“Externalities and Benefit Design in Health Insurance.”

Abstract

We model insurance design in the Medicare prescription drug coverage market and show that strategic private insurer incentives impose a large fiscal externality on the traditional Medicare program. Using policy induced variation in subsidies, we document that plans that cover medical expenses spend more on drugs than plans that are only responsible for prescription drug spending, consistent with drug spending offsetting some medical costs. The effect is driven by drugs that are likely to generate substantial offsets. Our equilibrium model of plan design endogenizes plan characteristics and accounts for selection; the model estimates confirm that differential incentives to internalize offsets can explain disparities across plans. Counterfactuals show that the externality created by stand-alone drug plans is $520 million per year.