Economic Report of the President 1994 - The American Presidency ...

Box 4-1.—Moral Hazard and Adverse SelectionAll insurance markets face two potential problems. The first,called moral hazard, involves incentives. Insurance may encouragethose who are covered to use insured services morethan they otherwise would, or it may discourage the insuredfrom taking steps to lower their need for such services. Insuranceagainst any kind of risk—including health risks—alwaysinvolves some element of moral hazard. When people usehealth services more than they would without insurance, thetotal amount insurers must pay increases, and they in turnmust increase their prices. Furthermore, because individualspay less than the full social cost of the services they receive,too much of society's resources will be devoted to such services.The second problem is adverse selection. People who knowthat they are more at risk than others of falling ill are morelikely to purchase health insurance. Therefore, insurers whoset their prices at the average cost for the population as awhole are likely to discover that their prices do not cover theircosts, because their customers are on average sicker than thepopulation at large. To address this problem, insurers have incentivesboth to charge prices that exceed the cost of coveringthe average person and to select risks as best they can. Thehigher prices of insurance that result from adverse selectionhave the perverse effect of discouraging some healthy peoplefrom purchasing insurance. Because of the adverse selectionproblem, all people must be required to purchase insurance ifeach of them is to be charged the average cost of providing insurance.INSURANCE MARKET REFORMPrivate insurance markets have a number of shortcomings thatimpede the realization of universal coverage.INSURING MAJOR RISKS AND PREEXISTINGCONDITIONSEconomic theory suggests that at a minimum well-functioning insurancemarkets should insure against the expenses that accompanylarge medical risks because those are precisely the ones thatcause the most financial hardship to individuals and families, arethe least susceptible to moral hazard, and have the lowest administrativecosts as a share of benefits. In our current system, however,private insurance markets often fail even when judged against thisminimal standard.137