Health Insurance Cost Sharing: Coinsurance, Copays & Deductibles

This segment explains the concept of adverse selection and how insurers manage risk. Adverse selection occurs when individuals who are most likely to need insurance are the ones who purchase it, creating a higher risk for insurers. For example, someone who feels unwell or needs medical care immediately is more likely to buy health insurance. This creates a higher risk because the pool of policyholders contains more high-risk individuals. Adverse selection can be reduced through group insurance, where most members are not seeking coverage due to immediate need but rather as a benefit of employment. The Medical Information Bureau (MIB) is a database that stores medical information about individuals for the past five years, funded by insurance companies to help assess risk and prevent adverse selection.

Insurance relies on risk pooling—the law of large numbers spreading risk across many participants. Reinsurance allows insurers to transfer correlated risks to larger pools. However, information asymmetry persists: while insurers may know more about average risks, individuals know their own specific circumstances better. This creates an ongoing informational advantage for buyers over sellers, complicating market functioning.

Adverse selection occurs when asymmetric information exists before a transaction takes place. When one party to a contract has more information than the other, the party with more information can exploit the other's ignorance. For example, in the insurance market, individuals with higher health risks are more likely to buy insurance than those with lower risks. This leads to a pool of insured individuals with higher average risk than the general population, causing insurance companies to raise premiums, which causes healthy individuals to drop out, creating a vicious cycle.

Adverse selection occurs when high-risk individuals disproportionately seek insurance, creating unsustainable business models. Risk pooling requires balanced numbers of good and poor risks so premiums from lower-risk individuals can cover claims from higher-risk ones. Every insurance contract requires four elements: consideration (exchange of value—the insurer promises payment while the insured offers application and premium), legal purpose (compliance with laws preventing coverage of illegal enterprises), offer and acceptance (applicant submits application, insurer reviews and accepts), and competent parties (legal age and sound mind). Agents must not write contracts with minors or individuals lacking capacity.

Insurance markets face fundamental challenges due to asymmetric information. Adverse selection occurs when high-risk individuals are more likely to purchase insurance than low-risk individuals, creating a pool disproportionately filled with high-risk customers. Insurance companies calculate premiums based on expected risk levels, setting higher rates for high-risk individuals (e.g., $6,000) versus low-risk individuals (e.g., $2,000). The goal is to maintain a balanced risk pool where approximately 75% are low-risk and 25% are high-risk. When the pool becomes unbalanced with too many high-risk individuals, premiums must increase for everyone to cover expected claims. Experience rating helps insurers adjust premiums based on individual medical history and claims patterns.

The RAND Health Insurance Experiment (1974-1984), the largest randomized social experiment in U.S. history costing $82 million, demonstrated that cost-sharing reduces healthcare utilization but shows diminishing returns on health outcomes, meaning that beyond a certain point, additional insurance coverage does not significantly improve health while continuing to increase spending; this finding has profoundly influenced healthcare policy across multiple administrations, including the Affordable Care Act, and established RAND as a leading health policy research institution.

Major health insurance experiments like the RAND Health Insurance Experiment addressed two fundamental questions: healthcare elasticity (how insurance affects healthcare demand) and health outcomes (whether insurance improves health). The RAND study found that free health insurance significantly increased healthcare utilization including doctor visits, outpatient services, hospital admissions, and total expenses—all statistically significant. However, despite increased utilization, there was no statistically significant improvement in physical health outcomes including general health index, cholesterol, blood pressure, or mental health. Additional studies like the Oregon Health Plan lottery confirmed these patterns while showing that insurance provides important financial protection against healthcare expenses, protecting households from catastrophic medical costs.

The RAND Health Insurance Experiment randomly assigned families to insurance plans with varying co-pays (from zero to $1,000 annual deductible). Those in high-deductible groups had 40% fewer office visits, were 23% less likely to be admitted to hospital, and spent 31% less on healthcare. However, there was no discernible difference in health outcomes except for vulnerable populations with severe hypertension. More care did not result in better health status or longer life.

This section presents the empirical evidence establishing that moral hazard exists in health insurance markets. Three key studies demonstrate this: the Oregon Health Insurance Experiment (randomized lottery for Medicaid coverage showing 40% increase in emergency room visits), the RAND Health Insurance Experiment (random assignment to plans with 0-95% coinsurance showing spending decreases with higher cost-sharing), and Medicare Part D bunching analysis (revealing 30% excess mass at the doughnut hole kink). These randomized evaluations overcome adverse selection by ensuring treatment groups are comparable, providing causal evidence that health insurance increases healthcare utilization through price-responsive demand.

Economist Martin Feldstein demonstrated that optimal health insurance requires positive cost-sharing because consumption smoothing benefits are small relative to moral hazard costs. When healthcare spending is small relative to income, individuals are nearly risk-neutral about insurance, so smoothing benefits are minimal. However, reduced cost-sharing induces substantial moral hazard, causing overutilization without proportionate benefits. The RAND experiment randomly assigned participants to insurance plans from completely free care to $5,000 deductibles, finding healthcare demand is downward sloping with elasticity of -0.2 (relatively inelastic). People with higher deductibles used substantially less healthcare, yet health outcomes were similar between groups. However, low-income chronically ill patients experienced worse health with higher deductibles. Optimal design requires income-based cost-sharing (ACA implements this) and value-based insurance design varying cost-sharing by clinical value, though implementation remains challenging.

The Supreme Court upheld the ACA's preventive care mandate in Kennedy v. Braidwood Management, Inc., confirming that non-grandfathered plans must cover preventive services without cost sharing. The 2026 Maximum Out-of-Pocket (MOOP) limits increased to $10,600 for individuals and $21,200 for families (up from $10,150 and $20,300). MOOP limits apply only to in-network essential health benefits and must be embedded if the family MOOP exceeds the individual limit. The OBBA introduced Medicaid work requirements beginning in 2026, requiring able-bodied adults to complete 80 hours per month of work, volunteering, or education to maintain eligibility, with exemptions for pregnant women and the elderly. Loss of Medicaid eligibility qualifies as a HIPAA special enrollment event.

The out-of-pocket maximum is the maximum amount an enrollee pays annually for covered in-network services, after which the plan pays 100% of costs. Preventive care services (well-woman visits, cancer screenings, immunizations, FDA-approved contraceptives) are required to be provided without any cost sharing under the ACA. The maximum out-of-pocket limit protects enrollees from extremely high annual costs but is not the amount everyone will actually pay—most people never reach this limit.

The ACA established annual out-of-pocket maximums for family plans through marketplace exchanges, currently capped at $19,000. However, these limits reset every year and remain extraordinarily high for most American families. The law's designers apparently did not anticipate that insurance companies would use high-deductible plans and prior authorization as mechanisms to effectively deny coverage or force patients to pay substantial amounts before receiving necessary care.

Out-of-pocket maximums (or limits) are the maximum amounts an insured person will pay annually for covered services. In 2021, the ACA mandated maximums of $8,550 for individuals and $17,100 for families. Once reached, insurance covers 100% of eligible costs. Monthly premiums do not count toward these limits, only deductibles, copays, and coinsurance do.

This section covers out-of-pocket maximum and preventive services. The out-of-pocket maximum is the maximum amount one pays before the insurer pays 100% of allowable amounts for covered services; this includes deductibles, co-pays, and co-insurance. Preventive services (screenings, immunizations, and other services) do not require meeting deductibles and do not require co-payments or co-insurance from in-network providers. However, services for diagnosis or follow-up for problems may still be charged even if the initial visit was preventive.