Risk and the Economics of Information

Agenda

• Current Events

• Risk Aversion

• Adverse Selection

• Principal Agent Problem

Exam!!

• Tuesday April 7th

• Midterm question sheet:– 7 total questions

• 70-80% of the test will be from these questions

• The rest will be from short answer questions

• Closed book/notes/internet/text/email/chat/text – just you

and the test

• Can either hand write, or type on your laptop

Bonus Learning

• Mike McBride – April 6th, 4:00pm

• John Haupert – April 9th afternoon

Tenet USPI Baylor Scott & White?

• Tenet – USPI– Tenet and USPI will combine their short-stay

surgery and imaging center assets into a new joint venture.

– more than 200 ambulatory surgery centers, 16 short-stay surgery hospitals, and 20 imaging centers across 29 states—making it the largest ambulatory surgery provider in the country.

– Estimated value of $2.6 billion

Tenet USPI Baylor Scott & White?

• Tenet – Baylor Scott & White– At the same time Tenet and BSW announced a

deal to jointly own 5 Tenet hospitals in North Texas.

– BSW majority owner and will operate under the BSW brand

– Tenet’s ACO also entered into an affiliation agreement with BSW’s Quality Alliance

What is the Sustainable Growth Rate?

• How does Medicare Pay Physicians?– In 1992 Resource-based relative value scale

(RBRVS)– A point value for each service (RVU)• Physician work – time, effort, skill required to furnish

the service (55%)• Practice expense – separated out for “Facility” and

“non-Facility” (42%)• Malpractice insurance – varies by specialty (3%)

Paying physicians

• Typical physician service set a value of 1, then

everything else is relative to that: – a service with 1.6 RVUs is 60% more costly than the

typical service, etc.

• Now all they have to do is set the dollar value for one

unit of service. Conversion Factor– In 2015 it is $35.7547

• CMS Common Procedural Coding System (CPT-4)

SGR

• In 1997 Medicaid switched to a “Sustainable Growth

Rate” when updating the conversion factor– Target global spending level• If this year spending is greater, next year the conversion

factor gets reduced to make up the difference

– Over the past 15 years as medical spending growth greatly exceeded GDP growth…• Kicked can down the road

• Repeals the SGR and provides stability and 5 years of

payment updates

• Improves the existing fee-for-service system by rewarding

value over volume and ensuring payment accuracy

• Incentivizes movement to alternative payment models

• Expands the use of Medicare data for transparency and

quality improvement

Risk and The Economics of Information

Moral Hazard in the Market

Quantity of Medical Care

Price of Care

$100

$150

3 5

Without Insurance: $100*3=$300 expenditure

With insurance: $150*5=$750 expenditure

Supply

Why do we demand insurance?

• Suppose I give you the choice:1. Get $900 for sure2. A 90% chance at $1,001 and a 10% chance at

nothing

• Now lets say you face the following1. Lose $900 for sure2. A 90% of losing $1,001 and a 10% chance of

nothing

Risk and PreferencesGains Losses

High Probability Event

Low Probability Event

Desperate gamble

Lottery TicketsInsurance Markets

95% to win $10,000Fear of disappointment RISK AVERSEAccept unfavorable settlement

95% chance to lose 10,000Hope to avoid lossRISK SEEKINGReject favorable settlement

5% chance to win $10,000Hope of Large GainRISK SEEKINGReject Favorable Settlement

5% chance to lose $10,000Fear of large lossRISK AVERSEAccept unfavorable settlement

Risk Aversion

• Suppose you have a 5% chance of incurring a 10,000

loss in a given year.

• You are offered insurance against this loss. For a

$500 annual premium.

• Would you pay more than $500?

• On average I will lose $10,000*.05=$500 per year

Risk Aversion

• $500 is what is known as the actuarially fair premium

• A risk averse individual would be willing to pay more than this

• The insurance company needs a price of at least $500 to

cover the cost of payouts

• Health insurance markets exist because individuals are risk

averse enough to be willing to pay more in premiums than

the cost of their coverage

Risk and Insurance

• These are relatively rare but expensive events.

• Consumers are willing to pay a premium to avoid the risk

• Insurance companies pool large groups of individuals

together which eliminates (or greatly reduces) the risk

• You can think of insurance companies taking your risk in

exchange for a fee.

An Alternative View

• Instead of a mechanism to reduce risk an alternative view of insurance

can be as a financing mechanism

• Health care is expensive. Even if I knew that in the next few years I

was going to need heart surgery I could not pay for it no matter how

well I planned.

• But since it is a relative unlikely event, it will only occur to a small

fraction of the population.

• So insurance transfers money from healthy people to the sick and

enables them to pay for highly valuable services

Experience vs. Community Rating

• Unlike life or auto insurance, health insurance tends to use community rating

over experience rating.

• Why?

• Experience rating tends to reduce moral hazard and focuses on individual risk

• Community rating creates an externality and encourages over-use, but lowers

costs for the sick

• Employer wellness programs and other tools are now being implemented to

move away from pure community rating

• But it is a slippery slope

Too Much Insurance?

• Is insurance too generous?

• Car insurance does not pay for routine maintenance

• It does not pay if you blow your engine because it ran out of oil

• It covers the risk of an accident

• Yet health insurance tends to pay for the routine things, why?– Tax treatment encourages generous insurance– Easier to distinguish accidents from routine for autos than for

health– Fairness/ethical issues

Economics of Information

• Uncertainty creates the market for insurance, which

can cause a market distortion.

• Another issue arises when there is asymmetric

information

• If the individual knows more about their health needs

than the insurance company then problems can arise.

• This is known as Adverse Selection

Adverse Selection

Probability

Spending

$0 $100 $200 $300 $400

1/n

Adverse Selection

Probability

Spending$0 $200 $300 $400

1/.5n

Adverse Selection

Probability

Spending

$0 $200 $300 $400

1/.25n

Adverse Selection

Probability

Spending$0 $200 $300 $400

1

Adverse Selection

• The bad tends to push the good out of the market

• Solution requires a way to compel the healthy to participate– Employer-provided insurance– Insurance mandate– Medicare– Medicare Part D

• Or move to experience rating– Individual prices

Adverse Selection

• It doesn’t always have to result in full market failure

• Let’s look at it in a little more detail

Adverse Selection in Insurance

$

Qmax

Demand

MC

AC

Qeq

P

Minimum Price needed to insure everyone

Welfare loss

Adverse Selection in Insurance

$

Qmax

Demand

MC

AC

Qeq

P

Special Case – if people are very risk averse

$

Qmax

Demand

MC

AC

P

Special Case 2: now what happens?

$

Qmax

Demand

MC

AC

P

Minimum Price needed to insure everyone

The market fails completely – Death Spiral

Adverse Selection

• Even with adverse selection, the market could still function – though

not necessarily efficiently

• But a “death spiral” is possible

• The more risk averse the population is, the less adverse selection will

occur

• Young invincibles – tend to be both below average users and less risk

averse

• Lowering admin costs improves efficiency of market – Shifts costs

curves downward

King vs Burwell

• “through an exchange established by the state”

• What happens if people in these states lose their subsidy?

Under a “normal” market:

SupplyDemand

Q1

p1

Price and quantity both fall, depending on elasticity of supply

But insurance is not normal!

$

Qmax

Demand

Qeq

P

Now Q falls but Price RISES

The Principal-Agent Problem

• There is a principal who has some objective and they hire an agent

• The agents is supposed to represent the principal’s interest

• But a problem arises if the agents do not have the same incentive as

the principal

• The Principal-Agent problem occurs when agents pursue some of their

own objectives in conflict with achieving the goals of the principal.

• Generally this requires asymmetric information – or high monitoring

costs

Where do we see the principal-agent problem?

• Babysitters– parents are the principal, babysitters are the

agents

• Employer-employee relationships– Piece rate pay– stock options– tiered compensation• Why do earnings rise with tenure?

Where do we see it in healthcare?

• Patients are the principal– They don’t understand healthcare, medicine, the

healthcare system– They need help

• They hire the physician to be their agent– Relationship of trust

• Why has the hospital and physician historically been separate?

• Does the agent act in the best interest of the principal?

The Shopping Problem

• The consumer needs a “shopper”• Health care is an “experience” good

• Marcus Welby Medicine– The perfect agent physician chooses as the

patients themselves would choose if the patients had the same information the physician does.

The shopping problem and physician-induced demand

1. Insurance tends to shield the consumer from price sensitivity. The

consumer inefficiently produces health. “I want it all”

2. Patients tend to rely on the providers when deciding how much to

“shop"

3. Payers worrying about moral hazard tend to pay more for “doing

things” rather than talking. – Acute care vs. chronic care– behavioral health vs. physical

4. Suppliers have incentive to do more based on 1 and 2 above as well

as legal concerns.

Solutions to the shopping problem?

• In the managed care era – the payer became shopper

• HD/HSA – the consumer becomes the shopper

• Who is the shopper in an ACO?

• Direct Primary Care

Jigsaw Exercise – Round 1

• Aashini Anna Beatrice• Brin Caroline ThomasGroup1• Christian Christina Dolapo• Elle Emily ShawntaeGroup2• Gopal Hugh Jessica• Justin Katherine Sarah• Mr. Hornbeak

Group 3• Livia Mariah Patrick• Rebecca Ryan Mr. HupfeldGroup 4

Jigsaw Exercise – Round 2

•Aashini Christian Gopal•Livia ThomasGroup 1•Anna Christina Hugh•Mariah Mr. HornbeakGroup 2•Beatrice Dolapo Jessica•Patrick ShawntaeGroup 3•Brin Elle Justin•Rebecca SarahGroup 4•Caroline Emily Katherine•Ryan Mr. HupfeldGroup 5