In an ungated 2004 article in Health Affairs, John Nyman explains his theory of health insurance in intuitive terms. It’s worth a full read, but I’ll summarize it anyway.

It begins with the observation that health care spending is encouraged by health insurance. Is this problematic? Nyman wrote,

Conventional health insurance theory provided a ready evaluation of this increased spending: It represents a welfare loss [*] and should be reduced. Conventional insurance theory also provided the policy solution: Impose coinsurance payments and deductibles to increase the price of medical care to insured consumers and reduce these inefficient expenditures. In the 1970s many insurers adopted copayments to reduce health care spending. In the 1980s and 1990s economists also promoted utilization review and capitated payments to providers as further ways to reduce moral hazard. The managed health care system we have now is largely a product of this theory.

Renewed calls for increased cost sharing (more “skin in the game”) reflect the belief that insurance promotes wasteful health spending. However, it has been recognized for almost thirty years that the conventional insurance theory that supports this belief and has motivated insurance design for decades does not apply to all types of health care. Nyman quotes Mark Pauly as having pointed out that it was only intended to apply to “routine physician’s visits, prescriptions, dental care, and the like” and that “the relevant theory, empirical evidence and policy analysis for moral hazard in the case of serious illness has not been developed.”

Then Nyman developed it. In his Health Affairs article he sidesteps the math (for that, see his book) and illustrates the crucial element of his theory with an example.

[C]onsider Elizabeth, who has just been diagnosed with breast cancer. Without insurance, she would purchase only the $20,000 mastectomy required to rid her body of the cancer. If she had purchased an insurance policy for $4,000 that paid off with a $40,000 cashier’s check upon diagnosis of breast cancer, she might purchase the $20,000 mastectomy and also a $20,000 breast reconstruction procedure. For economists, this behavior implies that the additional $40,000 in income from the insurance pool had increased her willingness to pay for the breast reconstruction so much that it is now greater than the $20,000 market price, causing her to purchase the second procedure. This moral hazard is efficient because she could have spent the additional $40,000 on anything she chose but opted to purchase the breast reconstruction. The purchase of this additional procedure represents a moral-hazard welfare gain to the extent that with the additional $40,000 in income, she would have now been willing to pay more than the $20,000 that it cost to produce the procedure.

In this example, the additional care used, $20,000 for breast reconstruction, was unambiguously welfare improving. Elizabeth valued it at more than its cost (the economist’s definition of welfare improving). If she hadn’t, she’d have spent the $20,000 another way. However, because health insurance policies do not pay off with lump-sum payments, but rather pay directly for health care, the interpretation of the additional care used due to insurance is ambiguous.

For example, if Elizabeth had instead paid $4,000 for insurance that simply paid for her health care when ill, she might also purchase the same two $20,000 procedures, resulting in the same payout of $40,000 from the insurance pool. But it is not clear whether she is responding to the zero price by opportunistically purchasing a breast reconstruction procedure that she barely values, or responding in the same way that she would have responded if the insurer had written her a check for $40,000. As a result, we cannot tell whether this additional moral-hazard spending represents a welfare loss or a welfare gain.

How much additional spending due to insurance is a welfare gain? In his book, Nyman calculates that the majority of it is, perhaps as much as 70%. A number of policy implications follow that differ from those implied by an assumption that all moral hazard is a welfare loss. Nyman lists them as:

Cost sharing is often not appropriate, particularly for cost-effective, life-saving or health-preserving interventions,

Subsidizing insurance premiums to encourage coverage is beneficial, and

High health care prices are harmful because they discourage use of care.

It is not incorrect to say that insurance promotes additional health spending. It does. If you believe Nyman’s theory, it is incorrect to say that all that additional spending is wasteful, a welfare loss. A little is. Most is not. More skin in the game is not more efficient even if it saves money. Some things are worth the price.

* “Welfare loss” here is used in the neoclassical economic sense: that the amount individuals are willing to pay out of pocket is below the marginal cost of health services rendered. Individuals only demand such services because their actual out of pocket liability is reduced below marginal cost due to insurance. More here.

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