1. Discussion of Health Insurance Theory: The Case of the Missing Welfare Gain John A. Nyman, University of Minnesota Lorens A. Helmchen School of Public Health and Institute of Government and Public Affairs University of Illinois at Chicago

2. Main Result: Efficient Moral Hazard Ex post moral hazard: medical care that would not be consumed if uninsured Decompose into efficient, inefficient moral hazard: 1.Start with “price payoff insurance” (PPI): price of medical care reduced from P=MC to cP, where 0 ≤ c < 1 is coinsurance rate 2.Find enrollee’s consumption under PPI, M PPI 3.Replace PPI with “contingent claims insurance” (CCI): price of medical care now equals marginal cost, P=MC, but enrollee receives lump sum payment of M PPI · P when sick  consumption bundle under PPI still affordable under CCI 4.Observe enrollee’s consumption under CCI, M CCI 5.Efficient part of moral hazard (no price distortion): M CCI – M U 6.Inefficient part of moral hazard (price distortion,cP < P): M PPI – M CCI Policy implication: Find insurance contracts that do not to curb the entire moral hazard, M PPI – M U, only the inefficient part, M PPI – M CCI.

3. Did we miss a welfare gain?  “The income transfer in price payoff insurance provides an additional welfare gain that has been missing from conventional health insurance theory”  People buy insurance to reduce fluctuations in utility across health states.  If uninsured, EU u = (1-π)U(Y 0, H 0 ) + πU(Y 0 - p M M U, H 0 – S + h(M U )) where M U satisfies first-order condition: p M U income = U health h’ For major medical procedures, binding integer constraint: M U ≥ M U > Y 0, so EU u = (1-π)U(Y 0, H 0 ) + πU(Y 0, H 0 – S) [medical technology beyond reach]  Health insurance transfers income from the healthy to the ill state.  If price payoff insurance (PPI), enrollee receives M PPI s.t. S = h(M PPI ) EU PPI = (1-π)U(Y 0 – P, H 0 ) + πU(Y 0 - P, H 0 ) = U(Y 0 - P, H 0 )  transfer enough funds from healthy to ill state to pay for major medical

4. Minimizing Inefficient Moral Hazard  If price payoff insurance (PPI), receive M PPI s.t. S = h(M PPI ), so that EU PPI = (1-π)U(Y 0 – P, H 0 ) + πU(Y 0 - P, H 0 ) = U(Y 0 - P, H 0 )  If p M U income = U health h’, all moral hazard is efficient  demand-side cost-sharing reduces efficient moral hazard  If p M U income > U health h’, some moral hazard is inefficient  How to ensure efficient utilization, i.e. that satisfies p M U income = U health h’? demand-side cost-sharing but would force enrollee to bear risk = disutility utilization management but payer-provider organization must guess M* correctly contingent claims insurance (CCI): pays p M M PPI, so that EU CCI = (1-π)U(Y 0 – P, H 0 ) + πU(Y 0 – P + p M [M PPI – M CCI ], H 0 – S + h(M CCI )) As p M U income = U health h’, EU CCI ≥ EU PPI

5. Modified Elizabeth Example  Diagnosed with breast cancer  Prices total mastectomy: $20,000 breast reconstruction: $20,000 2 extra days in the hospital: $ 4,000$44,000  Medical care consumption when ill no insurance: mastectomy PPI insurance: mastectomy, breast reconstruction, 2 extra days in the hospital CCI insurance: mastectomy, breast reconstruction, $4,000 spent on non-medical

6. Why (not) switch to CCI? EU CCI = (1-π)U(Y 0 – P, H 0 ) + πU(Y 0 – P + I – p M M CCI, H 0 – S + h(M CCI )) CCI better suited than PPI to yield efficient medical care consumption: M CCI satisfies p M U income = U health h’ equalize utility across health states (minimize risk borne by enrollee) when marginal product of medical care, h’, small  illness-contingent payout determined by enrollee’s risk and preferences provide access to treatment that becomes unexpectedly available after enrollment but is more expensive, albeit even more valuable, than what the insurer budgeted for at time of enrollment

7. Why (not) switch to CCI? EU CCI = (1-π)U(Y 0 – P, H 0 ) + πU(Y 0 – P + I – p M M CCI, H 0 – S + h(M CCI )) Concerns “difficult to observe illness and, therefore, costly to monitor for fraud”  Under CCI patients defraud, under PPI providers defraud (supplier-induced demand, upcoding, billing for services never rendered)  at what stage is fraud cheapest to detect: diagnosis or treatment? lump sum payment of $44,000 contingent on breast cancer diagnosis or lump sum payment of $24,000 contingent on mastectomy “costly to write the complex contracts that would specify the various clinical conditions under which different payoffs would be made”  PPI has same problem “insurer underpays”: I < p M M PPI  at the time of enrollment, enable consumers to compare payouts from different plans (analogous to “coverage comparison” under PPI)

8. Why not switch to CCI? EU CCI = (1-π)U(Y 0 – P, H 0 ) + πU(Y 0 – P + I – p M M CCI, H 0 – S + h(M CCI )) Concerns (continued) “variation in cost of treatment”: h(M CCI ; ε)  providers could offer insurance against variation (as they do under PPS) “externalities of improving health”: ∂U society /∂M CCI > ∂U enrollee /∂M CCI most acute for preventative medical care  use PPI with subsidies  limit CCI to conditions with minimal externalities (e.g.breast reconstruction) “disintermediation”  effect on p M unclear – no more bulk buying through MCOs, price transparency may end price discrimination  coordination problem of implementation: without posted prices, consumers won’t sign up for PPI; but without many prospective patients in PPIs, providers not under pressure to post prices