Information and the Market for Health Insurance

Currently, in the market for most private health insurance, information is transmitted by the employer to the employee. That is, the employer, by offering one or more health benefit plans to retain employees, has substantial incentives to offer a plan or plans that coincide with the majority of the employees' desires. The employer generally has professional benefit managers on his staff to review potential legal loopholes and benefit inconsistencies in the plans offered. The most cost-effective insurer can be selected by the individual who has ample time to gather information before his or her decision. If the employer is to offer a greater array of benefit packages or a different structure of benefit packages under procompetition legislation, one would expect the employer to become an even more important source of information to the employee.

Information and the Market for Health Services. In general, an individual either does not know or is not concerned about the prices of physician and hospital services, the "appropriate" number of ambulatory procedures and lengths-of-stay in hospitals, or the "appropriate" number of hospital beds or types of sophisticated equipment in an area. Thirdparty insurers ( Blue Cross and the commercial insurers) and alternative delivery systems, however, know the prices of physician and hospital services and may well know the appropriate number of ambulatory procedures and lengths-of-stay in hospitals as well as the appropriate number of hospital beds or types of sophisticated equipment in an area. "Appropriate" is defined here as the point beyond which marginal benefits of health services are zero.

In addition, third-party insurers and HMOs clearly already have incentives to contain costs. Among third-party insurers, for example, generally vigorous competition in dental insurance has resulted in extensive pre-treatment review of dental procedures. Firms that are more successful in reducing the escalation of costs in dental care will be able to secure more business from the employer. The incentives that HMOs already have to contain costs have been described elsewhere. Furthermore, the fact that hospital prices are not still higher suggests that there are some limits to what third parties will pay or to the level at which providers will set their prices.

Cost containment involves certain costs, however, especially from the viewpoint of the traditional third-party insurer. These include the transaction costs of designing and carrying out the program, of ascertaining what appropriate medical procedures are, and of negotiating with the providers and potentially alienating the patients.

How might a third-party insurer with increased incentives use information to contain costs to a greater extent than at present? With a large number of enrollees and with physicians as consultants on its staff, the third-party insurer can examine more closely procedures or tests that exceed the point beyond which marginal benefits are zero. It can also question fees for procedures that exceed the mean for a group of enrollees in a particular location. A recent study of a small "administrative services only" firm that attempts to collect this information and subsequently use it to deter unnecessary utilization and higher than average fees found that the firm enjoyed some success in curbing higher fees as well as prohibiting procedures beyond which marginal benefits are zero. In instances where the marginal benefits were positive, the firm was less successful.

This seems to be consistent with Kenneth Arrow's notion that "an insurance company can improve the allocation of resources to all concerned by a policy which rations the amount of medical services it will support under the insurance policy." Arrow then suggests that
there might be a detailed examination by the insurance company of individual cost items allowing those that are regarded "normal" and disallowing others, where normality means roughly what would have been bought in the absence of insurance.

Third-party insurers might also generate and utilize information based on an entire health care market. An analysis might be made of the appropriate number of hospitals and beds within a hospital, as well as the appropriate number of sophisticated technologies. Insurers would then refuse to pay for that capital configuration beyond which the marginal benefits are zero.

A third party will not, however, attempt to contain costs for the entire health care market unless the firm has a substantial market share. A firm incurs certain expenses in setting up a cost containment program, including the design and administration of such a program. At the same time, these cost containment efforts are subject to the free-rider effect. Other insurer-competitors in the same market would also benefit if cost containment efforts were successful. In order to provide an incentive for an insurer's efforts at cost containment, which may potentially affect the entire health care market (a public good), a tax credit might be provided to internalize some of the benefits.

Not only do HMOs have the same types of information available to them as health insurers, but, because of their incentive structure, they can use this information to contain costs. Physicians who are paid on a salary basis have no incentives to provide services beyond which the marginal benefits are zero. The salaries of physicians and paraprofessional personnel need not be higher than their opportunity costs. The HMO, however, generally does not engage in the types of global cost containment that limit the number of hospital beds or sophisticated technical equipment.