Health Insurance and Market Failure since Arrow

Sherry A. Glied Columbia University

Illness is usually unexpected and often costly. Health insurance is a contingent claims contract that moves funds from the usual state of the world, when one is healthy, to the unexpected and costly state, when one is ill. In this sense, it is a market success: an institutional response to a natural feature of the demand for health care. Without such an institution, there would be no market to transfer funds between health states. In its operation, however, health insurance introduces its own set of market failures. The key features of the health insurance institutions we observe now are, in turn, responses to the existence of these market failures. This recursive relationship between institutions and market failure is a core organizing theme of Arrows article. Arrow described institutional arrangements in health care as responses to the market failures of his time. Strikingly, to a reader in 2001, Arrow gave health insurance relatively little airplay in his article. Instead, Arrow devoted the bulk of his essay to the training and organization of professionals and the nature of hospitals. Today, most writers would view the topics Arrow stressed as largely secondary in importance to the organization and nature of health insurance in explaining the functioning of the health care system as a whole. Health insurance, a source of market failure on its own, has now become a central force in addressing the other market failures Arrow identied throughout the health care market. The purpose of this article is to build on Arrows work in examining the evolution of insurance institutions in response to the market failures
Journal of Health Politics, Policy and Law, Vol. 26, No. 5, October 2001. Copyright 2001 by Duke University Press.

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that arise in individual insurance contracts and in the market for health insurance. This institutional evolution, in turn, explains why health insurance moved from the periphery to the core of the health care sector. Finally, this evolution also illuminates where private market institutions can, and where they cannot, effectively address insurance market failures.
Arrow on Insurance

Arrow addressed two aspects of health insurance in his 1963 article (and in his 1965 response to comments on it): the form of insurance contracts and the functioning of the insurance market. With respect to the form of insurance, he noted that the scope of insurance coverage was limited. Insurance arises to cover unexpected events, so health insurance sensibly did not typically cover services that were predictable, such as maternity care. Arrow also pointed out that there was little insurance available for illness-related disabilities. He explained these limitations of insurance contracts as a market response to moral hazard, which leads to expanded utilization in the presence of insurance. Arrow described the coexistence of three types of insurance: cash indemnity policies, cost indemnity policies, and prepayment plans. In his view, none of these existing insurance contracts fully addressed the problem of moral hazard. He suggested that insurance contracts generally lacked much incentive for patients or providers to seek, or provide, low-cost services. Thus, expansions of health insurance drove up expenditures on health care. Arrow emphasized two features of insurance market functioning. First, he noted the role of large groups in the insurance market. He viewed the existence of these groups as an institutional response to administrative economies in the selling of insurance, pointing out the difference in costs between individual and group coverage. Arrow attributed gaps in coverage largely to the difculty that certain groups had in taking advantage of administrative economies in the purchase of coverage. Groups that did not have direct access to employer-sponsored insurance lacked individual coverage, he implied, because they faced very high loading costs associated with the difculty of selling individual policies. Second, he considered the role of the relatively noncompetitive, Blue Crossdominated insurance market of his day. That market pooled unequal risks providing insurance that directly contradicted the economic theory of insurance markets. He argued that Blue Cross was an institutional response to the lack of long-term health insurance. Community-rated

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insurance offers coverage against the risk of a change in ones basic state of health. Similarly, Arrow viewed the low level of competition in the insurance market as an institutional response to the problem of adverse selection.
The Changing Form of Coverage and Market for Insurance

The nancial role of insurance in the health care sector has nearly doubled since 1963. In 1963, 46 percent of all medical expenses were paid by insurance. In 1998, 83 percent of all medical expenses were paid by insurance (authors tabulations of the National Health Accounts). This expansion is a consequence of shifts both in the form of insurance contracts and in the insurance market. The form of insurance contracts has changed signicantly since 1963. The scope of coverage has broadened dramatically. Virtually every aspect of health care, from hospital stays to eyeglasses, is now covered by insurance. Disability insurance also is widespread, and about 35 percent of workers own a private disability insurance policy, while almost everyone holds limited and implicit disability income insurance through the Social Security Income and Social Security Disability Insurance programs. The organizational form of health insurance has changed. The coexistence of three types of insurance in Arrows day suggested a market without a dominant institutional form. Today, virtually all insurance is a form of prepayment. In about 90 percent of instances, what we call traditional indemnity coverage includes an out-of-pocket payment limit beyond which insurance pays all (Bureau of Labor Statistics 1999). This change, too, has expanded the share of insurance payments in total expenditures. There have been substantial changes in the insurance market as well. There has been some expansion in coverage. In 1963, an estimated 78 percent of the population held some form of health insurance coverage (Lees and Rice 1965). By 1999, 85 percent of the population held medical expense coverage. The small overall change masks a major distributional change. While the elderly were most likely to lack coverage in Arrows day, today virtually all the aged have insurance coverage through the public Medicare program. Mechanisms for pooling in the health insurance market have changed as well. Community rating has all but disappeared. In its place, public and private institutions now perform the task of pooling risks more broadly. The costliest segments of the market, the elderly and those with

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permanent disabilities, are now covered by public programs. In the private market, almost all coverage is now purchased through employers, the continuation of a trend that was already well under way by 1963. Individual insurance is only a residual category today.
Explaining the Growth in the Insured Share of Expenditures

The growing share of expenditures that is paid by insurance is a consequence of both public actions and private market forces. Public coverage expansions, particularly the introduction of Medicare and Medicaid in 1965, mean that many of the most costly previously uninsured now hold coverage. New coverage means that some expenses are now paid by insurance rather than out of pocket. In addition, new coverage has led, through moral hazard, to a net increase in health expenditures. Legislation also expanded the scope of coverage, for example, by mandating that insurers cover pregnancy and other services. In the private sector, the growing role of health insurance is, in large measure, a consequence of the rise in the cost of health services. In 1963, health expenditures accounted for 5.5 percent of the GDP. By 1998, that share had more than doubled to 13.5 percent. But average statistics are not informative about the demand for health insurance to protect against unanticipated risk. Insurance transfers funds from good states of health to bad states, so a better statistic compares good and bad states. Such a measure is the ratio of average expenses for the top 1 percent of health care spenders to average incomes. In 1963, those who found themselves in the bad state the top 1 percent of spenders spent an average of $12,960 (1996 dollars), about 1.3 times average personal income ($9,886) in that year (Glied 1997). In 1996, by comparison, the top 1 percent spent an average of $61,500 (1996 dollars), nearly 3 times the average income of $21,385 in that year (authors tabulations of the MEPS). While borrowing and saving could plausibly substitute for formal health insurance contracts in 1963, that was not a realistic option for most people in 1996. Expanding the scope of insurance, in turn, led to further increases in cost through moral hazard effects. Arrow anticipated neither the legislative actions nor the extraordinary cost growth that occurred in health care markets since 1963. In his 1965 article, he argued that the large economies of scale in insurance purchasing were a good argument for government purchasing. His only comment

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about cost growth concerns the role of moral hazard in raising the cost of major medical insurance. Looking backward, the missing piece in Arrows article is the role of technological change, the phenomenon that, according to most subsequent observers, has propelled the growth in the cost of health care since the early 1960s (Newhouse 1992).
Technology, Market Failure, and Insurance Institutions Today

Public coverage expansions and regulations have obviously played an enormous role in our health care system. They have not, however, had a profound impact on either the form of insurance or the functioning of the private insurance market. Indeed, the one remaining 1963-style insurance contract that, with only a few revisions, exists in todays market is the Medicare indemnity policy. Medicare addresses moral hazard through unlimited cost sharing, leaving beneciaries vulnerable to the nancial costs of long-term illnesses. Moreover, it excludes coverage for relatively predictable costs, such as outpatient prescription drugs. At the market level, Medicare and Medicaid pulled some of the costliest cases and worst risks out of the private insurance market. The categorical nature of eligibility for these programs (especially Medicare), however, means their introduction did not alter the problems of economies of scale in administration and adverse selection that Arrow identied in the private market of 1963. Instead, the factor that has had the greatest impact on insurancerelated market failure and institutional response has been technological change in health care. Technological improvements in the nature and quality of health care have made access to care more important and have driven increases in the cost of care. Better quality and higher cost care have precipitated the expansion in the extent and scope of private health insurance coverage and thus led to increased moral hazard. Many analysts also argue that expanded health insurance has interacted with the process of technological innovation and diffusion to introduce a new form of market failure, dynamic moral hazard, into the market (Goddeeris 1984; Baumgardner 1991). This line of research argues that the existence of health insurance encourages the development and dissemination of cost-increasing technologies. In the presence of insurance-induced moral hazard, technology

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developers and providers compete to attract patients by choosing technologies that improve the quality of care. There is little reason to develop or choose technologies that lower costs. Technological change has altered the forms of market failure in health insurance that Arrow identied in 1963. But the interplay between market failures, wherever they originate, and institutions that Arrow described in 1963 continues now. Just as Arrow argued in 1963, each of these market failures has generated its own set of institutional responses, and, in turn, these institutional responses have led to further market failures.
Technological Change and the Form of Coverage

Health insurance, Arrow points out, provides nancial protection against risk. But the types of contracts that Arrow observed would leave purchasers in todays health insurance vulnerable to substantial risk. Unlike Medicare, private health insurance contracts have evolved since 1963 in ways that have reduced the nancial risks of purchasers. The extent of cost sharing has been limited, and the scope of coverage has been expanded. Consider prescription drugs, an area where technological change has led to an explosion in spending. In 1963, prescription drug expenditures averaged $86 per capita (1998 dollars) and 95 percent of these costs were paid out of pocket; today, drug expenditures average $323 per capita. While Medicare does not cover prescription drugs, 73 percent of all drug costs are covered by health insurance today. This more generous coverage corrects the market failure of too much risk bearing, but at a cost. Better protection against risk through lower cost sharing means that without other changes, insurance contracts today would generate additional moral hazard with respect to the level of utilization. They would also give consumers even less incentive to search for low-cost providers and may generate dynamic moral hazard. For example, in the presence of insurance without strong controls for moral hazard, hospital competition can degenerate into a medical arms race in which hospitals seek to attract physicians (and, by extension, patients) by acquiring better, but more costly, technology (Luft et al. 1986). The increase in moral hazard at a point in time and over time, associated with lower cost sharing, in turn, has generated a raft of new institutions that address moral hazard problems in other ways. These include

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various forms of supply-side cost sharing and direct monitoring of utilization through utilization review, which address the direct moral hazard effect. The development of closed, or preferred, panels of providers has shifted the search function from consumers to insurers, who, because they bear most of the nancial risk of utilization, have a strong incentive to search efciently. Some evidence suggests that these new ways of addressing moral hazard also have an effect on dynamic moral hazard. A growing literature shows some differences in the patterns of diffusion and introduction of technologies between markets where managed care is dominant and those where traditional insurance is dominant (see, for example, Chernew et al. 1998). These new institutions move health insurance squarely to the middle of some of the central health care system problems related to asymmetries of information between consumers and providers identied by Arrow in 1963. In the presence of asymmetric information between consumers and providers, supply-side cost sharing, a technique insurers use to reduce moral hazard, can lead to underservice and skimping on quality. Consumers have difculty evaluating the quality of panels of providers, just as they did in selecting an individual physician. These developments move existing market failures under the umbrella of health insurance. In Arrows original conception, insurers played no part in addressing the market failure associated with the asymmetry of information between consumers and providers. In the context of these new methods of addressing moral hazard, as well as the growing complexity of decision making in this market, insurers are also beginning to act as information intermediaries. The development of quality reporting, health plan report cards, and brand-name health plans may allow insurers to address moral hazard without tripping over these persistent market failures.
Technological Change and the Insurance Market

Technological change has also directly and indirectly affected the asymmetries of information that exist between the purchaser and the insurer at the moment of purchase. These asymmetries may lead to adverse selection in the insurance market. Better diagnostic tests (likely to be exacerbated in the future with genetic testing) and better (and more costly) treatment of chronic diseases mean that many consumers now have both more information and more incentive to seek out insurance

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that offers them the best possible package in response to their idiosyncratic risk prole. In a free market, insurers generally respond to adverse selection with respect to chronic and predictable conditions by removing them from coverage. This is a market failure, as Arrow noted, in that presumably people would prefer to have insurance against the risk of developing such conditions. This problem is exacerbated when technological improvements make treatment more effective and more costly. In that circumstance, limiting insurance coverage leaves many people without nancial access to valuable care. The market response to this increase in selection has been further degeneration of the individual health insurance market and increased reliance on employer-sponsored coverage. This solution is of limited effectiveness. Employees who lose or leave their jobs may lose health coverage entirely or be unable to buy coverage that protects them against chronic conditions. These problems of incomplete coverage (both at a point in time and over time) have generated legislative responses in the form of insurance coverage mandates that compel insurers to include costly chronic conditions, such as mental health problems, within the scope of coverage, and portability legislation. Improved technology and its attendant costs have increased the normative importance of all gaps in coverage. As the quality of medical care increases, people want more of it. As technology drives costs up, though, growing numbers of people can no longer afford coverage that would give them access to the latest improvements. The insurance market has not effectively addressed this problem. Instead, public funding plays an increasingly important role in paying for the costs of care for those who could not otherwise afford it. Since Arrow wrote, the public sector of health care nancing in the United States has expanded vastly from 25 to 45 percent. And new initiatives, such as Medicare prescription drug coverage and coverage expansion, suggest that the public share is just going to grow further.
Health Insurance: Market Failure or Market Success?

Arrow identied two types of market failures associated with health insurance: those related to the insurance contract and those related to the insurance market. Both types of market failure have been challenged by technological change over the intervening four decades. The evidence

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suggests that insurance has been a market success with respect to the problems associated with individual contracts. There have been many effective innovations that help reduce nancial risk while controlling moral hazard. Some even seem to be holding back inefcient technological change. Insurance has been much less of a success with respect to the insurance market. Technological change has improved the quality of care but also increased its costs. In combination, these two factors make it even more valuable for people to hold coverage today than in Arrows day. Yet the insurance market has not succeeded in developing effective mechanisms, beyond employer-based coverage, for providing coverage to those who have chronic conditions or are at high risk of developing serious problems. Nor has it developed stand-alone mechanisms for redistribution of insurance to those who cannot afford it. In this area, larger pools and government action, as Arrow foresaw, are the only likely solutions.

References
Arrow, Kenneth. 1965. Uncertainty and the Welfare Economics of Medical Care: Reply. American Economic Review 55(1):154 157. Baumgardner, James. 1991. The Interaction between Forms of Insurance Contract and Types of Technological Change in Medical Care. RAND Journal of Economics 22(1):36 53. Bureau of Labor Statistics. 1999. Employee Benets in Medium and Large Private Establishments, 1997. Bureau of Labor Statistics Bulletin 2517 (Sept.). Washington, DC: Bureau of Labor Statistics. Chernew, Michael E., Richard A. Hirth, Seema S. Sonnad, Rachel Ermann, and A. Mark Fendrick. 1998. Managed Care, Medical Technology, and Health Care Cost Growth: A Review of the Evidence. Medical Care Research and Review 55(3):259 288. Glied, Sherry A. 1997. Chronic Condition. Cambridge: Harvard University Press. Goddeeris, John H. 1984. Medical Insurance, Technological Change, and Welfare. Economic Inquiry 22:56 67. Lees, Dennis S., and Robert G. Rice. 1965. Uncertainty and the Welfare Economics of Medical Care: Comment. American Economic Review 55(1):140 154. Luft, Harold S., James C. Robinson, Deborah W. Garnick, Susan C. Maerki, and Stephen J. McPhee. 1986. The Role of Specialized Clinical Services in Competition Among Hospitals. Inquiry 23:83 94. Newhouse, Joseph P. 1992. Medical Care Costs: How Much Welfare Loss? Journal of Economic Perspectives 6(3):3 21.