Externalities and Benefit Design in Health Insurance

Insurance plan design has important implications for consumer welfare. In this paper, we model insurance design in the Medicare prescription drug coverage market and show that strategic private insurer incentives impose a fiscal externality on the traditional Medicare program. We document that plans covering medical expenses have more generous drug coverage than plans that are only responsible for prescription drug spending, which translates into higher drug utilization by enrollees. The effect is driven by drugs that reduce medical expenditure and treat chronic conditions. Our equilibrium model of plan design endogenizes plan characteristics and accounts for selection; the model estimates confirm that differential incentives to internalize medical care offsets can explain disparities across plans. Counterfactuals show that strategic insurer incentives are as important as selection in determining endogenous plan characteristics.