Principal Agency Theory and Health Care Utilization

I. INTRODUCTION The way in which the health care industry is organized has undergone significant changes over the past 20 years, making it a particularly interesting arena for industrial organization analysis. There are currently two primary types of health insurance plans: traditional indemnity insurance (fee-for-service) and managed care organizations. Under fee-for-service (FFS), the provider is paid for each procedure or service dispensed to a patient. Managed care is more complex--health maintenance plans (or health maintenance organizations, HMOs) take many forms and health care providers are reimbursed in different ways. Of particular importance for this study is capitation. This form of reimbursement is one where the plan pays a fixed amount of income to the physician to care for a patient over a certain period of time. Physicians do not get additional payments, even if the cost of the patient's care is more than what was expected. Essentially, this fixed fee payment per patient transfers the financial risk of treatment from the insurer to the physician and is almost a textbook example of how to implement an incentive-compatible contract to contain excessive use of services. Principal agency theory, however, suggests that transferring the financial risk of treatment from the insurer to the physician can be costly if physicians are risk averse (Eeckhoudt et al. 1985). For example, levels of risk aversion vary across medical specialties and this has implications for medical malpractice (Danzon 1983). Also, incentive-compatible contracts may result in the physician not being a good agent for the consumer, leading to an underprovision of appropriate care. There is a significant literature documenting that managed care patients, on average, have significantly lower lengths of stay than FFS patients. (1) However, these effects appear to vary by diagnosis, and investigators have generally not attempted to systematically model why this is so. This is a key focus of our article. Another mechanism for containing costs is for a third-party insurer to retain the financial risk of treatment but invest in directly monitoring the care provided by the physician. Some examples of monitoring include utilization review, mandatory preapproval of care, required second opinion options, and so on. Dranove and Satterthwaite (2000) report that utilization review has been widely adopted by U.S. health plans with 90% of indemnity plans and 100% of preferred provider organizations using this as a tool to control costs. The empirical studies by Wickizer and Lesser (1998) and Wickizer et al. (1989) report statistically significant reductions in inpatient utilization of 12-13% by employees enrolled in plans that conduct utilization review. Scheffler et al. (1991) reports a 4% reduction in the length of stay (LOS) by Blue Cross plans that adopt utilization management. Lindrooth et al. (2002) examine the effect of utilization management by managed care companies, finding that at least in mental health settings, utilization review accounts for 65% of the reduction in inpatient care under managed care contracting. However, little has been done to examine how monitoring performs relative to capitation and in what cases it is most effective at containing costs. From a social welfare perspective, the monitoring approach to cost containment is likely to be preferable if monitoring such decisions is low cost relative to the costs associated with introducing income risk to the physician and agency costs with respect to the physician consumer relationship. On the other hand, in situations where monitoring is difficult, incentive-compatible contracting would be a more efficient way to finance health services. (2) Previous researchers have examined applications of the principal agent framework to health care markets. DeBrock and Arnould (1992) model the health care provider (the physician) as an agent who works for the principal (the insurer). …