By Katherine Baicker, Sendhil Mullainathan and Joshua Schwartzstein
Working Paper 18468
National Bureau of Economic Research, October 2012


This paper develops a model of health insurance that incorporates behavioral biases. In the traditional model, people who are insured overuse low value medical care because of moral hazard. There is ample evidence, though, of a different inefficiency: people underuse high value medical care because they make mistakes. Such “behavioral hazard” changes the fundamental tradeoff between insurance and incentives. With only moral hazard, raising copays increases the efficiency of demand by ameliorating overuse. With the addition of behavioral hazard, raising copays may reduce efficiency by exaggerating underuse. This means that estimating the demand response is no longer enough for setting optimal copays; the health response needs to be considered as well. This provides a theoretical foundation for value-based insurance design: for some high value treatments, for example, copays should be zero (or even negative). Empirically, this reinterpretation of demand proves important, since high value care is often as elastic as low value care. For example, calibration using data from a field experiment suggests that omitting behavioral hazard leads to welfare estimates that can be both wrong in sign and off by an order of magnitude. Optimally designed insurance can thus increase health care efficiency as well as provide financial protection, suggesting the potential for market failure when private insurers are not fully incentivized to counteract behavioral biases.


6.3 Evidence on Private Plans

These results suggest that competitive forces do not lead to efficient equilibrium insurance contracts when insurees are naive about their biases, but that the insurer will have an incentive to counteract biases when this saves the insurer money. These results may shed light on why more health insurance plans do not incorporate behavioral hazard into their copayment structures. Recall the evidence from Table 2 (from full paper at link below), which summarizes the features of several major insurance plans. Co-payments are rarely a function of the health benefit associated with the care for a particular patient.

Nevertheless, insurers could increase profits by promoting adherence to medications and treatments that save money over a reasonably short horizon (relative to the typical tenure of their enrollees), and the model suggests that insurers will invest in encouraging care in such instances.

Moral hazard in health insurance is said to occur when patients obtain unnecessary care merely because they don’t have to pay for it. Requiring patients to pay for at least a portion of their care, through deductibles, co-payments and coinsurance, supposedly disincentivizes patients from obtaining such unnecessary care, but does so at the cost of patients declining care that is quite appropriate and should be obtained. This paper attempts to compensate for that by adding behavioral hazard to that of moral hazard when determining when and how much financial exposure patients should have when accessing care. If the behavior of patients might cause them to underuse care, then cost sharing should be adjusted downward accordingly.

That’s the theory. In practice it would greatly add to the administrative burden of private health care financing to try to identify not only each instance when a patient might be inclined to overuse care unnecessarily (moral hazard), but also each instance in which a patient might avoid beneficial care because of cost barriers (behavioral hazard), and then to modify the patient’s share of each cost entailed based on these economic hazards.

Current estimates on how much could be saved by avoiding moral hazard are flawed anyway, primarily because they ignore the deleterious effect of behavioral hazard. Yet private insurance products incorporate cost sharing that does ignore behavioral hazard, except in very limited instances such as preventive services or cost sharing for important maintenance drugs. Once you make the adjustments in cost sharing that would prevent most or all behavioral hazard, the savings would dramatically diminish and might even be totally offset by the costs of the administrative excesses.

The most effective way to prevent behavioral hazard is to remove all financial barriers to care. The moral hazard remaining does not even apply to the eighty percent of health care that is consumed by patients with greater needs who have long exceeded their deductibles and stop loss. It’s simply not worth applying cost sharing measures to the remaining twenty percent of care for those of us who are relatively healthy, when the resulting decrease in our total national health expenditures would be almost negligible.

Besides, who are all of these people who are demanding care that they simply do not need? Thinking back through my decades of family practice, no one individual comes to mind.