IHP 620 Module 4 Market Failure Paper Example

When Choice Backfires: Selection and Moral Hazard in Granite Peak's Employee Plans

[Student Name]

Southern New Hampshire University

IHP 620: Economic Principles of Healthcare

Module Four Paper

[Instructor Name]

[Date]

The organization, setting and figures below are a composite written as a model document. No real employer, client, colleague or patient is described.

When Choice Backfires: Selection and Moral Hazard in Granite Peak's Employee Plans

Granite Peak Health offers employees two plans. The Premier plan is a preferred provider plan with a $500 deductible and access to most providers in the region. The Core plan limits care to Granite Peak facilities and affiliated physicians, with no deductible. The system now pays 82% of the premium for either plan. Finance leaders propose instead paying a fixed $7,200 per employee toward either plan, so employees choosing Premier pay the full difference. This paper examines what economic theory and evidence predict.

Two Distinct Problems

Insurance markets suffer from two information problems that are easy to confuse. Adverse selection arises when people know more about their expected health costs than the insurer, so those expecting high costs choose more generous coverage. Moral hazard arises because insurance lowers the price patients pay at the point of care, leading them to use more. Both make generous plans costlier, but they call for different responses, so distinguishing them matters.

How Selection Works

Einav and Finkelstein (2011) presented selection with simple demand and cost curves. When the people most willing to pay for coverage are also the costliest to insure, the average cost of those enrolled exceeds the cost of the marginal person deciding whether to join. Pricing at average cost then drives out lower-cost people, raising average cost further. The result can be too little coverage relative to what would be efficient, and in extreme cases a market unravels. They also discussed remedies, including mandates, subsidies and risk adjustment.

Why Employers Face This Problem

Employer plans are more exposed to selection than many people assume. Employees can switch plans every open enrollment, they know their own health, pregnancies and planned surgeries better than the plan does and the plan must charge every employee the same premium within a tier. Unlike an individual insurance market before the Affordable Care Act, an employer cannot deny coverage or price by health status. The combination of free annual choice and uniform prices is exactly the setting in which Einav and Finkelstein's framework predicts selection will bite.

A Cautionary Case

Cutler and Reber (1998) studied Harvard University's decision in the mid-1990s to switch from subsidizing a generous preferred provider plan more heavily to contributing an equal amount toward each option. Employees who stayed in the generous plan faced much higher premiums. Healthier and younger employees moved to cheaper plans, the generous plan's remaining enrollees were sicker and costlier, its premium rose again and within three years it was discontinued. The switch also produced savings because plans competed more on price, but the loss from selection offset a substantial share of those gains.

What Granite Peak's Data Show

Premier enrollees cost the plan about 38% more per person than Core enrollees. Part of that gap reflects who chooses Premier: its members are older on average and more likely to have chronic conditions or ongoing specialist relationships. After adjusting for age, sex and diagnoses using the administrator's risk scores, the gap narrows to about 12%. The remaining difference reflects Premier's higher outside prices and the extra use its broader access and lower barriers encourage.

Table 1. Premier and Core Plan Comparison

Note. Composite plan data for the most recent year.

Predicting the Effect of a Fixed Contribution

Under the proposal, an employee choosing Premier would pay about $2,700 a year more than today. Healthier Premier members, who gain little from broad access, would likely switch to Core, leaving Premier with sicker, costlier members. Its premium would then rise, prompting another round of departures. The Harvard experience suggests this could eliminate Premier within a few years, stranding employees who rely on specialists outside the Granite Peak system.

What the System Would Gain

The proposal is not without merit. A fixed contribution would make employees see the full price difference between plans, encourage more to choose the lower-cost Core plan, which keeps care inside Granite Peak's facilities, and give the administrator reason to negotiate harder with outside providers. Finance estimates savings of about $4 million a year if one-fifth of Premier members switch. The question is whether those gains would survive the selection that follows.

How Much Is Moral Hazard?

Einav and Finkelstein (2018) reviewed evidence on moral hazard in health insurance and concluded that people do use substantially more care when it is cheaper at the point of service, based on randomized evidence such as the RAND and Oregon experiments and many natural experiments. They emphasized that responses vary across people and services and that patients often respond to their expected end-of-year price under deductible plans rather than the price of each visit. For Granite Peak, part of the 12% risk-adjusted gap likely reflects this response to Premier's broader network, while the Core plan's lack of a deductible pushes the other way.

Why the Distinction Matters

If the cost gap were mostly moral hazard, making Premier members pay more would reduce wasteful use. Because much of it is selection, a fixed contribution would mainly penalize sicker employees for being sick and destabilize the plan. The right tool depends on the diagnosis.

A Better Design

Granite Peak can keep much of the price competition it wants while limiting selection. The system could set its contribution using risk-adjusted premiums, so employees pay only for the portion of Premier's cost that reflects its prices and access rather than the health of its members. It could also narrow the price gap by steering Premier members to high-value outside providers, and keep Premier's deductible to temper additional use. Periodic monitoring of enrollment and risk scores would catch the early signs of a spiral.

Equity Considerations

A fixed contribution would fall hardest on older employees and those with chronic illness, and on lower-wage employees for whom $2,700 is a large share of pay. A risk-adjusted approach spreads the cost of illness across the workforce, which is the purpose of insurance in the first place.

Conclusion

The proposal to pay a fixed amount toward either plan would encourage price competition but, given that much of Premier's higher cost reflects the health of its members, it risks setting off the kind of adverse selection spiral seen at Harvard. Separating selection from moral hazard points to a risk-adjusted contribution that captures savings without penalizing illness.

References

Cutler, D. M., & Reber, S. J. (1998). Paying for health insurance: The trade-off between competition and adverse selection. The Quarterly Journal of Economics, 113(2), 433-466. https://doi.org/10.1162/003355398555649

Einav, L., & Finkelstein, A. (2011). Selection in insurance markets: Theory and empirics in pictures. Journal of Economic Perspectives, 25(1), 115-138. https://doi.org/10.1257/jep.25.1.115

Einav, L., & Finkelstein, A. (2018). Moral hazard in health insurance: What we know and how we know it. Journal of the European Economic Association, 16(4), 957-982. https://doi.org/10.1093/jeea/jvy017