk enhancing behaviour. Then they could provide monetary assistance to

policyholders who have medical problems or ailments that are not a result of risky

behaviour on the client’s part without raising the cost of premiums (which is the most

likely result of attempts to make-up for losses due to moral hazard).

1.2) TYPES OF MORAL HAZARD :

Moral hazard can be found on both the demand side and the supply side of a healthcare

transaction. Health insurance reduces the actual cost of healthcare used by an insured

individual to a price below the market price of the care enjoyed.

4 P. Zweifel, and F. Breyer , HEALTH ECONOMICS, 156, 157 , (1997)

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Demand side moral hazard is representative of consumer triggered increase in

consumption of services due to their low actual price to the insured patient.

It includes excessive spending on the initiative of the consumer who knows that the cost

burden will be shifted to his/her insurance provider.5

Supply side moral hazard (supplier induced demand) is over-supply at the initiative of

the medical care provider who takes advantage of the near absence of any financial

considerations on the part of the consumer when he agrees to buy the excess healthcare

because the costs will be transferred to the health insurance provider. Thus overcharging

and frivolous medical tests prescribed by medical practitioners and hospitals contribute to

moral hazard in a significant manner.6

Moral hazard is of two types when it is related to health insurance : ‘ex ante’ moral

hazard and ‘ex post’ moral hazard.

1). ‘ex ante’ moral hazard: The individual enjoying the health insurance cover may

influence the probability of falling ill through prevention or the lack of it, and this might

be tantamount to a general change in lifestyle.7

For example the consumer of health insurance might not practice the measures required

to safeguard health and prevent illness because he has little or no financial incentive to do

so. He might feel that his health insurance plan will be covering any medical cost he

might incur as a result of his risky, health threatening behaviour and when the medical

costs are indeed incurred the insurance company has to foot the bill and moral hazard is

created.

2). ‘ex post’ moral hazard:In the event of the insured consumer falling sick the

consequent financial loss( cost of accessing healthcare) is not fixed. A choice between

less costly medical care and expensive alternative forms of healthcare is almost always

available to the consumer .8 The healthcare that the consumer buys will be influenced by

the insurance cover he enjoys and he might buy healthcare that he wouldn’t have bought

5 David M. Dror , REFORMING HEALTH INSURANCE : A QUESTION OF PRINCIPLES ? , 53 (2), International Social Security Review, 75, 89, (February, 2000)6 Id.7 Zweifel, and Breyer, supra note 4, at 68 Zweifel, and Breyer, supra note 4, at 6

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if he had to pay the prevailing market price for it himself out of his own resources. This

represents a moral hazard.

Chapter Two: The Mechanism by Which Moral Hazard is

Created (explained through economic

terminology)

Moral hazard is created by mainly three phenomena exhibited in healthcare transactions:

1). Overutilization generated by the insured population,

2). Overutilization generated by the provider,

3). Insurer behaviour that encourages first two patterns. 9

According to conventional theory insurance practically reduces the price of healthcare

care that a sick, insured person enjoys to zero (it is admitted that the insured party has to

pay a certain amount as premium). As a result insured parties purchase more healthcare at

market price than what they would have purchased if they did not enjoy insurance

coverage. In an economist’s opinion this is what gives rise to a moral hazard situation.

Economists interpret this particular consumer behaviour of purchasing medical services

only when their effective price (for the insured party) drops to zero by virtue of insurance

coverage as being evidence to the fact that value of this care to consumers is less than the 9 David M. Dror, REFORMING HEALTH INURANCE: A QUESTION OF PRINCIPLES?, 53 (2), International Social Security Review, 75 , 92, (February 1992).

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market price charged for it.10 But the additional care still incurs substantial cost in order

to be produced and the insurance company has to pay for that cost.

Healthcare is supposed to have a high degree of price inelasticity (data concerning the

U.S.A show that 1% increase in healthcare cost leads to only .17% decrease in healthcare

expenditure and that income elasticity for healthcare is between 0-0.2)11.

So the consumer does not exhibit any marked reluctance to shell out money for

healthcare when faced with a medical problem.

But the case of consumers opting for medical care only when its effective price has

dropped to zero because of insurance represents an inefficiency in the light of the price

elasticity enjoyed by healthcare expenditure. The difference between the considerable

expenditure incurred in creating the healthcare service( shown by its high market price)

and its apparently low value to the insured consumer enjoying it ( shown by the lower

insurance price paid by him that lets him enjoy the costly healthcare) represents an

inefficiency.12 Thus health insurance acts as an incentive to demand pricier healthcare but

the real value of this care to the customer is lesser than market cost. This is what

conventional economic theory deems to be ‘moral hazard welfare loss’.

According to Pauly insurance reduces the price of healthcare to the insured individual to

below the marginal cost and thus acts as any other subsidy. 13

The economic mechanism behind the creation of a moral hazard and its welfare loss

effect will be further explained in the following pages with the help of indifference

curves and budget lines.

10. Zweifel, and Breyer, supra note 4, at 6.11 Randall P. Ellis, ELASTICITY OF DEMAND FOR HEALTHCARE, available at http://www.rand.org/pubs/monograph_report/2005, (last visited on September 8, 2010).12 Nyman, supra note 2, at 4.13 Pauly, “THE ECONOMICS OF MORAL HAZARD: COMMENT”, American Economic Review, 531, 534, June 1968.

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Figure 1. Situation faced by a consumer suffering from an ailment. Two different cases

are explored here- consumer with insurance cover and consumer without insurance cover.

The budget line AC denotes the options that can be accessed by the ill consumer without

insurance cover. The said customer maximizes his welfare by choosing care that costs

OB’.

In case of sick customer having insurance cover the resources available to him to buy

other products and services will be lesser by the amount his insurance policy costs him.

In spite of this the concerned budget line will exhibit a smaller absolute slope because of

the subsidy provided by health insurance (Nyman).

Line DEF is the budget line confronting a consumer enjoying an insurance plan with 20%

co-insurance rate. On being made to deal with this budget line the consumer response is

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choosing care costing OE’. He is now better off than he was at B because of the income

transfer from the common pool of money collected by insurance company to his pocket

for reimbursal of his healthcare expenditure.

But this income effect is accompanied by a subsidy effect that decreases the gains. GEN

shows the budget line based on prices prevailing in the market passing through E. If the

consumer had been given access to this funding or income and given the liberty to buy

healthcare at prevailing market price then he would opt to be at the point G. The

difference in welfare that exists between points E and G measures the welfare loss

caused by the subsidy effect (moral hazard) of insurance.14

Chapter Three: Empirical Evidence Surrounding Moral Hazard

and its Welfare Loss Creating EffectThe RAND Health Insurance Experiment conducted between 1971 and 1982 was a

landmark study conducted to assess behaviour of health insurance consumers and to

ascertain the nature of moral hazard existing in the health insurance industry.

For the purpose of conducting the experiment two thousand seven hundred and fifty

families encompassing more than seven thousand seven hundred and fifty individuals all

lesser than sixty-five years of age were included as the subjects of observation and a

urban / rural balance was maintained among the participants in the experiment. They

were assigned to five different types of insurance plans – free care, cost sharing with

twenty-five percent, fifty percent and ninety-five percent co-insurance plans and the fifth

one was non-profit HMO (co-operative) style care (free of charge). Spending from one’s

own resources was limited to one thousand dollars annually or fifteen percent of one’s

own income( whichever was lower). The average tenure of participation was three to five

years.15

EFFECTS :

14 Joseph P. Newhouse, and Vincent Taylor, THE ECONOMICS OF MORAL HAZARD :FURTHER COMMENT , available at http://www.rand.org/pubs/papers/2008/P4680-1.pdf , (last visited on September 8, 2010)15 No particular author’s name mentioned, RAND HEALTH INSURANCE EXPERIMENT, available at http://www.rand.org/pubs/research_briefs/RB9174/index.html, ( last visited on September 8,2010)

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1). After averaging across all levels of co-insurance it was found that the participants in

the Health Insurance Experiment made one to two fewer visits to the doctor’s chamber

annually and there were twenty percent fewer hospitalizations than those enjoying free

care.16

2). Participants in cost sharing plans incurred less expenditure on healthcare and this

saving on costs were a result of using fewer services rather than finding lower prices.

Those with twenty five percent co-insurance plans spent twenty percent less, those with

ninety five percent co-insurance spent thirty percent less on healthcare.17 But a point of

concern is the finding that reduction on spending came from participants deciding not to

initiate care which might not be the best thing to do from the point of view of personal

health and wellbeing. It was found that cost-sharing had only a modest effect on the cost

of an episode of care.

So the RAND experiment under study proved the existence of moral hazard by finding

that participants used less healthcare when faced with payments from their own resources

because of co-payment obligations.

CASE STUDY (conducted by the researcher himself) :

The researcher decided to see for himself the effect of health insurance and its

behavioural effects on a person he knows. He decided to examine the behaviour of his

mother, Smt. Chandana Banerjee (who enjoys comprehensive free care style insurance

coverage by virtue of her husband’s terms of employment in a public sector undertaking

in India) when she used healthcare resources. The findings are presented in the following

few paragraphs.

Smt. Chandana Banerjee, 47, suffers from high thyroxin secretion (hyperthyroidism),high

blood pressure and cardiac problems related to a fairly sedentary lifestyle and excess

body weight. By virtue of the comprehensive coverage insurance plan she enjoys she has

access to fairly competent physicians and expensive healthcare which go a fairly long

way in alleviating her medical problems.

16 Id.17 Id

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A positive consequence of the health insurance plan she enjoys( from the point of view of

beneficial health safeguarding practices) is that she readily visits her physician’s office

when she is in discomfort or is advised to do so. But this very same lack of hesitation in

accessing healthcare irrespective of its costs (‘ex-post’ moral hazard) is where the issue

of moral hazard rears its head.

In the opinion of the researcher ( Smt. Banerjee’s son) the health insurance plan that the

subject of the case study enjoys has lulled her into a sense of security since she feels that

the medical care to which she has free access to will be sufficient to ameliorate the health

issues she suffers from. Thus she shows a marked indifference to taking preventive action

in the form of adopting health safeguarding practices like doing physical exercise and

practicing healthy dietary habits like consumption of fruits and vegetables as part of a

balanced diet( ‘ex-ante’ moral hazard). She rationalizes her risk enhancing behaviour

with her firm belief that the medical care she enjoys because of the insurance plan can

obviate any damage that she might be causing to her health.

We find that a case of ‘information assymetry’ exists here because the insurance

company does not know about her health risk enhancing behaviour that she indulges in

and the insurance company has to foot the bill that she incurs as a result of over-

dependence on healthcare.

In course of an interview with Smt. Banerjee regarding this topic she mentioned that her

physician prescribes a fairly excessive amount of medical testing procedures on each one

of her visits and recommends frequent reconsultations (to the tune of almost once a

week). In the opinion of the researcher this is a probable case of the healthcare provider

inducing excessive expenditure on his client’s(who enjoys insurance cover and thus

would have almost no objection to this practice on financial grounds) part . The

researcher knows that the physician of Smt.Banerjee is aware of the comprehensive

insurance plan enjoyed by her.

Thus through this case study we find that both ‘demand induced moral hazard’ and

‘supply side induced moral hazard’ exist in a fairly mundane physician-patient

relationship.

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Chapter Four : Methods Adopted To Mitigate Moral Hazard And

Their Efficacy

Healthcare is generally price inelastic- people who have access to it will pay the

prevailing prices ,at least for critical care ,absolutely essential visits to the physician and

prescribed medicines. Moral hazard arises when an insured person chooses unnecessary/

more expensive form of healthcare because she/he knows that the insurance company

will be paying for it. But only conditions that recognizes the existence of a choice about

the service will be price sensitive and demand for inelastic services do not depend on

their price.18

Remedy For DEMAND-SIDE Moral Hazard:

The benefit package bestowed by the insurance contract on the consumer should

have clearly laid out terms that limit coverage to high impact, low frequency

risks corresponding to random and inelastic services. 19

Levying co-payment for each and every healthcare service utilized by consumer.

This will act as a financial incentive to the customer to make responsible

consumere decisions when it comes to buying healthcare.

Other forms of out-of-pocket expenditure like deductibles, capitated payments ,

cost sharing contracts and the like to limit expensive, frivolous medical care.

Remedy For SUPPLY-SIDE Moral Hazard:

‘Managed Care’ has emerged as the answer to the problem posed by supply-side moral

hazard. Here the medical service providers are pre-assigned to the insured customer of

the managed care plan.These medical practitioners and purveyors of healthcare are

contractually obligated to the insurance company to provide treatment to the ill customers

subscribing the managed care plan in a financially responsible manner in return for a

bulk, almost assured number of customers. The insurance company can maintain a level

18 David M. Dror, REFORMING HEALTH INSURANCE: A QUESTION OF PRINCIPLES? , 53 (2), International Social Security Review, (February 2000) , 75, 8919 Id.

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of scrutiny and control over the healthcare expenditure of its customers and in turn can

offer lower rates of premium to the customer too.

Criticism of the Methods Adopted by Insurance Companies to Counter

Moral Hazard

Using co-payments as a method of controlling demand side moral hazard has led to

success in curbing medical expenditure on part of the customer as shown by the RAND

health insurance experiment(1971-1982). But this reduction in spending came from

people deciding not to initiate healthcare and cost-sharing in the form of deductibles and

co-payments reduced the use of both effective, essential and less-effective or frivolous

care similarly.20Cost sharing was ineffective in the sense that it could not discriminate

between unnecessary expenditure and essential healthcare expenditure which was

supposed to be its mandate. Reduction in level of essential care or non-initiation of such

care on part of an insured invidual due to financial constraints imposed by co-payments is

harmful to society because it leads to festering of disease and loss of man-hours to the

economy. Correspondingly productivity declines. Thus co-payments act as a blunt

instrument that only blindly protects insurance company balance sheets to some

extent.Also cost-sharing by co-payment imposition led to consumer suffering more

income risk which is exhibited by the increased marginal utility of income after he has

paid for the treatment.21

Using ‘managed care’ as a means of erasing supply-side moral hazard raises important

questions about free choice and it being curtailed in lieu of relatively insignificant

financial incentives. It curbs the consumers freedom of choice by limiting their eligibility

to get reimbursement to healthcare provided by certain fixed health practioners and

hospitals. So the patient will have financial constraints if he is dissatisfied with the care

that he receives or wants to go for a second opinion regarding his health.

20 No particular author’s name mentioned, RAND HEALTH INSURANCE EXPERIMENT, available at http://www.rand.org/pubs/research_briefs/RB9174/index.html, ( last visited on September 8,2010).21 Ching-To Albert Ma, and Michael H. Riordon, HEALTH INSURANCE , MORAL HAZARD AND MANAGED CARE, available at, http://www.columbia.edu/~mhr21/ma.pdf (Last Visited on September 8, 2010)

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Instead of pushing for more economically sound medical decisions managed care shifts

the financial responsibility of containing moral hazard to care providers who now stand

as the ‘gatekeepers’ of healthcare.

Managed care has also weakened the weakened the relationship between price elasticity

and moral hazard in health care.22

A Better Way to Contain Moral Hazard Prevalent in Health Insurance:

Co-payments have behaved as blunt instruments in the sense that they have managed to

curtail essential, critical healthcare spending by insured individuals which is not a desired

result. Co-payments should be linked to the ailment suffered by the insured customer and

the health insurance company has to make the necessary effort to verify the nature and

extent of illness. This will have an welfare increasing effect on society in the long run.

(case study):

A RAND study showed that exemption from payment of co-insurance on cholesterol

level lowering drugs led to improvement in the state of health indicators for patients for

whom it is an essential drug and consequently more than one billion dollars was saved in

medical costs by increasing adherence to medical advice and reducing costs that are

incurred in hospitalization.23

Since an insurance company is usually not able to or not inclined to monitor expenditure

on or efforts towards prevention of illness the insurance premium it demands is

dependent only on the extent of benefits it has to pay out and not on the preventive

measures adopted by customer. Usually, in the current state of affairs ,there is no

financial incentive for the customer to take preventive measures against illness in return

for a reduced premium. But introducing such financial incentive could kill two birds with

the same stone- it can control healthcare expenditure by leading to fewer hospitalizations

and also exempt the economy from the loss of man-hours due to hospitalizations.

This incentive for increased preventive efforts could be brought about by adopting the

following principle and measure:

22 Dror, supra note 18, at 1423 Dana P. Goldman, and Geoffrey F. Joyce, CUTTING DRUG CO-PAYMENTS FOR SICKER PATIENTS ON CHOLESTEROL-LOWERING DRUGS COULD SAVE A BILLON DOLLARS A YEAR, available at http://www.rand.org/pubs/research_briefs/RB9169/, (last visited on September 8,2010)

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The incentive for the insured customer to take preventive measures progressively

decreases with increase in extent of healthcare insurance coverage. Thus the probability

of contracting illness also greatly increases and as a consequence the costs incurred by

the insurance company also increases. Thus company is forced to raise insurance

premiums to cover for losses. Provided the insurer takes this into consideration it should

charge an insurance premium that increases progressively with the level of benefits

chosen rather linearly. Individual will take this into account and indulge in preventive

actions which would decrease hospitalizations and potential moral hazard.24

Chapter Five : A DIFFERING OPINION ON MORAL HAZARD

AND ITS WELFARE LOSS EFFECT

Economist John Nyman is a vociferous opponent of the school of thought that says that

what they consider to be moral hazard is unfailingly welfare decreasing. But another

school of opinion holds that purely economic views moral hazard ignores many reasons

of exigency and practicality that create or dampen demand for healthcare in a customer.

The two mechanisms of insurance payments that are in vogue the most- the price pay-

off mechanism and the contingent-claim mechanism – yield very different conclusions

regarding moral hazard and its welfare loss effect.

A price pay-off mechanism reimburses the exact medical expenses incurred by an

insured patient while contingent claims insurance plans pay out a fixed, pre-determined

amount to the insured patient which varies with the type of ailment.

A contingent claims insurance plan lump sum pay-out to an ill customer the theoretically

increases his desire to spend on medical care that he needs at every possible market price

and in simple terms it makes him exercise a degree of prudence. He buys healthcare for

which he has to pay the market price out of the limited lumpsum payment he got from the

insurance company. This is supposed to create a welfare benefit to society.25

24 P. Zweifel, and F. Breyer, Health Economics, 156, 180, (1997)25 John A. Nyman, THE THEORY OF DEMAND FOR HEALTH INSURANCE, available at http://www.google.books.com ,( last visited on September 9, 2010.)

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A price-pay off insurance plan represents a reduction to zero of the of the price of

medical care and a movement along the consumer’s original demand curve. The true

marginal cost of the medical care has not changed and the additional consumption –that

is, moral hazard- is not worth the resources to provide it and represents a welfare loss.26

Nyman opines that different interpretations arrive at from the same theory implies a

flawed understanding of moral hazard.

Economists have not factored in the consideration that healthcare customers won’t go

for such risky, life threatening procedures like limb amputation, coronary bypass surgery

or organ transplants just because their insurance company will pay for it if they really

had no need for it. But the conventional view of moral hazard and its welfare loss effect

has led to imposition of co-payments and the like that act as constraints in the pursuit of

healthcare for a large number of people. Imposing co-insurance payments on patients

undergoing angioplasties and open heart surgery is a manifestly senseless and insensitive

act.

John Nyman opines that moral hazard is actually a generator of welfare gain and has

turned conventional theory on its head. In essence an insurance contract obligates the

insurer to transfer income from the many clients who pay into the resource pool

maintained by the company and remain healthy to those who become ill enough to need

medical care.27

According to Nyman income effect derived from transfer of income from those who

remain healthy to those who become illcauses additional medical care to be purchased

thus generating welfare gain to society.28

Conclusion: Thus we see that the issue of moral hazard generates pretty sharp

opinions and also intense debate on how to control it in the best possible manner. But it

has to be admitted that it is a disturbing issue confronting insurance companies and their

balance sheets. The redressal mechanism that has been outlined in this paper is the

groundwork for further specialized study about moral hazar and its effective containment.

26 Id27 Id28 Id

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Index of Authorities:

Books:- 1). Pindyck, Rubinfeld , MICROECONOMICS, 2009 ed.

2) P. Zweifel, and F. Breyer , HEALTH ECONOMICS, 1997 ed.

3) John A. Nyman, THE THEORY OF DEMAND FOR HEALTH

INSURANCE,

4) Gravelle, Rees, MORAL HAZARD AND INSURANCE CONTRACTS,

1993

Articles: 1). David M. Dror, REFORMING HEALTH INURANCE: A QUESTION

OF PRINCIPLES?, 53 (2), International Social Security Review,(February 1992).

2). Joseph P. Newhouse, and Vincent Taylor, THE ECONOMICS OF

MORAL HAZARD :FURTHER COMMENT , available at

http://www.rand.org/pubs/papers/2008/P4680-1.pdf ,

3). Pauly, “THE ECONOMICS OF MORAL HAZARD: COMMENT”,

American Economic Review, June 1968.

4). Ching-To Albert Ma, and Michael H. Riordon, HEALTH INSURANCE ,

MORAL HAZARD AND MANAGED CARE, available at,

http://www.columbia.edu/~mhr21/ma.pdf

5). John A.Nyman, IS MORAL HAZARD INEFFICIENT? THE POLICY

IMPLICATIONS OF A NEW THEORY, available at

http://www.content.healthaffairs.org/cgi/content/fall/23/5/194

6). P. Randall, Thomas G. McGuire, SUPPLY SIDE AND DEMAND SIDE

COST- SHARING IN HEALTHCARE, 7 (4), Journal of Economic Perspectives, 1993

7). Tom Baker, ON THE GENEALOGY OF MORAL HAZARD, 75 (2),

Texas Law Review, 1996

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