Disentangling Moral Hazard and Adverse Selection in Private Health Insurance

By David Powell and Dana Goldman
National Bureau of Economic Research, January 2016

NBER Working Paper 21858


Moral hazard and adverse selection create inefficiencies in private health insurance markets and understanding the relative importance of each factor is critical for policy. We use claims data from a large firm to isolate moral hazard from plan selection. Previous studies have attempted to estimate moral hazard in private health insurance by assuming that individuals respond only to the spot price, end-of-year price, expected price, or a related metric. The nonlinear budget constraints generated by health insurance plans make these assumptions especially poor and we statistically reject their appropriateness. We study the differential impact of the health insurance plans offered by the firm on the entire distribution of medical expenditures without assuming that individuals only respond to a parameterized price. Our empirical strategy exploits the introduction of new plans during the sample period as a shock to plan generosity, and we account for sample attrition over time. We use an instrumental variable quantile estimation technique that provides quantile treatment effects for each plan, while conditioning on a set of covariates for identification purposes. This technique allows us to map the resulting estimated medical expenditure distributions to the nonlinear budget sets generated by each plan. We estimate that 53% of the additional medical spending observed in the most generous plan in our data relative to the least generous is due to moral hazard. The remainder can be attributed to adverse selection. A policy which resulted in each person enrolling in the least generous plan would cause the annual premium of that plan to rise by $1,000.

From the Introduction

Moral hazard and adverse selection create inefficiencies in health insurance markets and result in a positive correlation between health insurance generosity and medical care consumption. The policy implications are very different, however, depending on the relative magnitudes of each source of distortion, though isolating the independent roles of both moral hazard and adverse selection is rare in the health insurance literature. This paper separates moral hazard and adverse selection for the health insurance plans offered by a large firm.

The average observed expenditures in the most generous plan are $3,969 more than the per person costs in the least generous plan. We estimate that if selection were random, that the most generous plan would lead to $2,117 in more spending than the least generous plan, implying that 53% of the differential can be attributed to moral hazard. We also estimate adverse selection without restrictive structural assumptions. We find that if everyone in the sample were enrolled in the least generous plan that the premium for that plan would increase by over $1,000.

2.1 Moral Hazard and Adverse Selection

Optimal policy depends on the relative important of adverse selection compared to moral hazard in explaining the correlation between plan generosity and medical care costs. The policy implications for moral hazard are different than those required to confront adverse selection. Adverse selection typically requires risk-pooling, while distortions driven by moral hazard would motivate additional cost-sharing.

3.4 Attrition

If we define attrition as individuals enrolled in 2005 but enrolled for less than 365 days in 2007, the attrition rate in the MarketScan data (selecting on firms in the data in both 2005 and 2007) is 58.3%. Our sample has a 58.7% attrition rate.


Understanding moral hazard and adverse selection in private health insurance is widely- recognized as critical to policy. While the literature has frequently estimated the effect of price on medical care consumption, it has typically resorted to parameterizing the mechanism through which individuals respond to cost-sharing. We show that these assumptions typically contradict economic reasoning, and we provide empirical evidence that these specifications perform poorly. In this paper, we estimate the impact of different health insurance plans on the entire distribution of medical care consumption using a new instrumental variable quantile estimation method. These estimated distributions are the distributions caused by the plans in the absence of systematic selection into plans. We map these causal distributions to the parameters of the plans themselves. We can statistically reject that individuals only respond to the end-of-year price.

We also estimate the magnitude of adverse selection. We find favorable selection in the least generous plan and adverse selection in the most generous. We estimate that adverse selection is responsible for $773 of additional per-person costs in the most generous plan, implying that an individual considering this plan would pay over $60 per month in additional premium payments simply to cover the expected costs of the population selecting into the plan. Similarly, a policy which resulted in our entire sample enrolling in the least generous plan would cause annual premiums for that plan to rise by over $1,000.

We estimate that moral hazard is responsible for 53% of the differences in expenditures between the most and least generous plans. Adverse selection also plays an important role, accounting for the other 47%. In the absence of moral hazard, the difference in average medical expenditures across these plans would be $2,117 instead of $3,969. Finally, we find that using the previous year’s medical expenditures as a metric of selection greatly overstates the magnitude of selection.


PDF of full paper (53 pages):

In health insurance, moral hazard occurs when individuals obtain more health care than they would have if it were not paid for by the insurer. Adverse selection occurs when individuals with greater health care needs select plans that provide greater coverage. Both have an impact on health care spending. This paper estimates the relative impact of each of these in spending under private health insurance.

Each is responsible for roughly half of the differences of expenditures between the most and least generous health plans. So enrollees in the more generous plans pay higher premiums because of both moral hazard and adverse selection.

Today’s standard in insurance coverage is shifting towards lower actuarial value plans – plans that pay a lower percentage of the total health care costs. What does this study tell us about premiums for these less generous health plans? As more people enroll in them, which they are, the premiums increase to cover the additional expenditures for those who otherwise would have enrolled in the more comprehensive plans. The lower actuarial value plans are subject to favorable selection (the healthy buying less expensive plans in anticipation of not needing care), but that diminishes as higher cost patients move from the more comprehensive plans into these cheaper plans.

The insurance actuaries set premiums based partly on anticipated moral hazard and adverse selection. Though less comprehensive plans theoretically have less moral hazard and no adverse selection, the lower premiums are attractive even to those with higher health care needs. As Powell and Goldman have shown, increased enrollment in the least generous plans cause premiums for those plans to increase. This likely goes a long way toward explaining why premium increases this year were much higher than the overall rate of inflation, even though the rate of increase in total national health expenditures has slowed.

Under a single payer national health program, adverse selection doesn’t even exist since everyone is in the same plan. Efficiency is an important goal of health care reform, and wouldn’t it be much more efficient putting these health economists to work designing a simple single payer financing system, instead of laboring over the complexities of making a dysfunctional and inequitable market of private health plans somehow work for us, though not very well?