Academic journal article Journal of Risk and Insurance

Risk Selection and Optimal Health Insurance-Provider Payment Systems

Academic journal article Journal of Risk and Insurance

Risk Selection and Optimal Health Insurance-Provider Payment Systems

Article excerpt


This article presents a model of the important health-policy dilemmas of risk selection and moral hazard. When providers can increase revenues by selecting favorable risks, capitation or purely prospective payment is unlikely to be optimal. A second best payment system may involve mixed levels of both demand- and supply-side cost sharing: consumers may prefer to pay deductibles and co-payments rather than to have their healthcare providers receive large financial rewards for skimping on care or discriminating against expensive-to-treat patients. Risk adjustment can improve the terms of the social trade-off between inefficient utilization and inequitable coverage. The role of professional ethics is also considered.


It has been recognized for a long time that how we pay healthcare providers and how we insure consumers against the risks of medical expenditures--that is, how we design health insurance-provider payment systems--can have significant consequences for the equity and efficiency of a healthcare system. Health insurance creates a problem of moral hazard: fully insured consumers tend to overuse services that appear to be "free" or are heavily subsidized. Demand-side cost sharing (e.g., deductibles and co-insurance), often used to discourage this over-utilization, compromise the purpose of insurance by making the consumer pay unpredictable, nontrivial co-payments. Alternatively, providers can be given financial incentives to restrict care. Since providers have considerable influence over treatment decisions, supply-side cost sharing can be a powerful instrument for controlling healthcare costs. Along with the good incentives to curb wasteful over-utilization, however, are bundled perverse incentives to deny benefic ial but costly services and to shun the sickest patients (risk selection). Part of the recent backlash against managed care in the United States stems from consumer discontent with such potentially quality-damaging cost-control measures. [1]

This article develops a simple model to illustrate the incentive trade-offs associated with the dual "market failures" of moral hazard and risk selection. Previous theoretical results on optimal payment systems emerge as the special case of our model when there is no consumer heterogeneity. The model suggests that when providers can increase revenues by selecting favorable risks, demand- and supply-side cost sharing [2] can no longer in general achieve the social optimum. The "second best" optimal payment system may involve mixed levels of both demand- and supply-side cost sharing. Purely prospective or capitation payment is unlikely to be optimal. The results underscore the fact that policymakers seeking cost containment, patient choice, and universal access must attend to selection incentives when designing or reforming healthcare systems.

The article is organized as follows. The first section gives an overview of the policy significance of risk selection. The next section presents the model. Then, the article focuses on how the presence of risk selection alters previously derived results on optimal payment systems. A simple extension to risk adjustment of provider payments is presented in the fourth section. The following section puts the model in the context of previous theoretical work. The conclusion discusses limitations and other potential extensions.


A healthcare provider-insurer or health plan has a financial interest in trying to enroll consumers at low risk for treatment and to discourage high-risk consumers from enrolling. Such behavior is called risk selection. Newhouse (1996) defines selection as "actions of economic agents on either side of the market to exploit unpriced risk heterogeneity and break pooling arrangements, with the result that some consumers may not obtain the insurance they desire" (p. 1236). [3] Selection leads to inefficiency as well as inequity [4] because it defeats risk pooling and prevents individuals from being able to buy insurance against becoming a bad risk in the future or having a child who is a bad risk (ibid. …

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