20/2/2011

Anonymous Student Number: Z0905156

IS THERE AN ECONOMIST IN THE HOUSE?: AN ECONOMIC APPRAISAL OF THE US HEALTHCARE SYSTEM IN LIGHT OF THE 2010 REFORMS AND ALTERNATIVE STRUCTURES.

EXECUTIVE SUMMARY 3

I. INTRODUCTION 5

II. THE ECONOMIC THEORY OF HEALTHCARE 7

II.I – IMPERFECT KNOWLEDGE 8II.II – UNCERTAINTY 10II.III – SOLUTIONS FOR IMPERFECT INFORMATION IN HEALTHCARE 14II.IV – EXTERNALITIES 15II.V – EQUITY 17

III. THE US HEALTHCARE SYSTEM: STRUCTURE AND PROBLEMS 18

III.I – EQUITY AND THE US 18III.II – THE STRUCTURE OF THE US HEALTHCARE SYSTEM 19III.II.I – THE PRIVATE SECTOR 22III.II.II – THE PUBLIC SECTOR 30

IV. THE AFFORDABLE CARE ACT 34

IV.I – THE ACA AND ADVERSE SELECTION 34IV.II – THE ACA AND MORAL HAZARD 38IV.III – THE ACA: IMPERFECT KNOWLEDGE AND EXTERNALITIES 40

V. ALTERNATIVE HEALTHCARE SYSTEMS 42

V.I – ALTERNATIVE METHODS OF FINANCE AND PROVISION 42V.II – INTERNATIONAL QUALITY COMPARISONS 47V.III – LESSONS FOR THE US 50

VI. CONCLUSION 52

BIBLIOGRAPHY 54

APPENDIX A. INSURANCE MARKETS 62

Appendix B. The Adverse Selection Death Spiral 66

2

Executive Summary

The US health care system is currently undergoing a period of extraordinary change due to

the introduction of the ‘Affordable Care Act’ (ACA) of 2010. This paper has two aims: first, to

provide a comprehensive economic appraisal of the reforms by first evaluating the pre-ACA

health care system and analyzing the proposed reforms. Secondly, this paper aims to

consider alternative health care systems to contextualise the discussion and find lessons for

the US system that may be incorporated in future reforms.

The paper begins by providing the economic framework upon which the discussion is based.

It is found that the private market for health care requires some form of Government

intervention to compensate for substantial market failures, in particular imperfect

knowledge, imperfect information and external effects of vaccination consumption. As the

US system gives a low weighting to redistributive concerns, redistribution is only briefly

considered.

It is found that the US system suffers from the market failures outlined in the framework,

despite attempts to curtail information problems via use of employer-provided health

insurance and managed care organisations. In addition, cost-containment is found to be

poor. It is concluded that the ACA should comprehensively address these information

imperfections and increase the range of insurance choices provided by employers.

The ACA is found to be largely an improvement on the status quo, however it does not fully

confront a root cause of spiralling costs – instead, it relies heavily on new tax revenue from

Medicare, leading to questions regarding its sustainability. Regarding alternative systems, it

is found that the US already incorporates characteristics of other systems in Medicare and

3

Medicaid, and the reforms appear to move it towards a Switzerland-style model; it is also

noted that use of cost-containment systems from alternative systems could be adapted for

use in the US system.

4

I. Introduction

On March 23rd 2010 the President of the United States, Barack Obama, signed the Patient

Protection and Affordable Care Act, which was to be shortly joined by a package of

amendments - the Healthcare and Education Reconciliation Act - on March 30 th 2010. The

final aggregate, called the ‘Affordable Care Act’ (ACA), has proven to be one of the most

divisive documents of social policy in the US in recent memory1, and realises an ambition

held by numerous presidents, from Theodore Roosevelt to Bill Clinton, to provide a

substantial, systemic reform of the US Healthcare system.

The ACA is fascinating on two levels. In one consideration, it attempts to tackle the failings

of a system that is aimed at providing a vital service in the World’s largest economy; in a

2009 report by the US Census Bureau, 16.7% of Americans were found to be without

healthcare insurance in 2009, a 1.3% rise on 2008. As this paper explains, this problem is a

manifestation of the failings of a privately funded healthcare system, and problems continue

to those fortunate enough to have insurance. The other source of interest comes from the

anomalousness of the US structure amongst the OECD countries. A paper by Anderson and

Poullier (1999) finds that in 1997 the median percentage of populations covered by a

Government-assured health insurance scheme in the OECD nations was 100%; by stark

contrast, the US was at the bottom of the list with 33.3%. This betrays an implicit value

judgement pertaining to the role of Government in the healthcare system, which has been

enforced to a unique degree.

1 A USA Today/Gallup Poll conducted on March 22nd 2010 found that, nationally, 49% of adults felt the passing of the ACA would be a ‘good thing’, with 40% claiming it would be a ‘bad thing’.5

At such a crucial time in the evolution of the US healthcare system, a comprehensive study

is therefore warranted to understand what has put so many Americans in such a dire state

vis-à-vis their healthcare coverage, to analyse a unique structure of fundamental

importance, and confront the logic of reforms that threaten to change the rules of the

game.

This paper will attempt to provide answers to three distinct, yet intimately related

questions. Firstly, how did the pre-ACA structure function and how did it perform? This must

surely provide the base for any discussion of such a complex and powerful topic, and is the

consideration of chapter III. From this base, we will confront the ACA’s main features to

answer our second question – from an economic perspective, how relevant and potent are

the reforms in the ACA? This question shall be the focus of chapter IV. Chapter V answers

‘how do alternative healthcare systems compare with the pre-ACA system?’ This will

contextualise the discussion, and provide solutions to the failings of the pre-ACA system

that can, to a degree, be contrasted with those outlined in the ACA. A theoretical framework

underpins the analysis, and chapter II will provide a brief summary of the most significant

characteristics and failings of a private healthcare market. The conclusion ties the paper

together and projects a statement pertaining to where the US healthcare system is currently

and where it is likely to go.

6

II. The Economic Theory of Healthcare

To start, it is integral to reaffirm that the focus of the discussion is indeed about healthcare

and not health status. Health status derives from multiple sources, of which healthcare is

but one; Arrow (1963) notes the importance of necessities such as clothing and food, whilst

Phelps (2003) makes the distinction that consumption goods can be split into those that will

add to, or detract from, your ‘stock’ of Health. This paper focuses on healthcare to keep

discussion concise, however the reader is urged to remember that the economic

perspective of the healthcare system is only a single perspective of a single factor in the

goodness of the health of a nation.

Healthcare is subject to onerous Government intervention, as noted by Phelps (2003), in all

aspects of the market; inter alia, on the demand side by backing a substantial proportion of

individuals, and on the supply side by rigorously testing physicians and technologies to

ensure a high degree of quality. Should the market work in a Pareto optimal fashion,

according to what Arrow (1963) calls the ‘First Optimality Theorem’, the Pareto optimal

point should be a competitive equilibrium; the presence of heavy Government intervention

is thus evidence that something is fundamentally wrong in the private market for HC. This

naturally leads us onto the question – what are the conditions that a pure market would

need to meet in order to satisfy the First Optimality Theorem and which of these does the

HC market fail?

Barr (2004) names these conditions the ‘standard assumptions’2 although failure to meet

one or more of these is not necessarily to preclude the market from being able to function

with relative freedom from the state, due to different degrees of market failure and

2 Perfect competition, perfect information, no public goods, no externalities and no increasing returns to scale.7

Government intervention. Healthcare suffers from serious information problems and

externalities which mean that any HC system must be constructed to ensure that these

failures are assuaged rather than proliferated. We shall proceed by thus considering these

failures and discussing equity, which plays an integral part in the construction of any

healthcare system. This paper does not consider the remaining standard assumptions in any

length as they do not, relative to the main problems, pose an insurmountable threat to the

functioning of a private healthcare system.

II.i – Imperfect knowledge

To begin with the consideration of imperfect knowledge, it is first important to understand

the nature of healthcare demand, and therefore the Grossman (1972) model. The model’s

key conclusion is that rational, fully informed consumers will invest in healthcare until the

marginal benefit of that investment is equal to the marginal cost. Contentious empirical

results3 notwithstanding, the Grossman model is an important pillar of health economics in

that it allows us to model the link between demands for good health status and healthcare.

The model assumes perfect information, however it is more plausible that there is imperfect

information and hence non-optimal consumption due to incorrect evaluation of the benefits

and costs. To address this, an individual will seek assistance from a physician; however, the

physician has a conflict of interest between what Arrow (1963) notes as the social

expectation of the physician providing accurate advice, and ‘supplier-induced demand’

(SID). SID occurs when a physician encourages superfluous consumption of healthcare;

Roemer and Shain (1959) found that, in insured populations, there was a positive

3 See Wagstaff (1986, 1993)8

correlation between the number of hospital beds available and the number of hospital days

used in a population. Therefore, due to imperfect knowledge there are two factors

encouraging a sub-optimal level of demand – ignorance regarding the benefits and costs

associated with each procedure, and the SID effect.

Kenkel (1990) explores the empirical validity of the ignorance effect and concludes that

there is a positive correlation between consumer information and demand – thus, the

‘ignorance’ effect appears to be a reality. The SID effect, however, is far more contentious;

In a survey, Wilensky and Rossiter (1983) find that aggregated data tends to be supportive

of SID, whilst disaggregated data are more conflicted – patient-based studies find little

evidence of any SID but physician-based studies find abundant evidence. They conclude that

SID is likely to exist, but the magnitude of any such effect is unlikely to be large.

Figure 1 shows the ignorance and SID effect4. Let the equilibrium under perfect knowledge

be where MB = MC, as the Grossman model predicts, equating to a demand of Q*.

However, under imperfect knowledge we have seen that an under informed consumer is

likely to consider a lower MB curve of MB’’. The new demand is Q’ and Q*-Q’ is the

ignorance effect. Following the conclusion of Wilensky and Rossiter (1983), the consumer

may perceive the MB to be slightly above MB’’ due to SID. MB’ is one possible curve with a

corresponding demand of Q’’, where Q’’-Q’ can be denoted as the SID effect. In net,

consumption of healthcare is below the optimal level as dictated by the Grossman model.

4 We assume that the consumer faces a constant marginal cost over time.9

Figure 1: The Ignorance and SID Effects in HC Demand

II.ii – Uncertainty

Uncertainty of the timing of when we need treatment, what we are going to need treatment

for, and what specific treatment we will need is, as proposed by Arrow (1963), perhaps the

most debilitating problem for any private healthcare system. However, certainty is a

sufficient but not a necessary condition for a well functioning private market, as the market

itself provides an answer to uncertainty via insurance markets. Appendix A provides a brief

theory of insurance markets; we shall start here with the equation that links the supply and

demand sides of the market:

Equation 1: Supply and Demand Sides of an Actuarial Premium

(1+α) is a loading factor, p is the probability of illness, L is the monetary loss due to illness,

W1 is wealth if no illness is contracted, W* is the certainty equivalent. For insurance to be

10

viable, ‘p’ must be known or estimatable to allow uncertainty to be transformed into risk. ‘p’

must also not be zero or one, the latter constraint having serious implications concerning

pre-existing, chronic or terminal conditions. Finally, Barr (2004) notes that the probabilities

amongst the insured population must be independent of another – this is generally true in

healthcare except during epidemics in which case the Government will intervene.

Crucial to the ability of any insurance market’s functioning is the absence of information

asymmetries, and it is here where the problems of healthcare insurance become apparent.

Healthcare insurance falls prey to both manifestations of information asymmetry, moral

hazard and adverse selection, with severe results.

Figure 2: Moral Hazard and the Third-Party Payer Problem

Moral hazard has two potential manifestations: under-consumption of preventative care

and the third-party payer problem. The former stems from the observation by Pauly (1974)

that, in the absence of substantial costs, there may be an incentive for the individual to

11

under-invest in preventative goods – Morris et al. (2007) notes that an additional

repercussion of this is that pregnancy costs are often not covered by insurance plans in the

US, as pregnancy can be induced by the insured at any point due to gains from such a

contingency; hence, insurance firms act as if ‘p = 1’.

The third-party payer problem arises due to the endogeneity of ‘L’ and the structure of the

insurance market; a fully insured patient (and physician) will act as if their MPC is 0, when it

is likely that MSC > 0. Figure 2 shows that, if demand is price-elastic, an individual will

consume Q’ (D=MPB=MPC), above the optimal level of Q* (D=MPB=MSC), leading to a

welfare loss of XZY. However, if demand is price-inelastic (D’), there is no scope for moral

hazard.

An equally pertinent problem is that of adverse selection, highlighted by Akerlof (1970) to

be of critical importance in the health insurance market. The inability of an insurer to

differentiate between ‘good’ and ‘bad’ risks leads to what Cutler and Zeckhauser (1998)

term the ‘adverse selection death spiral’. Because bad risks will always be better off mixing

with good risks, any plan that caters to both risks will become continually more expensive,

until it is no longer feasible and either everyone is uninsured or they end up on a single plan

that caters specifically to good risks. Whilst a fuller derivation is provided in appendix B, it is

sufficient to state that, due to the ‘community rating’ of premiums based on the expected

average risk of a population, good risks (who incur lower premiums) subsidise bad risks

(who incur higher premiums). As the presence of bad risks push the group’s premium up,

good risks drop out in search of a lower cost plan. Their departure further raises the average

risk and premium, forcing further dropouts – this cycle continues until either of the

conclusions stated above. Cutler and Zeckhauser (1998) use the example of such a spiral 12

occurring in a Harvard health insurance plan – overall, the plan went from covering 20% of

Harvard employees to disbanding in the space of three years.

There is a vast empirical literature on both forms of information asymmetry and the third-

party payer problem has been observed in a range of healthcare systems. Barros et al.

(2008) finds limited evidence for it in a new health insurance scheme in Portugal, but makes

two caveats: one has to control for the presence of adverse selection and the SID effect is

difficult to empirically differentiate from the third-party payer problem. Coulson et al.

(1995) finds prescription drug refills are higher amongst elderly insured populations in the

US than those without insurance, suggesting price elastic demand (and therefore moral

hazard), whilst Chiappori et al. (1998) find moral hazard for home visits when faced with a

10% copayment5 , but not for visits to the hospital; hence, transport and transaction costs

may be a substantial proportion of total costs such that MPC is significantly non-zero even

under insurance.

Concerning adverse selection, Cutler and Zeckhauser (1998) note the problem of allocative

efficiency losses due to the insurer limiting the coverage of a plan as a response to the

presence of bad risks. Hence, adverse selection, as established by Rothschild and Stiglitz

(1976), leads to two types of equilibria; the failure of a pooling equilibrium (based on

community rating) means either the market fails entirely (no one is insured) or an attempt

at a separating equilibrium (where good and bad risks are attracted to different plans via

differences in coverage meant to ‘cream skim’ the good risks) leads to poor coverage.

Empirically, adverse selection is evident; in addition to the Cutler and Zeckhauser (1998)

example, Akerlof (1970) uses the observation of very limited or nonexistent private health

5 Copayments make the patient pay a certain percentage of the cost of treatment.13

insurance plans for the elderly as an example of adverse selection leading to total market

failure. Browne (1992) considers the difference between individual and group insurance

markets. He finds that good risks tend to purchase more insurance in the group market6

than in the individual market, and that in the individual market low risks effectively

subsidise high risks, as theory predicts.

II.iii – Solutions for Imperfect Information in Healthcare

A wider agenda of health-related education initiatives helps abate the ignorance effect; in

stemming superfluous consumption they may also impact on SID. However, a more targeted

source of the SID effect is through the payment scheme of doctors; the two predominant

physician payment schemes are fee for service (FFS) in which a physician is paid per service

provided, and fixed salaries. A study by Hickson et al. (1987) tested the differential impact of

payment schemes by segregating the doctors in a paediatric care centre into FFS and salary

earners. They found that, subject to a benchmark of the ‘correct’ level of paediatric care,

FFS physicians over provided care whilst salary earners under provided. Hence, switching

physicians from FFS to salary payment schemes, and implementing regulations to prevent

under provision of care, would be effective in countering SID (and moral hazard by the

physician).

Because moral hazard arises from the implausibility of observing an individual’s actions,

attempts to curb moral hazard must focus on incentives to affect their actions. Coinsurance

is a popular incentive system, involving the patient facing a portion of the MC of their

treatment, and comes in two broad forms: a deductible (a fixed dollar amount that the

insured is required to pay for any treatment requested) or a copayment (a percentage of the

6 Group insurance is less susceptible to adverse selection, as discussed in the next chapter.14

cost of treatment). Both instruments are common in health insurance packages, however,

as the individual does not face the MSC of their actions, they cannot fully compensate for

moral hazard. Alternatively a premium that rises disproportionately with the degree of

cover could be used, although this is may lead to poor coverage. Insurance companies also

make use of incentives, such as no-claims bonuses, to increase MPC.

Perhaps most troubling of the information problems, adverse selection has only one full

solution – mandating health insurance to prevent low risks dropping out of the market and

instigating the death spiral. Due to the inherent committal in social health insurance

systems7, the problem of adverse selection does not arise with considerable potency in

West European systems. However, whilst such a solution may assuage adverse selection, it

may be seen as inequitable that good risks are effectively subsidising bad risks. Costly and

invasive medical procedures to ascertain risk are an alternative solution, but impractical in

many cases. Finally, there are examples of ‘group insurance’ acting as a basis for stability in

the market; such an example is that of employer provided health insurance (EPHI), explored

in detail in the next chapter.

II.iv – Externalities

Although the main failings of the private health insurance market lie in informational

problems as described above, there are notable externalities in the consumption of

healthcare. Again, reflecting on the wider causes of health is important as there are negative

consumption externalities associated with certain commodities (e.g., cigarettes) and positive

externalities for the research of new treatments. Restricting the analysis to healthcare in

particular, there are clear positive externalities associated with the consumption of

7 Discussed in chapter V.15

preventative healthcare – specifically, the consumption of vaccinations. Phelps (2003) notes

that the more individuals that vaccinate themselves, the lower the expected cost of any

individual from contracting the disease.

Will the private market account for this? Individuals will not factor in such benefits from

herd immunization when deciding to have a vaccination, implying aggregate under-

consumption of vaccinations. Jansen et al. (2003) and Boulier et al. (2007) both consider

mumps; the former study notes that declining take up of the ‘MMR’ vaccine in the UK is

associated with increasingly large measles outbreaks, whilst the latter estimates large,

increasing, MSB associated with the vaccine (more than one case prevented for every

vaccination). While Brito et al. (1991) agree with the conclusion that a private market leads

to under-consumption, they argue that the Government should use the tax system to

provide incentives for vaccinations as opposed to crude mandates. Whilst this may be an

attractive proposition for vaccinations against low-fatality diseases, the expected cost

against potentially highly fatal and infectious diseases (e.g., Ebola, ‘swine flu’) are too high

to allow for anything less than total Government control of prevention. such a fact was

evident in the stockpiling of swine flu vaccines by Governments during the peak of the

pandemic in 2009.

II.v – Equity

Whilst the efficiency arguments outlined above provide a strong case for some form of

Government intervention in the healthcare market, the precise flavour of that intervention

will be partly dictated by notions of equity. However, there is considerable confusion in the

economics literature pertaining to what ‘equity’ may mean and how one may measure it; a

society may consider a distribution of resources equitable even if the distribution is unequal.

16

A useful distinction to make, therefore, is between horizontal and vertical equity: the former

is concerned with equal opportunity for those with equal need, whilst the latter is focused

on the redistribution of resources within the income spectrum.

What is meant by opportunity and need? Culyer and Wagstaff (1993) consider four

alternative definitions for both terms and note numerous conflicts between them whilst

Mooney (1983) considers seven plausible alternatives for the variable being equalised for

individuals of equal need. Broader equity principles also determine the desired magnitude

and direction of redistribution via the healthcare system – as Williams and Cookson (2000)

note, this would ideally lead to an equitable distribution of health as opposed to healthcare.

These definitional problems reappear in empirical studies. Horizontal equity is investigated

by regression analysis on variables influencing healthcare consumption, the results of which

depend on definitions of a ‘need’ or ‘non-need’ variable. Vertical equity studies often

consider the financing structure to see if it is progressive – however, this only considers

redistribution in cash, rather than outcomes. For the purposes of this paper it is sufficient to

simply note these problems, as we are focused on efficiency arguments; we do, however,

contextualise the discussion by considering the broader equity principle of the US system.

III. The US Healthcare System: Structure and Problems

III.i – Equity and the US

17

Before one may analyse the reforms included in the ACA, it is pertinent that the current US

healthcare system is analysed using the economic logic developed in the previous chapter

such that we can list the failings of the system. In turn, it is necessary to note the wider

notion of equity that the US subscribes to vis-á-vis healthcare, as this will have a

fundamental bearing on both the redistributional goals of the system and the breadth of

any Government intervention.

Examination of the US healthcare system betrays a libertarian notion of equity. Figure three

shows that private healthcare expenditures still constitute the largest proportion of total

healthcare expenditure despite a slowly growing public share8; combined with Anderson

and Poullier’s (1999) earlier stated conclusion that the US has the lowest proportion of

citizens with Government backed healthcare in the OECD, it is clear that there is some

restriction on the level of Government intervention in healthcare. Further credence to this

claim is provided by two companion studies by Wagstaff and van Doorslaer (1992a, 1992b)

in which equity in the delivery and finance of a selection of developed nations is examined

and compared using sample data ranging from 1980-1987. In the former study, the primary

concern is horizontal equity, loosely defined as equal treatment for equal need; definition

problems notwithstanding, the US is found to have unequal treatment for equal need

(although the ultimate direction is indeterminate). The latter study investigates vertical

equity ; they find that the US is the most regressive country in the sample, in both the

Kakawani and Suit progressivity indices9.

The system, therefore, has an implicit limit on the role of Government and is relatively

unconcerned with the ultimate distribution that arises. These are classic libertarian traits; it 8 The rise in public expenditures circa 1965 is due to the introduction of Medicare and Medicaid.

9 The US scores a -0.145 in the Kakawani index and a -0.160 in the Suit index.18

is a procedural notion of equity that is primarily concerned with the manner in which the

healthcare is obtained, as opposed to distribution of outcomes – whilst libertarians do also

allow for a limited role of Government to prevent acute destituteness, the Government

strictly facilitates the free market to realise its potential gains. It would be naive to suggest

that this is a definitive statement of equity in US healthcare, but for the purposes of this

paper it will suffice to note that the ACA reforms should minimise Government presence in

the sector and not be constrained by distributional goals except in acute cases.

III.ii – The Structure of the US Healthcare System

The US has a complex healthcare system that provides the first problem in analysis; figures 5

and 6 draw on information from B. S. Klees et al. (2009) and J. K. Iglehart (1999) to show a

simplified structure of the private and public sectors respectively, and this paper considers

them as largely separate entities for reasons of simplicity and conciseness. Note that the

analysis is being conducted is based on the broader structure of the systems, as opposed to

their finer detail.

19

Figure 3: Change in the Composition of US Health Care Expenditures Over Time, Source: CMS NHE Data

Figure 4: Comparison of Health Care Expenditures (as % of GDP) Amongst Select OECD Countries, Source: OECD

20

Figure 5: Structure of the Private Sector of the US Health Care System

21

Population Insurance Firms

Employer

Pay Premiums to

Direct

If in employment,

pays via

Premiums are Tax - Subsidised

Physician and Physician Practices

Reimburses according to

insurance plan

Provides health care

If no insurance, pays full cost; with insurance will pay coinsurance

Figure 6: Structure of the Public Sector of the US Health Care System

22

Population

Physician and Physician Practices

Federal Government

Revenue/ Expenditure

State Revenue/

Expenditure

Medicare Part A

Medicare Parts B + D

Medicaid

Mandatory Tax Contributions (Part A); Voluntary Premiums (Parts B + D)

General Tax RevenueProvides

health care

Pays coinsurance

III.ii.i – The Private Sector

Following Iglehart (1999), we shall follow the healthcare dollar through the private sector,

starting with a healthy population and ending with the patient in receipt of care. The first

transaction to consider is the payment of the premium to the insurance firm. Figure 5 shows

that there are two primary channels through which this transaction can occur – the

individual can pay the insurance firm directly, or they can purchase health insurance

through their employer.

The former channel is the traditional model of health insurance upon which the economic

analysis of chapter II was based; it is therefore theoretically susceptible to adverse

selection10. However, this channel of premium purchase is small relative to insurance plans

purchased via an employer. A report by the Employee Benefits Research Institute (2010)

shows that, in 2009, 91.0% of Americans with either EPHI or individual insurance had EPHI.

Two questions naturally follow: why is EPHI so popular? Are there any economic benefits of

EPHI?

In an EPHI plan, the employer will typically cover a portion of the cost at a subsidised rate

due to the tax exemption of any income of the employee that goes towards paying the

premium. Indeed, the portion of the premium that the employer covers is substantial;

Phelps (2003) calculates the share for individual insurance to be 73% in 1970 and a report by

the Kaiser Family Foundation (2010) finds that this percentage had risen to 86% by 1999,

although it suffered a decline to 81% by 2010. Therefore, answering the first question, the

explicit premium paid via EPHI is smaller than in directly purchased insurance.

10 Moral hazard, imperfect knowledge and externalities arise at a later stage in the system.23

It is contentious whether such a channel produces a net economic gain. The main benefit

comes from mitigating adverse selection; as health status isn’t generally a relevant factor in

deciding an individual’s employment, there will be a random mix of good and bad risks that

are unlikely to ‘drop out’11. This allows for the insurer to adopt a pooling equilibrium

solution based on average risk with relative security from the adverse selection death spiral.

A factor contributing to this security is the lack of choice facing employees: Jensen et al.

(1997) found that whilst the percentage of employees with two or more insurance choices

had increased in the two years from 1993 to 1995, in 1995 the average was only 62%. Most

of this rise had been concentrated in large firms12 (a rise from 75%–84%), a stark contrast to

small firms13 (7%–10%).

This lack of choice may be beneficial in preventing the death spiral, however it is clearly sub-

optimal in that it is unlikely to be allocatively efficient, possibly resulting in poor coverage

for certain risk bands. The other source of security, the link between employment and a

subsidised premium, gives rise to two sources for economic inefficiency. First, a

phenomenon known as ‘job lock’ occurs, where EPHI leads to labour immobility. Monheit

and Cooper (1994) report that there is typically a 20%–40% loss in mobility for a small

proportion of workers due to job lock, meaning that whilst it likely exists, its magnitude is

unlikely to be large. Second, Olson (2002) notes that both theory and empirical evidence

show that the inclusion of an EPHI plan induces the worker to accept a wage lower than

their marginal productivity and finds that those with health insurance coverage accept, on

11 Due to EPHI providing cheaper premiums.

12 200<employees.

13 1–49 employees.24

average, pay that is 20% below those who have no such coverage. The combination of these

factors would suggest that EPHI is a potential source for net inefficiency.

Focusing on the flow of funds and services between insurance firms and patients we

observe two further channels: the first is the traditional indemnity insurance plan which the

analysis of the previous chapter assumed whilst the second is a more recent channel that

has been termed ‘managed care’. Reminiscent of the split between EPHI and directly

purchased insurance, managed care dominates. Jensen et al. (1997) report a surge in

managed care enrolment during the mid–1990’s, where 72.6% of insured working

Americans were in a managed care plan. However, there has been a decline in recent years

while a more recent study by Draper et al. (2004) finds enrolment in health maintenance

organisations (HMO), the dominant managed care organisation (MCO) model, to have

peaked in the late 90’s at around 77 million insureds – this has gradually fallen to around 75

million in 2002. Once again, we must ask two questions: what is managed care, and why was

it suddenly so popular before falling out of favour? Are there any economic benefits to such

a model?

Managed care14 is an attempt to confront the problem of moral hazard in the healthcare

system through strict controls on both the demand and supply side. In particular, the third-

party payer problem, previously discussed, creates a significant problem for healthcare

costs; figure 4 shows that the US spends far beyond the OECD average and that this

divergence is increasing. Moral hazard is not the sole contributor to such large expenditures,

however theory suggests that moral hazard will contribute to Aaron and Ginsburg’s (2009)

14 MCOs attempt to merge the insurer, the physician and the hospital. The classic MCO is the HMO, where a group of physicians are the insurance firm; the largest rival structure is the Preferred Provider Organisation (PPO) which drives patients towards selected physicians in return for a lower FFS.25

finding that healthcare spending is likely to be excessive. Managed care plans were highly

popular due to the lower premiums they were able to offer as a result of the strict controls

in place; Jensen et al. (1997) note that not only were the premiums smaller than

conventional plans in absolute terms, they also had a slower rate of growth. In addition,

figure 4 shows a stabilisation in US healthcare expenditures during the peak of managed

care’s popularity.

On the demand side, MCOs use a mix of incentives and control measures. As with traditional

insurers, coinsurance is the primary incentive measure used. They also attempt to directly

control patient choice by forcing patients to get a second opinion15 or see a primary care

physician (‘gatekeeper’) before being admitted to a specialist; the problem with the former

method is that ‘second opinion’ physicians are likely to agree with their colleagues due to

the likelihood that they will ask their colleague for a second opinion in the future. Recalling

that Chiappori et al. (1998) find that transport and transaction costs are a significant portion

of the total cost of healthcare receipt, the latter measure may instigate under–consumption

of healthcare as it may raise the MPC above MSC.

On the supply side, the main incentive through which physicians are reigned in is through

the payment mechanism. FFS and salary payment mechanisms have already been compared

prior, however a key feature of HMOs is a prospective payment system of capitation where

the physician is allocated a fixed budget per patient. The physician will now restrict the

provision of healthcare to prevent going over–budget; Kerr et al. (1995) finds that physicians

respond to this constraint by increasing use of control measures such as gatekeepers,

15 In addition to managing moral hazard, this also mitigates the effects of supplier induced demand (SID) as the second opinion physician incurs no monetary gain/loss from their action.26

although PPOs still have incentives to over–provide due to remuneration being volume–

based.

In net, a study by Miller and Luft (1994) finds that HMO plans have lead to greater use of

preventative care, shorter in–patient stays and less consumption of expensive treatments

and procedures, suggesting that managed care plans have intrinsic economic benefits in

mitigating moral hazard and SID. However, the recent decline in the popularity of managed

care is, in part, due to the controls which make them economically beneficial; Lesser et al.

(2003) finds that in a competitive labour market, good economic conditions meant

employers whose health insurance plans offered more choice were at an advantage to

employers who focused on managed care plans. Due to this ‘inferior good’ nature of

managed care plans it is necessary to find a mechanism whose efficacy is invariant in

economic conditions or the labour market.

There are two sources for the direct flow of funds from the patient to the

physician/physician practice: coinsurance payments and out of pocket (OOP) payments

faced by the uninsured. The measures that have been discussed thus far in this chapter will

have little impact on those without insurance, because the dilemma that uninsured

individuals face is not necessarily a financial one – if the problem were that individuals

simply could not afford health insurance then it would be economically optimal for the

Government to introduce a lump–sum transfer that allowed everyone to purchase

insurance; this is the ‘second optimality theorem’ that would still allow for a Pareto optimal

allocation of resources. Rather, it is the problem of adverse selection that prevents

individuals from purchasing insurance. Data from a recent US Census Bureau report (2009)

lends support to this hypothesis – it shows that insurance coverage substantially rises with 27

income16 and that insurance is higher amongst employed persons17 (who, due to employer

provided care, are partially protected from adverse selection). Figure 7 shows that the

uninsured population, as a percentage of the total population, is economically acyclical,

suggesting it is a structural rather than transitory problem.

Figure 7: Number and Percentage of US Population without Health Care Insurance Over Time, Source: CMS NHE Data

This is not to suggest that the cost of healthcare is insubstantial for low income families,

indeed Iglehart (1999) notes that Medicare beneficiaries with incomes below the federal

poverty level, and without Medicaid benefits, spent half their income on OOP healthcare

costs.

16 The percentage of low income households (under $25,000) that are uninsured is 26.6%; for high income households (greater than $75,000) this is 9.1%.

17 The percentage of those with stable employment who are uninsured is 15.2%; the percentage of non workers who are uninsured is 29.1%.28

Concerning costs, figure 8 shows that the problem lies in private health insurance as

opposed to OOP payments, however it should be noted that the uninsured impose

substantial18 costs on the Government via uncompensated care costs where physicians are

reimbursed for care provided to fiscally insolvent patients. A report by the CEA (2009) notes

that healthcare costs are being driven, in addition to the factors prior mentioned, by poor

cost–effectiveness in the use of new technologies and high administration costs. The former

problem arises in part due to physician practices competing on the basis of technology as

opposed to price (due to the lack of traditional free market incentives) and is also a result of

SID; new technologies and treatments could mean greater healthcare demand.

Administration costs are high due to the fragmented system of multiple insurers and

providers, and due to the need to estimate risk and set premiums accordingly; a study by

Woolhandler et al. (2003) finds that administration costs in 1999 accounted for 31.0% of US

healthcare expenditures19.

18 A report by the Executive Office of the President Council of Economic Advisers (CEA) (2009) notes that uncompensated care costs borne by the Government in 2008 were $42.9 billion.

19 This is likely an overestimate, as administration costs for Public Health, Retail Pharmacy Sales, Research, Medical Equipment and Supplies and Construction were unavailable for the study.29

Figure 8: Relative Growth of Health Insurance Expenditures. Source: CMS NHE Data

Reforms targeted at the private sector of the US healthcare system should therefore

concentrate on three main areas.

i. Addressing adverse selection in the directly purchased insurance channel, but also

with an eye to EPHI.

ii. Confronting moral hazard without restricting choice to unacceptable levels where

individuals switch out of such plans in good economic times.

iii. Incentivizing small business owners to provide a range of choice in insurance plans to

partially improve the efficiency of EPHI.

30

In achieving these goals, they must provide incentives to encourage the use of cost–

effective treatments and technologies in addition to decreasing fragmentation and

administration costs.

III.ii.ii – The Public Sector

Although this paper is focused on the private sector, due to the ACA reforms being primarily

concerned with the failings of that sector, the public sector is, as shown by figure 3, a

substantial and growing part of the US healthcare system. The two largest components of

the public sector, Medicare and Medicaid, are themselves a response to two of the most

catastrophic failures of the private sector: Medicare is a response to the inability of the

elderly to purchase insurance due to adverse selection, as noted by Akerlof (1970), whilst

Medicaid insures some, but not all, of low income Americans unable to purchase insurance.

Figure 9: Medicare Enrolees and Medicaid Beneficiaries as a Percentage of the Total Population. Source: CMS NHE Data

31

Figures 3 and 9 exhibit the main problem facing the public sector: figure 3 shows an ever

increasing proportion of total healthcare expenditures were being accounted for by the

Public sector whilst figure 9 reveals that, whilst Medicaid has a seemingly cyclical pattern

due to its relationship with low income households, both Medicare and Medicaid coverage

have remained relatively stable over time. Further, figure 3 shows that it is the Federal

portion of the public sector that exhibited the largest proportional increase; the federal

budget is primarily used to fund Medicare20, implying that Medicare has the most significant

cost issues of the two programmes – a problem exacerbated when it is noted that Medicare

has the most stable coverage of the two. For this reason we shall focus on Medicare;

however, it is important to note that Medicaid does not cover all low income families, and

the reforms do address this problem.

Medicare provides coverage to the over–65 population via three channels - based on a

contributions record of mandatory taxes, the entire population receives hospital

insurance21, whilst the voluntary supplemental medical insurance22 is comprised of

insurance against physician costs and insurance for prescription drugs. Whilst the plan does

go a substantial way to mitigate the problems of adverse selection for the elderly, by

offering blanket coverage, it also inherits the cost problems that high–risk insurance leads

to; as figure 10 shows, Medicare expenditures have largely been above the rate of urban

consumer inflation23.

20 However, the Federal Government must also ‘match’ at least 50% of a state’s Medicaid expenditure.

21 Medicare part A; the funds are kept separate in a ‘Hospital Insurance’ fund.

22 Medicare parts B (physician costs) and D (drug coverage). Part C is ‘Medicare Advantage’, where the usual benefits of Medicare are made available through private health plans (such as managed care plans); Part C does not offer any new content, rather it offers choice in the receipt of care.32

Figure 10: Growth Rate of Medicare Expenditures Compared with CPI-U Inflation. Source for Medicare Expenditure: CMS NHE Data, Source for CPI-U: US Bureau of Labour Statistics.

Due, in part, to the substantial costs inherent in insuring the elderly, McClellan (2000)

recognises that OOP spending is notably higher in Medicare than in private plans elsewhere,

driven by large coinsurance payments; he considers this large coinsurance to be the result of

“historical circumstance”, however our prior analysis would suggest that high coinsurance is

inevitable due to the high expected cost of the elderly population’s healthcare, and the

potential for moral hazard. Medicare also has gaps in coverage; Medicare does not cover

long-term nursing home care and, prior to the introduction of part D in 2006, there was no

remittance for outpatient prescription drugs. In response to the coverage gaps, McClellan

(2000) notes that 87% of Medicare enrolees have supplementary ‘medigap’ private

insurance plans.

23 As accurate data for this period is scarce we use urban-CPI inflation as a second best measure relative to pure health care inflation.33

There was an attempt in 198824 to move away from the extensive coinsurance; however it

was repealed in 1989. Rice et al. (1990) find that popular resistance was due to fears over

the role of the state (equity) and dissatisfaction with a new supplementary tax on the

elderly which would allow for the scheme to be funded purely by its beneficiaries. The

failure of Medicare reform provides lessons for the ACA; primarily, changes to the tax

system are likely to be resisted, and Americans give a high weighting to their notion of

equity. Medicare reform is, however, inevitable – there are serious cost sustainability issues

due to the presence of moral hazard and high cost of the elderly, although there has been a

degree of success with small reforms by switching Medicare–participating physicians and

hospitals to a prospective payment system, as noted by Phelps (2003).

IV. The Affordable Care Act

24 Under the Medicare Catastrophic Care Act (MCCA) (1988).34

This paper’s contention has been that the major inefficiencies of a private healthcare system

arise from two main sources: Information imperfections and externalities. With particular

reference to the US case it is the information asymmetries that create the largest problems.

With this in mind, this chapter shall analyse the reforms in terms of how they address

adverse selection, moral hazard, imperfect knowledge and externalities; due to the evident

lack of empirical data, the analysis shall be broadly theoretical. Excellent overviews of the

ACA provisions are provided by: The Kaiser Family Foundation25, US Government26 and

Harrington (2010).

IV.i – The ACA and Adverse Selection

Concerning young adults, the US Census Bureau (2009) finds that 30.4% of Americans aged

18–24 were uninsured, the highest of any age group. Whilst not necessarily a result of

adverse selection, it is a gap in coverage fostered by a transient period in young Americans’

lives, leaving them without their parents’ health insurance coverage or a form of EPHI, as

noted by Collins and Nicholson (2010). This has a detrimental impact on the labour market;

the authors find that 31% of young Americans delayed their further education whilst paying

off medical debt. The ACA solves this problem by allowing young adults of up to 26 years to

stay on their parents’ insurance plans. In addition, it extends coverage to the very poor by

automatic enrolment in Medicaid for individuals with incomes under 133% of the federal

poverty level, and reduces the coinsurance levels for Medicare enrolees27; pertinently, it

reduces the non-first-dollar deductible ‘donut hole’ in Medicare part D drug coverage by

offering tax rebates and reducing coinsurance from 100% to 25% by 2020. Finally, it

25 http://healthreform.kff.org/timeline.aspx

26 http://www.healthcare.gov/law/timeline/index.html

27 Although not to the same degree as the MCCA.35

enforces a minimum level of coverage by mandating that any insurance plan offered

through a health insurance exchange28 (HIE) offers a Government-defined bundle of

essential health benefits (EHB).

With respect to small businesses29, there will be tax credits for those offering health

insurance plans of up to 35% of employer costs in phase 130, increasing to 50% in phase 2.

However, whilst Claxton et al. (2007) found that small businesses were less likely to provide

any EPHI31, the reform does not necessarily induce the employer to address the lack of

choice in health insurance plans that was noted in chapter III. The phase 2 tax credit is

contingent on the insurance being purchased through the HIE, however, which may

implicitly help the range of choice due to potentially greater competition in the exchange.

A number of provisions deal with high-risk coverage. First, bans on lifetime limits on

coverage, a tool used to implicitly deny coverage to those with chronic conditions, and on

rescinding coverage of an individual come into effect in phase 1. In addition, a ban on

denying coverage to both children and adults with pre-existing conditions will come into

effect in phase 1 for children and phase 2 for adults. Adults in phase 1 will be able to enrol in

a federal-funded ‘high-risk pool’ which charges premiums equivalent to that for a ‘normal’

risk population and covers at least 65% of costs with limits on OOP expenditure. The high-

risk pool is, by design, temporary and that is reflected in its unsustainable structure; the

divorce of premiums and risk mean that the Government has set aside $5 billion to cover

28 HIEs are discussed in IV.iii

29 Defined in the ACA as having under 25 employees with an average wage of less than $50,000.

30 The ACA is being implemented in two phases: phase 1 is in effect from 2010 – 2013 inclusive, phase 2 is 2014 onward.

31 45% of small (3-9 employees) businesses contrasted with 99% of large (200+).36

administration costs and excess payments. Whilst high-risk pools are currently operated in

some states, they are small in magnitude: the Kaiser Family Foundation (2010) estimates the

coverage extends to around 200,000 Americans.

Coverage of individuals with pre-existing and chronic conditions is a key goal for US reform,

due to it being one of the most visible flaws of the pre-ACA system. However, the Phase 1

solution of high-risk pools is not a sustainable one. The crucial component of the ACA, which

allows for the sustainability of non-exclusion of high-risks, is the introduction of a mandate

for individuals and medium-sized32 businesses in 2014. Individuals without coverage and

employers who have employees on individually purchased insurance plans will pay fines.

The mandate could lead to lower premiums in two ways. First, there is greater risk

spreading due to a larger pool of insureds. However, equation 733 provides a caveat:

Equation 2: Insurance under Community Rating with Mandatory Insurance.

It is shown that the premium is determined by the ratio of the high risk population to total

population: . Therefore, whether premiums are cheaper or not will depend, inter alia,

on whether the number of higher risk persons that can now access coverage is smaller than

32 50+ employees.

33 Assuming that: the loss ‘L’ is equal for both groups, there are only two risk groups in a population ‘N’ and the probability of a high risk becoming ill is greater than that of a low risk PH>PL.37

the number of low risk persons induced to enrol. Also important is that mandatory

insurance is not a commitment technology for any single plan. The market for insurance will,

if anything, become more competitive due to the HIE, meaning individuals could still drop

out of plans, altering the high risk ratio. Whilst the ACA provides incentives for greater EPHI,

which does act as a commitment technology to single plans, the Congressional Budget Office

(CBO) estimates that there will be 3 million less Americans covered by EPHI in 2019 due to

the incentives of subsidies for purchasing insurance through the exchange. The role of EPHI

must also be re-examined, with adverse selection being confronted by the mandate and

EPHI propagating labour market inefficiencies, it is questionable whether EPHI should

receive continued support through tax incentives. Another channel for lower premiums is

the realisation of economies of scale due to a greater ‘N’: this would lower, currently

substantial, administration costs, manifested via a diminished loading factor .

There could be a period of calibrating the penalties and enforcement methods, however, in

which the benefits outlined above will not be fully realised. Glied et al. (2007) notes that

mandatory insurance legislation varies substantially in its efficacy, with conformance rates

between 30%-99%, attributing the variance to differences in the level of the penalty, the

affordability of insurance and the probability of an uninsured person being charged. The US

may experiment with different enforcement methods and penalties before finding an

optimal infrastructure.

IV.ii – The ACA and Moral Hazard

It would appear that in its attempt to confront adverse selection, the ACA has not dealt with

moral hazard in a systematic and comprehensive manner. Recall that the third-party payer

problem is inevitable given the US healthcare structure, and that the private sector currently 38

uses coinsurance to limit it; further, recall the ‘failure’ of MCOs and the need for an

alternative organisational structure.

The ACA, if anything, exacerbates the third-party payer problem. To increase coverage, it

provides subsidies for coinsurance payments, bans annual caps on coverage in phase 2 and

bans coinsurance altogether for preventative care. Whilst these extend coverage, and the

latter addresses moral hazard leading to under-consumption of preventative goods, it also

denies the private market of a crucial tool of raising the MPC of treatment, reducing

excessive consumption. In addition, there are no concrete alternatives to MCOs in the plan,

meaning the reform has failed to confront two large areas of moral hazard, with the

exception of Medicaid now fully funding visits to primary care physicians and Medicare

testing new systems of physician payment. For example, ‘bundled’ payments are to be

introduced whereby a hospital is, ex-ante, given a set payment for all the costs incurred in

treating a patient (in-patient and out-patient services included) – this is, in essence, a form

of capitation. As Cutler (2010) notes, the hope is that FFS will no longer be the dominant

payment scheme in Medicare.

However there are attempts at confronting other areas of moral hazard, although their

impact is limited as they are largely confined to Medicare/Medicaid. To encourage

consumption of preventative care, states will be afforded grants to encourage Medicaid

enrolees to use preventative care, and subsidies will be provided for employers to cover up

to a further 30% of an employee’s healthcare costs, contingent on attaining health-related

goals. Reforms also aim to reduce spending on inefficient technologies and procedures,

generating excessive demand, by establishing an excise tax of 2.3% on the sale of any

taxable medical device, linking Medicare payments to hospital quality, and creating the

39

Patient-Centred Outcomes Research Institute and Centre for Medicare and Medicaid

Innovation, which shall evaluate new technologies and delivery systems and provide

recommendations.

It should be noted that the CBO (2010) estimated that the ACA would, by 2019, reduce the

federal deficit by $143bn, meeting the President’s requirement that the ACA ought to be at

least budget neutral. If the reforms do not tackle moral hazard in a comprehensive manner,

where do the cost savings arise?

They arise largely from Medicare and Medicaid34 and account for $511bn of reduced

expenditures in 2010-2019. The remainder, $420bn, accrues through new taxes –

prominently, $210bn35 will be raised through a higher tax on Medicare enrolees who earn

above $200,00036. $60bn is to be raised through placing a progressively rising annual fee on

insurance firms. Insurance firms also have their ability to increase premiums limited, fees

imposed, and taxes on those who provide high cost insurance; this would suggest that there

will be a drastic cut in the loading factor, particularly due to administration costs, as firms

attempt to reduce X-inefficiency in order to remain competitive within the HIE. Indirectly,

therefore, the reforms may provide incentives for the creation of a rival organisational

structure to the MCO. In net, however, there is space for further reforms to confront the

third-party payer problem directly, as opposed to relying on high tax rates to control the

budget. The concern over cost sustainability (which stems from problems of moral hazard)

34 E.g., $156.6bn is to be saved by reducing annual market basket updates for Medicare providers and $38.1bn to be saved from changes to Medicaid prescription drug coverage.

35 Estimated by the Joint Committee on Taxation (2010).

36 This may escape the public opposition that the MCCA (1988) received due to the tax base being only a section of the Medicare beneficiary population.40

has been noted in the, still infant, literature on the reforms; Harrington (2010) and Doherty

(2010) both conclude that while there is considerable uncertainty associated with long-run

spending forecasts, it is likely that costs will continue to be problematic whilst payment

system trials are being evaluated, although Baicker and Skinner (2011) find evidence that

healthcare spending growth in OECD countries is curtailed by higher taxes, suggesting the

ACA taxes may have a similar (although smaller, due to being relatively limited in scale)

effect.

IV.iii – The ACA: Imperfect Knowledge and Externalities

Mechanic (1989) notes that whilst individuals make rational choices about their choice of

health insurance plan, there are a number of factors which may encourage a sub-optimal

plan being adopted, leading to allocative efficiency losses. Namely, the fact that insurance

companies compete on a wide spectrum of variables with few services available to help

consumers compare plans. Thus, a consumer may have a well defined preference ordering,

but matching preferences to variables is not straightforward.

HIEs are expected to be installed in every state, with a maximum of one HIE per geographic

area if there multiple in a state. They address the information processing problem primarily

by standardising insurance plans; each plan offered through the HIE has to include the

package of EHB, with plans being ranked by what proportion of the actuarial cost of the EHB

they cover37. Additionally, HIE will be able to provide clear comparisons of plans by

standardising variables and will use uniform enrolment forms for plans. Whilst this may lead

to allocative efficiency gains and efficiency gains from increased market competition,

standardisation could incentivize sub-optimal allocation of resources to maximise

37 Four ‘levels’ - bronze covers 60% of the cost, through to platinum which covers 90%. All insurers selling via a HIE must provide at least one gold and silver plan.41

performance in the variables which are used for comparison. Consequently, the net effect

will depend on the precise specification of the EHB and the variables covered. Additionally,

by limiting HIEs to one per geographic area and linking HIEs, costs incurred by fragmented

markets are reduced.

Regarding externalities, Orenstein and Hinman (1999) find that the US uses laws stipulating

access to schools being contingent on the consumption of certain vaccinations have been

decidedly effective: they find that most coverage rates exceed 80% and have been

associated with a decline in the diseases they protect against. However, they also note that

such laws are ineffective for consumption of vaccines for those below school age (up to two

years old). The ACA eliminates coinsurance for certain vaccinations, and while this is unlikely

to be as strong an incentive as the school laws, it could lead to a significant rise in coverage

rates if vaccine demand is sufficiently price elastic, or the fall in the marginal cost is

substantial. Further, the potential for moral hazard is limited as the full marginal benefit of a

vaccine is usually exhausted after one course of the vaccinations.

V. Alternative Healthcare Systems

With the ACA, the US healthcare system now moves into an era of near universal coverage

due to the individual mandate. Universal coverage already exists amongst most of the

OECD, with the average percentage of the total population falling under public health

insurance schemes among 22 comparable countries being 98.4% (Docteur and Oxley, 2003).

42

However, the US healthcare system remains anomalous in the manner in which it attains

universal coverage; only Switzerland has a comparable system of mandated private

insurance. Three questions are of immediate concern in the context of reforming US

healthcare: how do these systems operate? How do their outcomes compare to the US?

What lessons can be learnt from their experiences? This chapter shall consider these three

questions in turn, with particular focus on cost containment and moral hazard.

V.i – Alternative Methods of Finance and Provision

There are two defining features of any healthcare system: how that system is financed, and

how care is delivered. In the US system, the private sector that predominantly finances and

delivers healthcare; however in the rest of the developed and developing38 World, it is

public expenditures that dominate the finance of care. Regarding provision, a number of

systems either use public provision or (more commonly) a mix of public financing and

private provision. An important point to make is that whilst Wagstaff (2009) is correct in

asserting that the method of finance does not restrict a system to a certain method of

provision, some form of regulated private provision is generally observed. Even in the

publicly provided British National Health Service there are quasi-markets to encourage

competition, because adverse selection arises between the population and the insurance

firm (or analogous organisation), and moral hazard predominately arises due to incentives

embedded in the method of financing, rather than the method of provision. For this reason,

discussion is focused on financing methods.

There are two dominant models of healthcare financing that operate in developed nations:

Full-Tax Financing (FTF) and Social Health Insurance (SHI). Whilst precise details vary by

38 Wagstaff (2009) notes the emerging popularity of SHI systems in developing countries.43

system, the former finances healthcare by drawing from a pool of general tax revenue,

similar to how Medicaid is financed, and the latter finances healthcare by way of mandatory

contributions, similar to Medicare contributions, deducted from wage earnings, being paid

into a ‘sickness fund’ – analogous to an insurance firm bound by strict regulation. Before the

specifics of each system are debated, it is crucial to note that whilst there may be analogues

of the US system, both FTF and SHI fundamentally differ from a private finance system in

that the ‘premium’ (i.e., the tax that is paid) is based on ability to pay, not risk.

This has substantial implications for redistribution, as found by Wagstaff et al. (2000). They

find that, contrary to the US and Switzerland’s highly regressive systems, FTF systems

tended to be either proportional or slightly progressive39 whilst SHI systems tended to be

mildly regressive, although France was proportional – suggesting that such a system does

not necessarily prevent redistributional goals. However, because the US does not give a high

weighting to redistributive concerns, such findings are unlikely to influence any further

reforms; what are the efficiency arguments for either system?

Concerning adverse selection, both systems can be used to provide universal coverage,

although the existence of a contributions record in SHI systems can be used to exclude non-

contributors from care. Fortunately, this is not the case in West European SHI systems.

However, van de Ven et al. (2007) find significant incentives for a sickness fund to ‘risk

select’ amongst a selection of West European SHI systems as each fund is liable for the costs

of an insured and is unable to ask for higher contributions or turn down an applicant based

on risk. SHI systems use a system of ex-ante and ex-post ‘risk adjustment transfers’ to

redistribute from a fund with a lower expected cost to a fund with a higher expected cost, in

39 The UK had a Kakawani index of 0.051, the highest in the sample.44

order to mute any potential gains from such selection. However, the possibility of imperfect

transfers mitigates their efficacy, and funds were observed to be selecting through avenues

such as selective advertising. Adverse selection is of no tangible problem in FTF systems as

the entire population pays into, and draws from, the same pool of funds.

Solving imperfect transfers by making them all ex-post is not viable as sickness funds will be

fully reimbursed for all expenses, and the third-party payer problem becomes prominent.

This moral hazard is part of the reason why van de Ven et al. (2007) found two of the four

countries studied reducing the level of ex-post transfers. Both FTF and SHI systems face

moral hazard problems, and both use co-insurance as an attempt at mitigating it, as can be

seen in table 1. Also note that, whilst Switzerland drastically increases the standard

deviation of SHI OOP payments, both systems are compatible with a range of equity

principles. Additionally, a factor contributing to higher mean OOP payments in a FTF system

could be greater use of supplementary private insurance by the wealthy to achieve higher

care - no such incentive exists in SHI systems due to the competition between funds

providing a range of choices for the patient. FTF also use spending caps, which are

effectively a form of capitation, to curb moral hazard; in Canada each province’s Medicare

system has a set budget for the year.

Year

Country

OOP Expenditures as % of Total Healthcare Expenditures

1998 1999 2000 2001 2002 2003 2004 2005 2006

Belgium 15.4 15.2 15.3 16.0 16.2 16.5 16.0 15.7 15.8

France 7.1 7.2 7.1 7.2 7.0 6.8 6.7 6.8 7.0

Germany 11.0 10.9 11.1 11.2 11.4 11.7 13.2 13.2 13.4

45

Soci

al

Hea

lth

Insu

ranc

e Fi

nanc

e

Luxembourg 7.6 7.4 7.0 6.5 6.9 6.9 6.6 6.5 6.5

Netherlands 8.4 9.0 9.0 8.7 8.0 7.3 7.2 7.1 5.6

Switzerland 32.9 33.4 33.0 31.8 31.6 31.6 31.9 30.6 30.8

Mean % 13.7 13.9 13.8 13.6 13.5 13.5 13.6 13.3 13.2

S.D 9.9 10.0 9.9 9.6 9.5 9.7 9.8 9.3 9.6

Full

Tax

Fina

nce

UK 14.1 13.6 13.4 13.4 13.2 12.8 12.3 11.8 11.4

Canada 16.2 16.2 15.9 15.2 15.2 14.5 14.6 14.6 14.9

Spain 23.2 23.3 23.6 23.9 23.7 22.7 22.6 22.4 21.4

NZ 16.3 15.9 15.4 17.0 16.1 N/A 17.0 16.8 16.6

Denmark 16.6 16.1 16.0 15.9 15.8 14.6 14.7 14.8 14.3

Mean % 17.3 17.0 16.9 17.1 16.8 16.2 16.2 16.1 15.7

S.D 3.5 3.7 3.9 4.0 4.0 4.4 3.9 4.0 3.7

Table 1: OOP Spending as % of Total Healthcare Expenditures in Selected FTF and SHI Systems. Source: OECD (2010)

With regards to technical and allocative efficiency, Mossialos and Dixon (2002) note that

there is no direct link between the financing method and attainment of either aspects of

efficiency, although SHI is likely to be more responsive to consumer demand due to

competition between multiple sickness funds. Regarding effects on the wider economy,

Ballard and Goddeeris (1999) use a general equilibrium model and examine the effect of

introducing a FTF system in America – they find substantial ($27bn) efficiency losses and a

2.5% fall in the labour supply due to a 7.5% rise in tax rates in order to fund the system,

however the model does not take into account efficiency gains from lower administration

costs, greater risk pools and less underinsurance, so the losses are likely to be exaggerated.

In addition, Mossialos and Dixon (2002) note that it is theoretically possible for a SHI system

46

to lead to labour immobility due to contributions being deducted from wages – however,

job-lock is small even in the US40 and they find no substantive evidence of it in Germany.

Cost-containment in FTF systems is, as noted by Nonneman and van Doorslaer (1994),

primarily a political issue; the Government ultimately decides the portion of general tax

revenues to be allocated to healthcare. In addition, a single purchaser of private care has

the advantages of economies of scale to reduce administration costs, and monopsony

power in the market place that they can use to acquire lower cost care. However, the

budget constraint in a FTF system is ‘soft’ – if expenses exceed the cap, more resources can

be drawn. Additionally, the optimal allocation of funds to healthcare is highly contentious

and subsequently, revenues may fluctuate noticeably due to what Nonneman and van

Doorslaer (1994) call the “whimsical nature of Governments” – however, whilst they find a

larger standard deviation for average annual revenue from Government than Non-

Government sources, their study is limited to Belgium.

Cost containment in SHI systems parallels our discussion of cost containment in the US

system, as the tools used are analogues. Hofmarcher and Durand-Zaleski (2004) note that

sickness funds use ‘selective contracting’ of private providers of care, with payment

schemes being a mix of FFS, capitation and salary, with the latter two increasing as a

proportion of total payment schemes. Wagstaff (2009) notes growing attempts at managing

care, in a similar vein to the US MCOs. However, such efforts in a SHI system are ultimately

diluted due to the lack of autonomy sickness funds have in specifying their contracts;

Hofmarcher and Durand-Zaleski (2004) note that, whilst autonomy is increasing in some

systems, the ultimate financing decision rests with the Government. Indeed, such limits in

40 With a smaller safety net than Western European systems.47

contract specification reveal themselves in expenditure data; Mossialos and Dixon (2002)

find that average healthcare expenditures are lower in FTF systems than in SHI systems.

V.ii – International Quality Comparisons

Docteur and Berenson (2009) caution that quality comparisons are inherently difficult to

make reliable and accurate due to factors such as fragmented data, heterogeneous

collection methods and a large number of metrics and variables. That said, there have been

numerous attempts at international comparisons amongst select developed countries, and

we shall focus on two in particular: a contemporary study by The Commonwealth Fund (TCF)

(2010), and a comprehensive, but dated, study by the World Health Organisation (WHO)

(2000).

Metric

Country

Health Status Attainment of Goals Per Capita Health

Expenditure

Performance

(Level of Health)

Total Attainm

ent

Total Performance

Level (DALE)

Distribution

Responsiveness (Level)

Responsiveness (D

istribution)

Vertical Equity

48

USA 24 32 1 3 - 38 54 - 55 1 72 15 37So

cial

Hea

lth In

sura

nce

Fina

nce

Belgium 16 26 16 - 17 3 - 38 3 - 5 15 28 13 21

France 3 12 16 - 17 3 - 38 26 - 29 4 4 6 1

Germany 22 20 5 3 - 38 6 - 7 3 41 14 25

Netherlands 13 15 9 3 - 38 20 - 22 9 19 8 17

Switzerland 8 10 2 3 - 38 38 - 40 2 26 2 20

Full

Tax

Fina

nce

UK 14 2 26 - 27 3 - 38 8 - 11 26 24 9 18

Canada 12 18 7 - 8 3 - 38 17 - 19 10 35 7 30

NZ 31 16 22 - 23 3 - 38 23 - 25 20 80 26 41

Denmark 28 21 4 3 - 38 3 - 5 8 65 20 34

Table 2: Ranking of Selected Countries over Nine Metrics. Source: World Health Report, WHO (2000).

TCF (2010) examined seven countries41 that have a mix of financing and delivery systems,

and ranked them according to: the quality of care provided, access to care, technical

efficiency and horizontal equity. Surprisingly, for a system whose participants largely rank as

‘excellent/good’42, the US is last place for the aggregate ranking and all metrics apart from

overall quality, where it is second to last. It comes fourth (its highest ranking) in ‘effective

care’, which is based on preventative and chronic care – for reasons we have discussed, this

a relatively neglected sector of the US healthcare system – and in patient-centred care.

41 Australia, Canada, Germany, New Zealand, UK, Netherlands, US.

42 A Gallup poll released on November 19th 2010 shows 62% of Americans rate the quality of the system’s output as ‘excellent/good’.49

What is a surprise is that the US does not rank higher on the latter metric; one argument in

favour of the system is that due to the competition of the free market, insurers will be more

willing to adapt resources to match an individual’s preferences. However, such a mediocre

ranking would suggest that the distortive effects of market failures are sufficiently strong to

mitigate that responsiveness. The effect of FTF on responsiveness is ambiguous – New

Zealand ranks first, however Canada and the UK rank sixth and seventh respectively.

Whilst TCF (2010) provides an accessible ranking, an altogether more comprehensive study

was undertaken by the WHO (2000) which used eight metrics over 191 countries. Critically,

in using disability-adjusted life expectancy43 it provides a ranking of health status amongst

the countries; as noted at the start of chapter II, the ultimate aim of a healthcare system is

to maximise a nation’s health. Table 2 collects the findings for a selection of countries with a

mix of FTF, SHI and provision mechanisms.

The study reveals a number of interesting findings about the US system. In international

dollars the US spends more on healthcare per capita than anywhere else; however, this

expenditure does not translate into the highest quality of care. Indeed, the study

differentiates between attainment and performance; the former is an absolute measure of

quality, whilst the latter is a measure of cost-efficiency. What can be observed is that, whilst

the US does fairly well in terms of total attainment44, it performs poorly on total

performance, with a large differential between the two rankings. Where the system does

excel, in contrast to TCF’s findings, is in responsiveness – it ranks highest in the World, with

Switzerland (a system with substantial private involvement – see OOP payments in table 1)

43 Life expectancy net of years with disability (life expectancy in full health).

44 Heavily penalised by a very poor ranking on vertical equity, as is to be expected.50

coming second. Such a differential can be accounted for by the use of different metrics

being examined via the studies’ respective surveys – the WHO report focuses more on

dignity and autonomy, whilst TCF focuses on the patient–physician relationship.

Whilst a SHI or FTF system does not guarantee an improvement in either attainment or

performance (although France provides an example of how a SHI system can excel in such

metrics), they’re shown to have a smaller disparity between total attainment and total

performance than the US, with France obtaining a higher ranking for performance than

attainment; this suggest that whilst the complex organisational arrangements in the US are

able to mitigate the effects of market failures in terms of outcomes, alternative structures

are able to provide a comparable level of care at substantially lower cost by maximising the

performance of their resources.

V.iii – Lessons for the US

The US not only has much to learn from SHI and FTF systems, but already incorporates

features of both systems in its own. Medicare part A broadly resembles a single-payer SHI

system with a single ‘sickness-fund’, whilst Medicaid is essentially a FTF system. However,

innovations such as risk-adjusters and payment caps, although not without problems, can be

adapted for use in the private sector as they involve only minimal Government intervention,

which is congruous with the US systems’ libertarian ideology. While such measures may be

weaker than in a pure SHI/FTF system, they would be combined with stronger MCOs and

payment schemes than either alternative system is able to implement, due to insurance

firms commanding greater autonomy than sickness funds. In part, this could foster a

resurgence of MCOs as the risk adjustment transfers potentially allow more choice in the

range of care provided. Importantly, both alternative systems can be reconciled with a level 51

of care that is not only comparable with the US, but markedly more cost-efficient; however,

as the evidence of New Zealand in table 2 shows, care must be taken to ensure that such

cost-efficiency and attainment is realised. Further, a study by Gechert (2010) finds that

administrative costs in a SHI system are lower than in a supplementary private health

insurance system, suggesting SHI would curtail the substantial US administrative costs.

The ACA appears to move the US system towards a Switzerland-style SHI system, with

mandatory insurance for individuals, with a system of subsidies for low-income individuals,

and insurance firms, who are unable to decline an applicant based on risk, offering a

compulsory baseline package. However, the Swiss system goes further in partially divorcing

premium and risk; an insurance firm cannot make a profit off the compulsory baseline

package, and may only offer a community rating premium, not a premium based on

individual risk. In addition, prices of medical services are set once a year by a Government

agency. Such crucial omissions will put more pressure on private sources of cost

containment in the US system, although one may expect a convergence towards

Switzerland’s performance level.

VI. Conclusion

The US healthcare system is going through a period of extraordinary change. In applying a

theoretical framework constructed in chapter II we were able to analyse the system, finding

substantial problems in terms of imperfect information and cost-containment. We also

analysed the responses to such market failures, such as MCOs and EPHI, concluding that

such measures were left wanting in some regard. However, we also found a system that

52

remained largely true to the nation’s libertarian aspirations for such a system and reigned in

Government involvement.

Still, it was clear that a major reform of the system was necessary to curtail a drastic rate of

growth of expenditures, not comparable to the OECD average, and a high, structural level of

uninsured – any such reform would need to tackle the core problems of adverse selection

and moral hazard to be fully successful. The ACA, ultimately, does not fully confront all

these problems; it does, however, make considerable progress towards such an aim. The

crucial elements of the reform package are the mandate and Medicaid expansion, which

mitigates the worst effects of adverse selection and financially-related access to care

problems. On moral hazard, the picture is mixed; under-consumption of preventative care is

directly addressed, and there are attempts at confronting the third-party payer problem,

but they are largely trials and limited to operating in the public sector. The HIEs and EHB

provide an innovative solution to imperfect knowledge and are an interesting attempt at

cost containment through competition, although whether they will ‘bend’ the cost curve to

be sustainable is left to be seen.

Is the ACA sustainable? It is unclear; although adverse selection is mitigated, it is left to be

seen how insurance firms will cope with drastically more stringent rules and fees, in addition

to the greater competition HIEs are expected to foster. A further move to a Switzerland SHI

system would not be impossible, nor would a move to a Canadian FTF system, although the

ACA implies the US is heading towards the former. Indeed, post-ACA, the US system

occupies a middle-ground between pure private and SHI, reflecting a statement by Barr

(2004: 285, emphasis in original):

53

“... any strategy for addressing the problems of actuarial medical insurance leads

inescapably to institutions with the major characteristics of social insurance.”

A move toward a fuller SHI system is ultimately a political, rather than economic decision,

and that was reflected in an exchange between President Barack Obama and an audience

member at a rally in Iowa after the legislation had passed. The member appears to ask why

a public option45, which Cutler (2010) notes could be the basis for a full SHI system in a

further reform, hadn’t been included in the bill – to which the President replied:

“Because, we couldn’t get it through Congress.”

Bibliography

Aaron, H. J. and Ginsburg, P. B. (2009) ‘Is Health Spending Excessive? If so, What Can We Do

About It?’, Health Affairs, vol. 28, pp. 1260 – 1275.

Akerlof, G. A. (1970) ‘The Market for “Lemons”: Quality Uncertainty and the Market

Mechanism’, The Quarterly Journal of Economics, vol. 84, pp. 488 – 500.

Anderson, G. F. and Poullier, J-P. (1999) ‘Health Spending, Access, And Outcomes: Trends In

Industrialized Countries’, Health Affairs, vol. 18, pp. 178 – 192.

45 A Government-sponsored plan.54

Arrow, K. J. (1963) ‘Uncertainty and the Welfare Economics of Medical Care’, The American

Economic Review, vol. 53, pp. 941 – 973.

Baicker, K. and Skinner, J.S. (2011) ‘Health Care Spending Growth and the Future of US Tax

Rates’, NBER Working Paper Series, vol. w16772, pp. –. Accessed from:

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1759844

Ballard, C. L. and Goddeeris, J. H. (1999) ‘Financing Universal Health Care in the United

States: A General Equilibrium Analysis of Efficiency and Distributional Effects’, National Tax

Journal, vol. 52, pp. 31 – 51.

Barr, N. A. (2004) The Economics of the Welfare State, 4th ed, Oxford: Oxford University

Press.

Barros, P. P., Sanz-de-Galdeano, A. and Machado, M. P. (2008) ‘Moral Hazard and the

Demand for Health Services: A Matching Estimator Approach’, Journal of Health Economics,

vol. 27, pp. 1006 – 1025.

Boulier, B. L., Tejwant, S. D. and Goldfarb, R. S. (2007) ‘Vaccination Externalities’, The B. E.

Journal of Economic Analysis & Policy, vol. 7.

Brito, D. L., Sheshinsky, E. and Intriligator, M. D. (1991) ‘Externalities and Compulsory

Vaccinations’, Journal of Public Economics, vol. 45, pp. 69 – 90.

Browne, M. J. (1992) ‘Evidence of Adverse Selection in the Individual Health Insurance

Market’, The Journal of Risk and Insurance, vol. 59, pp. 13 – 33.

Centers for Medicare & Medicaid Services, National Health Expenditure Web Tables.

Accessed From: http://www.cms.gov/NationalHealthExpendData/downloads/tables.pdf

Chiappori, P-A., Durand, F. and Geoffard, P-Y. (1998) ‘Moral Hazard and the Demand for

Physician Services: First Lessons from a French Natural Experiment’, European Economic

Review, vol. 42, pp. 499 – 511.

55

Claxton, G., Gabel, J., DiJulio, B., Pickreign, J., Whitmore, H., Finder, B., Jacobs, P. and

Hawkins, S. (2007) ‘Health Benefits in 2007: Premium Increases Fall to an Eight-Year Low,

While Offer Rates and Enrollment Remain Stable’, Health Affairs, vol. 26, pp. 1407 – 1416.

Collins, S. R. and Nicholson, J. L. (2010) ‘Rite of Passage: Young Adults and the Affordable

Care Act of 2010’, The Commonwealth Fund. Accessed From:

http://www.commonwealthfund.org/~/media/Files/Publications/Issue%20Brief/2010/

May/1404_Collins_rite_of_passage_2010_v3.pdf

Congressional Budget Office (2010) Cost estimate for the amendment in the nature of a

substitute for H.R. 4872. Accessed From:

http://www.cbo.gov/ftpdocs/113xx/doc11379/AmendReconProp.pdf

Coulson, N. E., Terza, J. V., Neslusan, C. A. and Stuart, B. C. (1995) ‘Estimating the Moral

Hazard Effect of Supplemental Medical Insurance in the Market for Prescription Drugs by

the Elderly’, The American Economic Review, vol. 85, pp. 122 – 126.

Culyer, A. J. and Wagstaff, A. (1993) ‘Equity and Equality in Health and Health Care’, Journal

of Health Economics, vol. 12, pp. 431 – 457.

Cutler, D. M. (2010) ‘The Simple Economics of Health Reform’, The Economists’ Voice, vol. 7.

Cutler, D. M. and Zeckhauser, R. J. (1998) ‘Adverse Selection in Health Insurance’, Forum for

Health Economics & Policy, vol. 1.

Davis, K., Schoen, C. and Stremikis, K. (2010) ‘How the Performance of the US Health Care

System Compares Internationally 2010 Update’, The Commonwealth Fund. Accessed From:

http://www.commonwealthfund.org/~/media/Files/Publications/Fund%20Report/2010/

Jun/1400_Davis_Mirror_Mirror_on_the_wall_2010.pdf

Docteur, E. and Berenson, R. A. (2009) ‘How Does the Quality of Health Care Compare

Internationally?’, Timely Analysis of Immediate Health Policy issues, a Series of Briefs

Produced by the Urban Institute and the Robert Wood Johnson Foundation. Accessed From:

http://ssrn.com/abstract=1482677

56

Docteur, E. and Oxley, H. (2003) Health Care Systems: Lessons from the Reform Experience.

Accessed From: http://www.oecd.org/dataoecd/5/53/22364122.pdf

Doherty, R. B. (2010) ‘The Certitudes and Uncertainties of Health Care Reform’, Annals of

Internal Medicine, vol. 152, pp. 679 – 682.

Draper, D. A., Hurley, R. E. and Short, A. C. (2004) ‘Medicaid Managed Care: The Last Bastion

of the HMO?’, Health Affairs, vol. 23, pp. 155 – 167.

Executive Office of the President Council of Economic Advisers (2009) The Economic Case for

Health Care Reform. Accessed from:

http://www.whitehouse.gov/assets/documents/CEA_Health_Care_Report.pdf

Fronstin, P. (2010) ‘Sources of Health Insurance and Characteristics of the Uninsured:

Analysis of the March 2010 Current Population Survey’, EBRI Issue Brief, no. 347.

http://www.gallup.com/poll/126929/slim-margin-americans-support-healthcare-bill-

passage.aspx

http://www.gallup.com/poll/144848/ratings-healthcare-quality-coverage-best-years.aspx

Gechert, S. (2010) ‘Supplementary Private Health Insurance in Selected Countries: Lessons

for EU Governments’, CESifo Economic Studies, vol. 56, pp. 444 – 464.

Glied, S. A., Hartz, J. and Giorgi, G. (2007) ‘Consider it Done? The Likely Efficacy of Mandates

for Health Insurance’, Health Affairs, vol. 26, pp. 1612 – 1621.

Grossman, M. (1972) The Demand for Health: A Theoretical and Empirical Investigation, New

York: NBER.

Harrington, S. E. (2010) ‘U.S. Health-Care Reform: The Patient Protection and Affordable

Care Act’, The Journal of Risk and Insurance, vol. 77, pp. 703 – 708.

Hickson, G. B., Altemeier, W. A. and Perrin, J. M. (1987) ‘Physician Reimbursement by Salary

or Fee-for-Service: Effect on Physician Practice Behaviour in a Randomized Prospective

Study’, Pediatrics, vol. 80, pp. 344 – 350.

57

Hofmarcher, M. M. and Durand-Zaleski, I. (2004) ‘Contracting and Paying Providers in Social

Health Insurance Systems’. In: Saltman, R. B., Busse, R. and Figueras, J., Editors (2004) Social

Health Insurance Systems in Western Europe, Glasgow: Bell and Bain Ltd.

Iglehart, J. K. (1999) ‘The American Health Care System – Expenditures’, The New England

Journal of Medicine, vol. 340, pp. 70 – 76.

Jansen, V. A. A., Stollenwerk, N., Jensen, H. J., Ramsay, M. E., Edmunds, W. J., and Rhodes, C.

J. (2003) ‘Measles Outbreaks in a Population with Declining Vaccine Uptake’, Science, vol.

301, p. 804.

Jensen, G. A., Morrisey, M. A., Gaffney, S. and Liston, D. K. (1997) ‘The New Dominance of

Managed Care: Insurance Trends in the 1990s’, Health Affairs, vol. 16, pp. 125 – 136.

The Joint Committee on Taxation (2010) JCX – 17 – 10. Accessed From:

http://www.jct.gov/publications.html?func=startdown&id=3672

The Kaiser Family Foundation, Implementation Timeline. Accessed From:

http://healthreform.kff.org/timeline.aspx

The Kaiser Family Foundation (2010) State High-Risk Pools: An Overview. Accessed From:

http://www.kff.org/uninsured/upload/8041.pdf

The Kaiser Family Foundation and Health Research & Educational Trust (2010) Employer

Health Benefits – 2010 Annual Survey, Accessed from:

http://ehbs.kff.org/pdf/2010/8085.pdf

Kenkel, D. (1990) ‘Consumer Health Information and the Demand for Medical Care’, The

Review of Economics and Statistics, vol. 72, pp. 587 – 595.

Kerr, E. A., Mittman, B. S., Hays, R. D., Siu, A. L., Leake, B. and Brook, R. H. (1995) ‘Managed

Care and Capitation in California: How do Physicians at Financial Risk Control their own

Utilization?’, Annals of Internal Medicine, vol. 123, pp. 500 – 504.

Klees, B. S., Wolfe, C. J. and Curtis, C. A. (2009) Brief Summaries of Medicare and Medicaid

Title XVIII and XIX of the Social Security Act as of November 1, 2009. Accessed from:

58

https://www.cms.gov/MedicareProgramRatesStats/downloads/MedicareMedicaidSummari

es2009.pdf

Lesser, C. S., Ginsburg, P. B. and Devers, K. J. (2003) ‘The End of an Era: What Became of the

“Managed Care Revolution” in 2001?’, Health Services Research, vol. 38, pp. 337 – 355.

McClellan, M. (2000) ‘Medicare Reform: Fundamental Problems, Incremental Steps’, The

Journal of Economic Perspectives, vol. 14, pp. 21 – 44.

Mechanic, D. (1989) ‘Consumer Choice Among Health Insurance Options’, Health Affairs,

vol. 8, pp. 138 – 148.

Miller, R. H. and Luft, H. S. (1994) ‘Managed Care Plan Performance since 1980 – A

Literature Analysis’, The Journal of the American Medical Association, vol. 271, pp. 1512 –

1519.

Monheit, A. C. and Cooper, P. F. (1994) ‘Health Insurance and Job Mobility: Theory and

Evidence’, Industrial and Labour Relations Review, vol. 48, pp. 68 – 85.

Mooney, G. H. (1983) ‘Equity in Health Care: Confronting the Confusion’, Effective Health

Care, vol. 1, pp. 179 – 185.

Morris, S., Devlin, N. J. and Parkin, D. (2007) Economic Analysis in Health Care, Chichester: J.

Wiley & Sons.

Mossialos, E. and Dixon, A. (2002) ‘Funding Health Care in Europe: Weighing up the

Options’. In: Mossialos, E., Dixon, A., Figueras, J. and Kutzin, J., Editors (2002) Funding Health

Care: Options for Europe, Guildford ; King’s Lynn: Biddles Ltd.

Nonneman, W. and van Doorslaer, E. (1994) ‘The Role of the Sickness Funds in the Belgian

Health Care Market’, Social Science & Medicine, vol. 39, pp. 1483 – 1495.

OECD, OECD Health Data 2010 – Frequently Requested Data. Accessed From:

http://www.oecd.org/document/16/0,3343,en_2649_34631_2085200_1_1_1_1,00.html

Olson, C. A. (2002) ‘Do Workers Accept Lower Wages in Exchange for Health Benefits?’,

Journal of Labour Economics, vol. 20, pp. 91 – 114.

59

Orenstein, W. A. and Hinman, A. R. (1999) ‘The Immunization System in the United States –

the Role of School Immunization Laws’, Vaccine, vol. 17, pp. 19 – 24.

Pauly, M. V. (1974) ‘Overinsurance and Public Provision of Insurance: The Roles of Moral

Hazard and Adverse Selection’, The Quarterly Journal of Economics, vol. 88, pp. 44 – 62.

Phelps, C. E. (2003) Health Economics, 3rd ed, Boston: Addison Wesley.

Rice, T., Desmond, K. and Gabel, J. (1990) ‘The Medicare Catastrophic Coverage Act: A Post-

Mortem’, Health Affairs, vol. 9, pp. 75 – 87.

Roemer, M. I. and Shain, M. (1959) Hospital Utilization under Insurance. Hospital

Monograph Series, No. 6, Chicago: American Hospital Association.

Rothschild, M. and Stiglitz, J. (1976) ‘Equilibrium in Competitive Insurance Markets: An Essay

on the Economics of Imperfect Information’, The Quarterly Journal of Economics, vol. 90, pp.

629 – 649.

US Census Bureau (2009) Income, Poverty, and Health Insurance Coverage in the United

States: 2009. Accessed from: http://www.census.gov/prod/2010pubs/p60-238.pdf

US Department of Labour – Bureau of Labour Statistics, Urban Consumer Price Index.

Accessed From: ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt

US Government, Timeline: What’s Changing and When. Accessed From:

http://www.healthcare.gov/law/timeline/index.html

van de Ven, W. P. M. M., Beck, K., Van de Voorde, C., Wasem, J. and Zmora, I. (2007) ‘Risk

Adjustment and Risk Selection in Europe: 6 Years Later’, Health Policy, vol. 83, pp. 162 – 179.

Wagstaff, A. (1986) ‘The Demand for Health Some New Empirical Evidence’, Journal of

Health Economics, vol. 5, pp. 195 – 233.

Wagstaff, A. (1993) ‘The Demand for Health: An Empirical Reformulation of the Grossman

Model’, Health Economics, vol. 2, pp. 189 – 198.

Wagstaff, A. (2009) ‘Social Health Insurance Reexamined’, Health Economics, vol. 19, pp. 503

– 517.60

Wagstaff, A. and van Doorslaer, E. (1992a) ‘Equity in the Finance of Health Care: Some

International Comparisons’, Journal of Health Economics, vol. 11, pp. 361 – 387.

Wagstaff, A. and van Doorslaer, E. (1992b) ‘Equity in the Delivery of Health Care: Some

International Comparisons’, Journal of Health Economics, vol. 11, pp. 389 – 411.

Wagstaff, A., van Doorslaer, E., van der Burg, H., Christiansen, T., De Graeve, D., Duchesne,

I., Gerdtham, U-G., Gerfin, M., Geurts, J., Gross, L., Häkkinen, U., John, J., Klavus, J., Leu, R.

E., Nolan, B., O’Donnell, O., Propper, C., Puffer, F., Schellhorn, M., Sundberg, G. and

Winkelhake, O. (2000) ‘Equity in the Delivery of Health Care in Europe and the US’, Journal

of Health Economics, vol. 19, pp. 553 – 583.

Wilensky, G. R. and Rossiter, L.F. (1983) ‘The Relative Importance of Physician-Induced

Demand in the Demand for Medical Care’, The Milibank Memorial Fund Quarterly. Health

and Society, vol. 61, pp. 252 – 277.

Williams, A. and Cookson, R. (2000) ‘Equity in Health’. In: Culyer, A. and Newhouse, J.,

Editors (2000) Handbook of Health Economics vol. 1B, Amsterdam; Oxford: Elsevier.

Woolhandler, S., Campbell, T. and Himmelstein, D. U. (2003) ‘Costs of Health Care

Administration in the United States and Canada’, The New England Journal of Medicine, vol.

349, pp. 768 – 775.

World Health Organisation (2000) The World Health Report 2000 – Health Systems:

Improving Performance, France: Sadag.

61

Appendix A. Insurance Markets

Insurance markets, fundamentally, transform uncertainty into risk and offer protection

against that risk. On the supply side, an insurer will offer protection against the risk of a loss

of wealth (L) that will occur with an estimated probability (p), and also charge an amount to

cover administration costs (α); therefore, an actuarially fair premium (π) for any individual

can be estimated by:

Equation 3: An Actuarially Fair Premium

62

Figure 11: Risk Aversion in Wealth

The premium that an individual is charged is increasing in the administration costs faced by

the firm, the probability the loss-triggering event occurs and the size of the loss induced by

that contingency46.

The demand for insurance arises as a result from risk aversion; specifically, we are

concerned with a person’s risk aversion in wealth. Let us assume an individual has a utility

function of the following kind:

Equation 4: Utility Function of Representative Individual

Where the individual’s utility (Ui) is, inter alia, influenced by the level of wealth (W) in their

possession. We can denote this individual as risk averse in wealth if the following two

conditions hold:

46 This is a simplification, of course, although the general principle of all actuarial insurance is based upon this notion of a supplier being able to link a premium to the degree of risk involved. 63

Equation 5: Conditions for Risk Aversion

In essence, the individual must have a positive, but diminishing, marginal utility of wealth.

The implications of this risk aversion become clear when shown graphically in figure 3. Let

us assume that the individual only derives utility from wealth and that there are two states

of the World; in the first state, the individual has wealth W1 and a utility level of U(W1) – in

the second, they suffer a medical emergency and have a lower level of wealth, W0 with a

corresponding utility of U(W0). If we, for simplicity, assume a value of ‘p’ to be 0.5, then

their expected level of wealth can be given by W’, where W’ – W0 = W1 – W’; under

certainty, the level of utility associated with W’ would be U(W’)47. However, due to the

presence of uncertainty, the individual considers the expected utility instead - which is given

by U(W*) and equivalent to the level of utility gained from holding W* with certainty.

To link the supply and demand sides, we can observe the maximum premium, π*, that the

insurer can charge. Noting the fact that the insurer offers certainty, and that that individual

is indifferent between W’ with uncertainty and W* with certainty:

Equation 6: Maximum Premium, Fair Premium, Risk Premium

As shown above, the maximum premium can be decomposed into both a ‘fair’ premium,

which will leave the individual as well off as they would be with their mean wealth, W’, and

a ‘risk’ premium which increases the more the individual abhors uncertainty. It should be

47 Due to the concavity of U(W), U(W’) – U(W0) ≠ U(W1) – U(W’)64

noted that the risk premium component is not purchased by risk neutral48 or risk loving49

individuals as U(W*) ≥ U(W’); the risk neutral individual will purchase the fair premium,

whilst the risk loving individual will purchase only a fraction of the fair premium. However,

as a study conducted by Friedman (1974) shows, there is little doubt that consumers of

health care tend to be, to varying degrees as the study notes, risk averse, so we shall not

pursue the risk neutral or loving cases any further.

48 Risk neutral individuals have a utility function linear in wealth, such that:

49 Risk loving individuals have a utility function convex in wealth, such that:

65

Appendix B. The Adverse Selection Death Spiral

Adverse selection is a problem of ‘hidden information’. In healthcare and arises when a

patient has a superior knowledge of their likely demand for healthcare than an insurer; this

means that an insurer is unable to differentiate between a ‘good risk’ and a ‘bad risk’ that

will be more expensive to insure due to a higher ‘p’. It is in Akerlof’s (1970) seminal article

that the full extent of the problem is made clear; he notes that in the used car market, due

to the information asymmetry regarding the quality of a used car, the presence of poor

quality cars drives the price up until the market eventually the market breaks down. In

health insurance a similar phenomenon arises; let us begin with the concept of ‘community

rating’, which divorces a premium from the individual’s level of risk, instead focusing on the

average risk of a population.

Equation 7: Community Rating with High and Low Risk Groups

66

A premium arising from such a policy will resemble equation 3, where θ is the proportion of

high risk individuals in the population and pH and pL are the respective probabilities of a high

risk and low risk individual needing healthcare. If we note that pH > pL then we can rank the

community rating premium against the premiums that each group would occur based on

their specific risk:

Equation 8: Ranking of Premiums

The high risks benefit from this community rating, as the low risks drive the price of the

premium below what they would pay otherwise; however the low risks lose as they

effectively subsidise the high risks. It therefore follows that the low risks would either drop

out of the market, or substitute to a cheaper plan. The insurance company would therefore

be forced to reconsider the premium offered:

Equation 9: Community Rating Post Low Risk Exit

Hence, the price of the premium is inflated due to the higher average risk of the insureds. If

we assume that there is a spectrum of high risk individuals50 then the above scenario

repeats itself, with the lower risk group dropping out and the premium price rising once

again. This is what Cutler and Zeckhauser (1998) term the ‘adverse selection death spiral’;

because higher risks will always be better off mixing with lower risks, any plan that caters to

the higher risks will become continually more expensive until it is no longer feasible and

50 For example, one may decompose ‘High’ risk individuals into ‘Low-High’ Risk and ‘High-High’ Risk.67

either everyone is uninsured or they end up on a single plan that caters specifically to low

risks.

68