3.1 Basic Concepts

3.1.1 Key Terms

The following is a glossary of health insurance terms (Bureau of Labor Statistics, n.d.; Bureau of Labor Statistics, 2021). The sections that follow will cover the important concepts of adverse selection and moral hazard.

I. Plan Networks

In-network. Healthcare providers (e.g., specialists, hospitals, laboratories) that have accepted contracted rates with the insurer are considered in-network. As a result, the insured person typically pays a lower price for using services within the network.

Out-of-network. Healthcare providers who have not accepted contracted rates with the insurer are considered out-of-network. As a result, services received outside the network of healthcare providers with contracted rates typically carry a higher cost to the insured person.

II. Types of Plans

Conventional indemnity plan. An indemnity plan that allows the participant the choice of any provider without effect on reimbursement. These plans reimburse the patient and/or provider as expenses are incurred.

High deductible health plan (HDHP). This type of plan typically features a higher deductible and lower insurance premiums than traditional health plans. Normally, the plan includes catastrophic coverage to protect against large medical expenses, but the insured is responsible for routine out-of-pocket expenses until they meet the plan deductible.

Managed care plans. Managed care plans generally provide comprehensive health services to their members and offer financial incentives for patients to use the providers who belong to the plan. Four examples of managed care plans include:

• Health maintenance organization (HMO). A healthcare system that assumes both the financial risks associated with providing comprehensive medical services (insurance and service risk) and the responsibility for healthcare delivery to HMO members in a particular geographic area, usually in return for a fixed, prepaid fee. Financial risk may be shared with the providers participating in the HMO.
• Preferred provider organization (PPO). An indemnity plan where coverage is provided to participants through a network of selected healthcare providers (such as hospitals and physicians). The enrollees may go outside the network but would incur more out-of-pocket costs in the form of higher deductibles, higher coinsurance rates, or non-discounted charges from the providers.
• Exclusive provider organization (EPO). A more restrictive type of preferred provider organization plan under which employees must use providers from the specified network of physicians and hospitals to receive coverage; there is no coverage for care received from a non-network provider except in an emergency.
• Point-of-service (POS) plan. A POS plan is an HMO/PPO hybrid, sometimes referred to as an "open-ended" HMO when offered by an HMO. POS plans resemble HMOs for in-network services. Services received outside of the network are usually reimbursed like conventional indemnity plans (e.g., provider reimbursement based on a fee schedule or usual, customary, and reasonable charges).

Physician-hospital organization (PHO). Alliances between physicians and hospitals for the purpose of helping providers attain market share, improve bargaining power and reduce administrative costs. These entities sell their services to managed care organizations or directly to employers.

Self-insured plan. A plan offered by employers who directly assume the major cost of health insurance for their employees.

III. Payment Terms

Capitation. A fixed sum of money is paid to the provider per time unit (usually monthly) for each patient being treated by the provider.

Coinsurance. This form of medical cost-sharing requires an insured person to pay a stated percentage of medical expenses after the deductible amount, if any, is paid. After any deductible amount and coinsurance are paid, the insurer is responsible for the rest of the reimbursement for covered benefits, up to the maximum allowed charges. The individual is responsible for any charges in excess of what the insurer determines to be “usual, customary, and reasonable.” Coinsurance rates may differ between services received from an approved provider and those received from providers not on the approved list.

Copayments. The fixed dollar amount that an insured person must pay when a service is received before the insurer pays any remaining charges.

Coverage limits. Payment limits may be set in terms of a dollar or per-day ceiling on benefits. For example, a requirement that the participant pays a percentage of costs (coinsurance), or a requirement that the participant pays a specific amount (deductible or copayment) before reimbursement begins or services are rendered. For example, a $250 copayment for hospital room and board.

Deductible. The deductible is a dollar amount that an insured person pays during the benefit period–usually a year–before the insurer starts to make payments for covered medical services. Plans may have both individual and family deductibles. Some plans have separate deductibles for specific services. For example, a plan may have a hospitalization deductible per admission. Deductibles may vary between services received from an approved provider (i.e., a provider with whom the insurer has a contract or an agreement specifying payment levels and other requirements) and those received from providers not on the approved list or as part of a different tier of benefits. Some deductibles vary based on other factors (aside from plan network), such as employee length of service, salary range, or enrollee age.

Disease management. A comprehensive, integrated approach to care and reimbursement based on a disease's natural course. The goal of disease management is to address the illness or condition with maximum effectiveness and efficiency regardless of treatment setting(s) or typical reimbursement (Zitter, 1997).

Fee-for-service. A method of payment in which doctors and other healthcare providers are paid for each service performed. Examples of services include tests and office visits.

Gatekeeping. The requirement to visit a general practitioner, family practitioner, general internal medicine physician, or general pediatrician in an ambulatory setting and to obtain a referral prior to accessing specialist care (Garrido et al., 2011).

Maximum out-of-pocket expense. The maximum out-of-pocket expense is the most an insured person is required to pay during a plan year for covered in-network healthcare services. Payments toward the deductible, copayments, and coinsurance generally count toward this limit. Once the limit is reached, the health plan pays the full cost of covered in-network benefits for the remainder of the plan year (HealthCare.gov, n.d.-d).

Overall limits. Restrictions that apply to all or most benefits under the plan, as opposed to selected individual benefits. An example of an overall limit is a $300-per-year deductible that must be paid before medical expenses become eligible for reimbursement. Another example is an 80-percent coinsurance that applies to all categories of care except outpatient surgery.

Pre-authorization. A decision by a health insurer or plan that a healthcare service, treatment plan, prescription drug, or durable medical equipment is medically necessary. Sometimes called prior authorization, prior approval or precertification. Some insurance plans require preauthorization that the item/service/treatment is medically necessary before it will be covered.

Premium. Agreed-upon fees paid for coverage of medical benefits for a defined benefit period. Premiums can be paid by employers, unions, employees, or shared by both the insured individual and the plan sponsor.

Reinsurance. The acceptance by one or more insurers called reinsurers or assuming companies, of a portion of the risk underwritten by another insurer contracted with an employer for the entire coverage.

Stop-loss coverage. A form of reinsurance for self-insured employers that limits the amount the employers will have to pay for each person’s healthcare (individual limit) or the employers' total expenses (group limit).

Usual, customary, and reasonable (UCR) charges. Conventional indemnity plans operate based on usual, customary, and reasonable (UCR) charges. UCR charges mean that the charge is the provider’s usual fee for a service that does not exceed the customary fee in that geographic area and is reasonable based on the circumstances. Instead of UCR charges, PPO plans often operate based on a negotiated (fixed) fee schedule that recognizes charges for covered services up to a negotiated fixed dollar amount.

IV. Outpatient Prescription Drugs

Formulary drugs. A formulary identifies the prescription drugs covered by a health insurance or prescription drug plan. Formularies may include both generic and brand-name medications, and the amount an enrollee pays may differ depending on the drug and the plan's coverage requirements (HealthCare.gov, n.d.-a).

Brand-name drugs. These are drugs that once were or still are under patents.

Generic drugs. Generic drugs are FDA-approved medications that are equivalent to their brand-name counterparts in important characteristics such as active ingredient, strength, dosage form, and route of administration. They must also meet FDA standards for quality and manufacturing and provide the same expected clinical benefit as the brand-name drug (U.S. Food and Drug Administration [FDA], 2026).

Mail-order drugs. These are drugs that can be ordered through the mail. Some plans use mail-order pharmacies that typically provide a 3-month supply of maintenance drugs as a cost-containment measure.

3.1.2 Adverse Selection

There is no universal agreement on a definition of insurance. However, most definitions have these two key elements related to risk (U.S. Government Accountability Office, 2006):

1. Risk is transferred - An uncertain, possibly large, loss is transformed into a certain, small cost or premium for the insured, and an insured transfers risk to another entity.
2. Risk is spread - An insurer spreads risk over a large enough group for the law of large numbers to predict both total losses and the probability of a single loss with some accuracy.

One complication of health insurance markets is that those who demand insurance are the ones who are more likely to need insurance. This fact in itself might not be a problem, except that individuals also know more about their own health than the companies that are insuring them.

"Selection bias" is a major issue in the U.S. health insurance market. There are two types of bias: favorable selection and adverse selection. These terms are defined from the perspective of the insurer. When there is favorable selection, the insurer enjoys healthier enrollees. Conversely, with adverse selection, their enrollees are less healthy. In other words, adverse selection occurs when someone can purchase insurance only after knowing they need it, implying differences in health status or expected expenditures that the insurer cannot detect.

In practice, insurance companies often cannot classify people into precise risk groups or offer such targeted policies to low- and high-risk individuals. As a result, when lower-risk individuals opt out of the insurance market, leaving only high-risk individuals in the market (i.e., the selection is adverse), there is an information problem that is a source of market failure: the insurer will lose (or make less) money, and insurance is unavailable to low-risk individuals at a reasonable price.

3.1.3 Moral Hazard

Another complicating element for insurance is the moral hazard: the idea that, after purchasing insurance, individuals may behave in riskier ways. For example, think about your likelihood of being in a car accident. The probability that you will have an accident depends on many things: road conditions, the actions of other drivers, luck, and many others. It also depends on the actions you take as a driver of the car. There are many things we do that influence our likelihood of having an accident, including (but not limited to) the following:

• Properly maintaining the car
• Paying attention when driving
• Driving when tired
• Driving after consuming alcohol

These items are influenced by the decisions that we make. The link back to insurance is that, if we are insured, we may make different choices about the condition of our car, how we drive, and our physical state when we drive. In health insurance, moral hazard is more commonly associated with changes in the use of healthcare after insurance reduces the amount a patient must pay directly for services. When patients are responsible for only part of the cost, their decisions about whether and how much healthcare to use may differ from the decisions they would make if they had to pay the entire cost themselves (Einav & Finkelstein, 2018).

Insurance companies understand very well that their policies influence people's choices. Their response is to design insurance contracts that provide insurance without affecting individuals’ incentives too much. For example, in the case of automobile insurance, you will not receive full coverage for your loss in case of an accident. Instead, insurance contracts typically include: (1) a deductible, which is the amount of a loss you have to cover before any insurance payment occurs, and (2) a copayment, which is the share of the loss for which you are responsible. The same applies to medical insurance. In the event you are ill, health insurance will typically cover a wide variety of medical costs, but there will usually be a deductible and often a copayment. As with property or automobile insurance, the deductible incentivizes you to take actions that make you less likely to claim against the policy.

There are two main moral hazard issues with healthcare:

Moral hazard in health insurance can be considered from two perspectives. Ex ante moral hazard concerns whether having insurance changes behaviors intended to prevent illness or injury. Ex post moral hazard concerns how insurance affects the use of healthcare once care is needed. Research has provided much stronger evidence for the latter: when insurance reduces patients' direct financial responsibility for care, healthcare utilization tends to increase (Einav & Finkelstein, 2018).

The size of the health bill can also depend on choices about treatment. You will meet with your doctor to jointly decide on treatments when you are ill. Although your doctor will probably talk to you about various treatment options, their price will not be the focus of the discussion. Eventually, you will meet with someone else in the office to discuss how your treatment will be paid for and, in particular, how much will be covered by your insurance. In the end, you have a menu of treatments and a menu of prices that you have to pay. You will then choose the option from these menus that is in your best interest.

The insurance company pays some of your bill, so the amount you pay is lower than the actual treatment price. However, by the law of demand, you purchase more than you would if you had to pay the full price. For example, a patient may be more willing to obtain additional services or consultations when insurance reduces the amount the patient must pay directly for that care (Einav & Finkelstein, 2018).

3.1.4 Adverse Selection vs. Moral Hazard

Adverse selection and moral hazard are closely related problems in the health insurance industry that have unique differences (Maas, 2016). Both are caused by information asymmetry:

• Adverse selection is caused by asymmetry in information before insurance is purchased, such as when individuals/patients who know they are more likely to require care tend to choose more generous insurance plans.
• Moral hazard involves changes in actions after insurance is purchased, such as when insurance reduces the amount an individual must pay for healthcare and influences the amount of care the individual chooses to use.

The cost of managing both problems can be decreased by reducing uncertainty (i.e., gathering more information).

Table 1 Adverse Selection vs. Moral Hazard

(Maas, 2016)

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