Unbiased Analysis of Today's Healthcare Issues

Private Information and Long-Term Care Insurance

Written By: Jason Shafrin - Jun• 15•06

‘Adverse selection’ and ‘moral hazard’ are phenomenons which affect any analysis of the insurance market.  For instance, Cutler and Zeckhauser (1997) speak of an adverse selection ‘death spiral’ which made untenable the continued offering of a generous health insurance benefit at Harvard University.  In their NBER paper, Finkelstein and McGarry (2003) attempt to estimate the effect of private information in the long-term care insurance market. In 2000, the authors state that long-term care expenditures in the U.S. comprised 7.5% of all medical expenditures and 1% of GDP for a total of $100 billion.  Thus, analyzing this segment of the health insurance market is non-trivial and it will only increase in importance as baby boomers continue to retire in larger numbers.

The first item Finkelstein and McGarry investigate is whether there is a positive correlation between the amount of long-term care insurance purchased and the likelihood of using the insurance benefit.  If adverse selection is a problem, one would expect people who purchase large amounts of insurance will also be the ones who incur expensive long-term care costs for the insurance companies.  Surprisingly, they encounter no evidence of this.  Using a more specific test for adverse selection, however, the authors do find proof that adverse selection is a problem.  Examining a supplement to the Health and Retirement Study (HRS), they find that people who expect to enter a nursing home in the next five years are 1) more likely to enter a nursing home and 2) more likely to purchase long-term care insurance. 

So what explains the lack of correlation between the amount of long-term care insurance purchased and the likelihood of entering a nursing home if adverse selection is a problem?  It turns out that preferences explain the residual.  The authors posit that risk averse individuals are more likely to undertake preventative health care measures such as having a flu shot, cholesterol test, mammogram or prostate screen.  Using these measures as a proxy for risk aversion, Finkelstein, et al. find that risk adverse individuals are 1) more likely to buy long-term care insurance, but 2) less likely to need the benefit.  We see that the effects of adverse selection are offset by the fact that healthier, risk averse individuals also purchase excess amounts of insurance.  Thus, in aggregate–at least for the long-term care insurance–this market can reach a stable equilibrium. 

Finkelstein and McGarry (2003) “Private information and its effect on market equilibrium: new evidence from long-term care insurance,” NBER WP #9957.

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  1. BC says:

    My wife and I bought LTC insurance a couple of years ago even though we can afford to pay privately, at least for a few years. The main reason is that I would find it so disagreeable to have to actually write a check for $5,000-$10,000 per month for care if it became necessary, I would rather spend $3,600 per year (for the two of us) on insurance and hope that neither of us ever needs it. I have no idea how many other people feel similarly.

  2. [...] Healthcare Economist takes a look at ‘adverse selection’ and ‘moral hazard’ in insurance markets. [...]

  3. [...] Amy Finkelstein is one of my favorite healthcare economists and recently BusinessWeek ran an article (”So that’s why it’s so expensive“) profiling her and her work.  I have profiled Ms. Finkelstein before in my June 15th post describing her 2005 paper with McGarry.  She also has a new NBER working paper (”The aggregate effects of health insurance: Evidence from the introduction of Medicare“), which is very interesting.  Here’s the abstract: This paper investigates the effects of market-wide changes in health insurance by examining the single largest change in health insurance coverage in American history: the introduction of Medicare in 1965. I estimate that the impact of Medicare on hospital spending is over six times larger than what the evidence from individual-level changes in health insurance would have predicted. This disproportionately larger effect may arise if market-wide changes in demand alter the incentives of hospitals to incur the fixed costs of entering the market or of adopting new practice styles. I present some evidence of these types of effects. A back of the envelope calculation based on the estimated impact of Medicare suggests that the overall spread of health insurance between 1950 and 1990 may be able to explain about half of the increase in real per capita health spending over this time period.   [...]

  4. [...] In my June 15th post, I mentioned Cutler and Zeckhauser’s 1997 paper which discussed this concept of an adverse selection death spiral in the context of Harvard’s employee health insurance plans.  [...]

  5. When the baby boomer retirement kicks in the government better be prepared. I don’t think enough of our population is buying LTC insurance. That leaves them using their own assets and them relying upon the govt.

  6. [...] An NBER working paper by Cutler, Finkelstein and McGarry (2008) claims that preference heterogeneity may explain this phenomenon. If low-risk individuals also have a stronger risk aversion preferences, than they may buy more insurance than a high-risk individual who has risk loving preferences. This work is an extension of the Finkelstein and McGarry (AER 2006) article discussed in one of my earlier blog posts. [...]

  7. [...] public and health economics fields.  I have featured here work multiple times on this blog (see here, here, here, here and [...]