Moral Hazard and Healthcare

The 18th-century moral hazard logic of traditional insurance no longer serves the best interests of the healthcare industry and the communities and individuals who depend on health insurance for access to care.

Beyond Moral Hazard

Healthcare is very tangled up in the moral hazard logic which assumes that patients "consume less healthcare when they are required to pay more for it out of pocket."

There are several serious flaws in this line of thinking:

For the patient, the deterrent to moral hazard is already sufficient: the fear associated with uncertainty, treatment costs, medical debt, pain, not to mention the risk of harm due to medical errors. These elements loom large in the minds and motivations of patients. People generally try to avoid utilizing healthcare. Going to the doctor is not as appealing as eating pizza or drinking beer.
There is more than one form of over-consumption. People who "over-consume" health services are not being "greedy", they are usually being under-served. They return to the doctor over and over, or seek out additional doctors because they are not getting the solutions they need and the system is failing them. Its not indulgence, its distress.
Finally, the problem of clarity: when people order burgers at a drive thru, they are willfully, consciously making a decision to consume something: they are presented with a clearly priced menu, the opportunity to select from the options, the opportunity to confirm their order and the price, then promptly receive what they ordered. In contrast, Healthcare rarely - safe to say never - offers this kind of experience. Bills accumulate via non-transparent processes and fee schedules, then are delivered via inscrutable paperwork. Patients must wait to see if a treatment is effective or not. If it's not effective, then they are forced to start another cycle of "consumption."

In this context, going on about moral hazard and "over-consumption" is failing to connect to the realities people are living through. Moral hazard - as frequently invoked in healthcare discussions - fails to accurately describe the economic behaviors of patients and doctors in healthcare.

The Failure of the Moral Hazard Construct in US Healthcare

The moral hazard argument as structured today tacitly accepts the twisted insensitive logic that healthcare cost and complexity are actually good(!) because they help control moral hazard and supposedly limit what the industry has come to call "over-consumption". The US healthcare industry needs to either abandon moral hazard thinking, or admit that the mission statements about healthcare equity and "healthcare for all" are just purpose-washing. Right now, the industry attempts to serve two conflicting mental models - working in literal opposition to itself. The enormous waste and churn in US healthcare is the result.

The logic of moral hazard has been a dominant influence on pricing and capital management strategies of health insurance for decades now. Yet during that same time, moral hazard and its implementations have completely failed to control costs - which are higher than ever.

Healthcare Finance leaders on both the payer and provider sides should acknowledge that this construct no longer serves us.

It is time for more diligent financial innovation toward simple affordable healthcare.

Moral Hazard: Different Takes

In 2005, Malcom Gladwell published this essay which provides a good history of how moral hazard found a home in the health policy logic in the US, but interestingly not in other western nations.

The moral hazard section starts about 1/3 way thru - highly recommended read for healthcare leaders.

Not everyone agrees with Gladwell's argument.

This counter argument by Liran Einav and Amy Finkelstein offers a different take, and a window into the curiously selective way moral hazard is applied to the players in US healthcare system.

Einav and Finkelstein acknowledge dissenting opinions, but try to establish that moral hazard does exist in health insurance:

"Just like almost any other good, individuals increase their healthcare utilization when the price they have to pay for it is lower."

But healthcare is not just "like any other good." The purchase and selection process is very different. Patients aren't selecting and making purchase decisions the same way they are when they are shopping for rice or apples.

In "normal" retail there are a range of options with clear differences and clear pricing. All of the options are functional and typically backed by a return policy. One brand of rice might be more expensive than another, but I can make dinner with either one. I might like one better than the other. If the rice has bugs in it, I can return it for a refund. Whatever the scenario, I can manage to get some rice and not go hungry.

This, as you know, is not how healthcare works.

Significant portions of healthcare purchases are not discretionary. They are forced by life threatening events, and fear of harm to self or a loved one. This is not the difference between "nice rice" and "cheap rice". This is the difference between getting what you need or not making it.
Patients rarely have a full understanding of the price at the time they are making their purchase decisions. Neither does anyone else for that matter.
A very small percentage of patients drive a very large percentage of the spending.
Patients are not really agents capable of controlling their spending. They have no view into how pricing is calculated, or how it aggregates. In other words, they are not really in a position to be incentivized by price manipulation. Pricing can stress them out, deprive them of needed treatment or cause harm, but it can not to any reasonable mind provide a safe or effective means of guiding behavior. This should be over the doorway of every conference room where health insurance products are designed.

Curiously, Einav and Finkelstein acknowledge these realities throughout their paper linked above, but never crystallize them into actionable conclusions. The concluding paragraphs dissolve into hazy statements clinging to one premise: demand responds to pricing, so if we just make patients pay more, then demand will subside.

Their argument rests on a traditional economic assumption that predates the rise of corporate pricing power (the ability of companies to raise prices without fear of losing market share) and the way pricing power is enabled by debt - in healthcare's case: medical debt. In the face of national crisis of healthcare affordability it's an incredibly obtuse position to take.

How many times have you heard, "We didn't go to the doctor because we had no idea what it would cost"? Vague unclear pricing causes people to avoid care. Delayed utilization forces more expensive forms of utilization later.

Plot twist: I am inclined to agree with the writers that moral hazard may exist in healthcare. But perhaps the vector for moral hazard is not the patient.

Where does Moral Hazard really occur?

Caveat: The language here may seem unfair and accusatory to the passionate and deeply caring individuals working across the different industry verticals in healthcare. To be clear, we're attempting to describe the economics in play, NOT the intentions and character of the individuals working inside the systems guided by those economics.

Piggy bank eating coins — Photo by Andre Taissin / Unsplash

Who are the "bad actors?"

As described in the paragraphs above, moral hazard in healthcare is framed as if patients were the "bad actors", and that charging them more, or complicating their care pathways is just a necessary evil for counteracting the behaviors of these "bad actors."

It seems like such an obtuse position, in the face of the national crisis of healthcare affordability.

But for the financial establishment of healthcare it could also be very convenient line of financial logic: it justifies raising prices and taking a greater and greater share of GDP, while blaming things on "consumers."

But what do we mean by the financial establishment of healthcare?

This is where it is important to be very clear about who or what we might actually accuse:

Do not think in terms of individuals, companies or even healthcare industry segments.

Think in terms of economic roles.

There is a specific role that exists across the different verticals of healthcare:

That role in some way is responsible to preserve and grow capital.
This role is not evil. It has a legitimate purpose.
This role holds profound influence over healthcare processes and outcomes.
This role is subject to moral hazard.

Look at any government healthcare program, any hospital system, insurer, just about any team or organization in healthcare, and you will find a person or team that is required to play this role.

The Role that is subject to Moral Hazard

Let's call this role the "Capital Protector", and let's define it:

A Capital Protector is an entity that has a responsibility to preserve and grow capital. The Capital Protector entity may directly own the capital, or may be managing capital entrusted to it by another entity. The Capital Protector entity could be an individual, an organization, or even a set of affiliated organizations who have a shared interest in preserving a set of capital.

What are examples of Capital Protectors at work?

For-profit healthcare providers working to provide care while also provide return on investments to shareholders who support them.
Healthcare VCs try to generate largest possible revenues and ROI for new medical devices and treatments.
Health system finance teams trying to ensure healthy balance sheets.
Health insurers trying to maintain required reserves.

These entities have a large set of protective instruments at their disposal. A few examples (each of these are actually categories of protective instruments):

Political connections to ensure that rules are written in their favor or at least written fairly.
Insurance barriers that can be used to reduce how much is paid to cover a patient's treatment cost.
Regulation designed to protect investors and protect capital.

So where does the moral hazard arise?

If we state what moral hazard is in simple terms...

If I am given some kind of advantage, I may be tempted to take advantage of it in an inappropriate manner.

We can restate the moral hazard premise as follows:

Moral hazard in healthcare exists when capital protectors use the large set of protective instruments at their disposal to obtain one-sided benefits for themselves at the expense of individuals who need healthcare.

Summary: Conventional Wisdom vs Reality

The conventional healthcare industry thinking on moral hazard holds the following:

Moral hazard exists and it is a risk to the industry
Consumers are alleged to be the cause and source of this moral hazard
Onerous mechanisms like cost and complexity are appropriate and necessary for managing this moral hazard

It turns out that Capital Protectors may actually be the source of moral hazard in healthcare. This raises the interesting question: what might be the "onerous mechanisms" appropriate and necessary for managing this moral hazard?

And is an onerous control mechanism actually what is needed?

Maybe what is needed is a change in mindset that reframes the risk/reward equation and aligns our shared interests in a more productive equitable way?

We need to lay a new policy foundation for this reframing so we can correct the distorted economics of US healthcare. This reframing would start with the question: What are the responsibilities of capital managers to their societies?

If we want to achieve this kind of foundational change in healthcare, then what is the most timely and effective approach for doing so?

At a minimum we need to start challenging the status quo thinking so we can drive affordability in more meaningful ways. We should also begin actively experimenting with ideas outside of the canon of traditional health insurance underwriting so we can take more meaningful steps toward enabling affordability. This kind of financial innovation may be able to reveal a new path forward for an industry where our math has changed, our values have chanted but our mental models are still rooted in 18th century economics.

Further Reading