1. Reconsidering the Moral Hazard- Risk Aversion Tradeoff Joseph P. Newhouse, © 2006 Many thanks to David Cutler, Richard Frank, Jon Gruber, Tom McGuire, and Richard Zeckhauser for comments.

2. JHE and HE citation counts: Kodrzycki and Pingkang 2005, http://www.bos.frb.org/economic/wp/wp2005/wp0512.pdf. Some Prefatory Remarks l I thought about several topics for this talk  How and when does a subfield of economics get established? When is it recognized by the AEA classification system? When is there a field journal? A professional society?  Clear that health economics is established; JHE and HE now 1 and 2 in citation counts among all economics and policy journals taken jointly! l The questions at the top were too hard

3. The Future l Another natural topic: the future of the field l This is something of a fool’s errand, but several factors suggest continued vitality:  Technological change and cost pressures  Use of administered pricing  Off-frontier production, e.g. variations  A second-best world; few unambiguous predictions; need for empirical verification

4. Cost Sharing in Health Insurance l Instead of these topics I went back to what I worked on at the beginning of my career; the structure of cost sharing in health insurance  For example, the size of a deductible  Although I assume a health insurance context, the issues are also relevant in a health service context

5. Outline of Talk l Received theory and empirics l The context for reconsidering l An elaboration of received theory l Incorporating time-inconsistent preferences

6. Arrow, AER, 1963, 53(5): 941-978; 1968, 58(3):537-539; Pauly, AER, 1968, 58(3):531-537; Zeckhauser, JET, 2(1):10-26. Received Theory l Cost sharing in health insurance is traditionally framed as finding the optimal tradeoff between moral hazard and risk  From Arrow (1963, 1968), Pauly (1968), Zeckhauser (1970)  This is how our textbooks present it; e.g., Phelps, ch. 10, Feldstein, ch. 6, Zweifel and Breyer, ch. 6

7. Newhouse and the Insurance Experiment Group, Free for All?, chapter 4. Optimal Cost Sharing? - 1 l Using the framework of trading off moral hazard and risk, the RAND Health Insurance Experiment calculated the optimal cost sharing in 1983 dollars to be a $200 individual deductible, followed by 25% coinsurance, to a $1,500 stop loss

8. Optimal Cost Sharing? - 2 l These values were slightly above those in early 1980s indemnity policies, but…. l The RAND calculations didn’t consider the tax subsidy to employer paid premiums nor liquidity constraints, which would have lowered the optimal cost sharing  On the other hand, the calculations assumed actuarily fair insurance

9. What Happened? l Instead of cost sharing escalating with medical spending, we entered the era of managed care with lower cost sharing l Lower cost sharing was consistent with the idea that greater supply-side cost sharing had altered the moral hazard-risk tradeoff, which it probably did, but…

10. Two Problems Remained l Supply-side cost sharing was not well placed to affect the decision to initiate treatment for an episode, which the RAND data suggested was the principal margin that demand-side cost sharing affected, and…

11. Pauly and Ramsey, JHE, 1999, 18(4) 443-458; Rosenthal and Newhouse, Jnl Hlth Care Fin, 2002,28(4):1-10. Did Supply-Side Cost Sharing Reduce Deadweight Loss? l With minimal demand-side cost sharing and reliance on supply-side cost sharing there was no mechanism to reveal willingness-to- pay, so that services a consumer would have been willing to pay for might have been denied l Did this play a role in the managed care backlash?

12. And Now… l Whether because of the backlash or because supply-side cost sharing was about one-off effects, or both, demand-side cost sharing is now coming back on the table l The 2003 legislation authorizing Health Savings Accounts prescribed a minimum $1,050 deductible (individual), maximum $5,250 stop-loss (2006 values)

13. HSAs and Optimal Cost Sharing l Despite product change, the HSA figures are not so far from the RAND calculations  Health spending from 1983-2006 grew by ~5X  Ignoring the product change and using 5X to inflate, the HSA deductible is in line  The stop loss is larger by 3.5X, but medical care is a larger share of income, so a less than proportional increase would be optimal

14. Law Says Preventive Services Can Be Exempt l The Treasury defines preventive services as: periodic health examinations; routine prenatal and well-child care; tobacco cessation programs; immunizations; weight loss programs; various screening programs l Importantly for my story, the Treasury excludes services that treat existing conditions; they are subject to cost sharing

15. Should More Services be Exempt? l In particular, should cost sharing be reduced for chronic maintenance drugs and routine maintenance visits for chronic conditions?  Considerable evidence that compliance increases with less cost sharing  In some cases this may lower total lifetime cost; in others it may not, but it may improve health

16. Evidence on Capped Drug Benefits - 1 l The following slides compare results from two matched groups at Kaiser Northern California l One group had a drug benefit capped at $1,000 of member spending (no benefits after that), and the other group had no cap  All were Medicare eligibles over 65 years of age

17. Evidence on Capped Drug Benefits - 2 l The comparisons are for those who had diabetes, hyperlipidemia, or hypertension, and who filled a prescription for an anti- diabetic drug, a lipid-lowering drug, or an anti-hypertensive in the prior year l The tables show drug consumption, non- adherence, and physiologic outcomes  Adherence is having ≥ 80% of days covered

18. Odds Ratio results control for age, sex, race, comorbidities, office, ED copays. Physiologic odds ratio controls for initial value. Diabetics Benefit Not Capped (%) Benefit Capped (%) Odds Ratio (95% C.I.) Drug Quantity ($) -- 0.79 (0.73-0.86) Drug Non- Adherence 21.226.21.33 (1.18-1.48) Glycated Hg > 8% 17.019.71.23 (1.03-1.46) Odds ratio = capped/non-capped; Source: Hsu, et al., NEJM, June 1, 2006

19. Odds Ratio results control for age, sex, race, comorbidities, office, ED copays. Physiologic odds ratio controls for initial value. High Cholesterol Benefit Not Capped (%) Benefit Capped (%) Odds Ratio (95% C.I.) Drug Quantity ($) -- 0.73 (0.70-0.77) Drug Non- Adherence 26.531.41.27 (1.19-1.34) LDL>130 mg/dl 19.621.31.13 (1.03-1.25) Odds ratio = capped/non-capped; Source: Hsu, et al., NEJM, June 1, 2006

20. Odds Ratio results control for age, sex, race, comorbidities, office, ED copays. Physiologic odds ratio controls for initial value. Hypertensives Benefit Not Capped (%) Benefit Capped (%) Odds Ratio (95% C.I.) Drug Quantity ($) -- 0.85 (0.82-0.89) Drug Non- Adherence 14.618.11.30 (1.23-1.38) SBP>140 mm Hg 38.539.51.05 (1.00-1.09) Odds ratio = capped/non-capped; Source: Hsu, et al., NEJM, June 1, 2006

21. Odds Ratio results control for age, sex, race, years of Kaiser membership, comorbidities, office, ED copays. Use and Costs, Rate/100 Benefit Not Capped Benefit Capped Odds Ratio (95% C.I.) ED Visits45.249.21.09 (1.04-1.14) Non- elective Admissions 16.618.71.13 (1.05-1.21) Total Cost-- 0.99 (0.94-1.04)

22. Conclusion from Kaiser Study l A drug benefit capped at $1,000 versus no cap led to less compliance with chronic disease regimens, poorer physiologic health, and cost increases in other medical services that about equaled the savings in drug costs  If non-compliance were to continue and physiologic health to deteriorate further, the future increase in other medical spending may exceed the decrease in drug spending

23. Soumerai, et al., NEJM, 1991, 325:1072-1077, 1994, 331:650-655. Additional Evidence - 1 l Soumerai, et al. studies on caps in two Medicaid populations: 3 drug/month limit saved 35% on drugs, but more than doubled nursing home admissions  Among schizophrenics: Cap on mental health drugs raised other spending by 17 times the savings on drugs

24. Are You Saying: So What? l Did you already know that initial benefits with caps were poor economics and policy? l Then ask yourself whether an actuarily equivalent deductible with full coverage over the deductible would have yielded better or worse compliance results? l How many think better results?

25. Huskamp et al, NEJM, 2003, 349:2224-2232; Goldman, et al., JAMA, 2004, 291:2344-2350. Additional Evidence - 2 l In any event, if you don’t like caps, there are analogous findings about drug copays l Huskamp, et al. and Goldman, et al. find that increased copays decreased the use of ACE inhibitors, anti-hypertensives, anti- diabetics, and statins, though they have no data on other medical costs

26. Tamblyn, et al., JAMA, 2001, 285(4):421-429. Additional Evidence – 3 l Tamblyn, et al. find imposing cost sharing for drugs among the poor and the elderly in Quebec reduced drug use by 15-22%, but led to an approximate doubling of serious adverse events, meaning death, hospitalization, or nursing home admission  No cost data, but it seems likely that total costs increased

27. Rosen, et al., Annals of Internal Med, 2005, 143(2):89-99. Additional Evidence - 4 l Rosen, et al. (2005) simulate that full coverage of ACE inhibitors for Medicare beneficiaries who are diabetic would increase QALYs and save money relative to the default cost sharing in Part D

28. An Extreme Example l With Directly Observed Therapy, tuberculosis patients are paid to be observed swallowing their medications  Negative cost sharing!

29. 3 Cases to Stretch the Usual Risk-Moral Hazard Tradeoff l An easy one to warm up l A second one that is a straightforward elaboration of received theory l A third one that ventures further afield, time-inconsistent preferences

30. An Easy Case l The marginal social cost of another pill is frequently negligible, so any induced consumption has negligible deadweight loss l Assuming no increase in costs elsewhere, no moral hazard-risk aversion tradeoff l I assume for the remainder of the talk that marginal social cost is non-negligible  Of course, private costs of the pill are positive

31. Before Coming to Case 2: How Is Cost Sharing Determined? l For many cost sharing is determined by employer or government choice  Even with choice among plans, employer may have standardized cost sharing l As a result:  In many cases cost sharing is exogenous  And even with choice of plan, a person’s health costs are shared with an insurance pool

32. Goldstein-Pauly, in Role of Health Insurance in the Health Services Sector, 1976; Miller, JHE,24(5):931-939. The Employer’s Choice l How does an employer choose cost sharing?  Goldstein-Pauly (1976): Employers minimize labor cost, look at benefit to marginal worker; unions look at benefit to median worker – Labor cost = health care cost + productivity effects  Miller (2005): Employer who minimizes cost and offers plan choice sells more generous plan as an upgrade; a lump sum subsidy to all plans is probably not optimal

33. Public Insurance l Straightforward extension of Goldstein- Pauly median employee model to median voter?

34. An Implication l Tenure in the employment group is relevant for a cost-minimizing employer; ceteris paribus, firms with longer job tenure will provide insurance with less cost sharing if those services reduce future costs  I have not tested this l In Medicare life cycle costs relevant

35. A Note on Measuring the Risk- Moral Hazard Tradeoff l Much empirical analysis, the RAND HIE included, uses an annual time frame, but lifetime risk is relevant with chronic disease l Positive intertemporal correlation of health spending from chronic disease raises risk for a given level of positive cost sharing

36. Held and Pauly, JHE, 1990, 9(4): 447-461. Second Case: An Elaboration of Received Theory l Because costs are shared within a common insurance pool, less cost sharing for those services and/or individuals that lowers overall spending for the pool is the usual case of a subsidy to recognize an externality  Here too no moral hazard-risk aversion tradeoff  Held-Pauly (1990) take up an analogous case, but don’t frame the issue as optimal cost sharing for all services

37. A Third Case: Take Your Medicine! l We surely all heard that from our mothers l So why as adults do some persons not take drugs that will improve their future health but may not save them money?

38. One Answer l They are insured for other medical services and place a low value on the uninsured health costs such as pain, suffering l The second part doesn’t seem very plausible for the above cases of chronic disease l Models of time-inconsistent behavior seem relevant in this context

39. Strotz, 1956; Akerlof, 1991; Laibson, 1997; O'Donoghue and Rabin, 1999; Frederick, Loewenstein, and O'Donoghue, 2002. Models of Time-Consistent and Time-Inconsistence Preferences l Assume a standard health economics utility function: l With time-consistent preferences (standard discounting), or: 0 <  < 1 l Time-inconsistent preferences, quasi-hyperbolic discounting: 0 < β,  < 1 Maximize lifetime utility s.t. lifetime budget constraint

40. Gruber-Koszegi, QJE, 2001, 116(4), 1261-1305; J Pub Econ, 2004,88(9-10): 1959-1987. Already a Health Application l Gruber-Koszegi (2001, 2004) use a model with time-inconsistent preferences to justify much higher cigarette taxes to induce “compliance” with not smoking  With this model cigarette taxes are less regressive than usually assumed and may be progressive because “internalities” disproportionately accrue to the low income

41. Laibson, QJE, 1997, 112(2):443-477; O'Donoghue and Rabin, AER, 1999,89(1):103-124.. Time-Inconsistent Preferences and Optimal Cost Sharing - 1 l Solutions in these models depend on whether the individual is aware of the time- inconsistent preferences or not  Solutions are easier if unaware (naïve case) l Also can depend on whether example is immediate reward or immediate cost  Chronic disease application is immediate cost; small difference between  and β can generate large welfare losses if individual is naïve

42. Time-Inconsistent Preferences and Optimal Cost Sharing - 2 l In other words, with time-inconsistent preferences, induced compliance can be welfare increasing, potentially by a large amount, independent of risk

43. Specific Subsidies l Very specific cost sharing structures such as free ACE inhibitors for elderly diabetics are not found in the market (selection), but disease management and case management use non-price methods toward similar ends  Medicare could adopt such a structure and there could be mandates in private insurance

44. Conclusions: Social Perspective l Current cost sharing structure may not be optimal from society’s perspective l Without considering risk, welfare may be improved by selectively lowering cost sharing for certain persons and/or certain services l Case 1: Negligible marginal social cost  From social perspective, negligible cost sharing

45. Social Perspective, cont. l Case 2: Induced greater compliance that adds cost for the specific good or service but saves overall lifetime costs  Additional subsidy; externality l Case 3:Induced greater compliance that increases value of health by more than cost  Models of time-inconsistent behavior relevant?  Marginal Benefit of health = MC compliance

46. Conclusions: Private Perspective l From a private perspective:  Case 1 of negligible cost probably doesn’t exist  Cases 2, 3: Optimal subsidy will generally be less than from social perspective

47. Conclusions: Policy and Research l HSA legislation seems too restrictive l More generally, current cost sharing structure seems sub-optimal, even from a private perspective l Optimal cost sharing seems like a fruitful field for future research