The 5 Trillion Dollar ‘Agency Problem’ – Part 2

If you haven’t read Part 1, you can find it here.

Quick Recap

The U.S. spent $5 trillion on healthcare in 2023, yet health outcomes remain subpar. Despite common perceptions, no one—patients, doctors, hospitals, or insurers—seems to be profiting. Instead, complex financial flows and inefficiencies inflate costs. In Part 2, we explore where the money actually goes and why the system remains unsustainable.

The Health Insurance System

Continuing from Part 1, we follow the money deeper into the healthcare system. At its core, U.S. healthcare heavily relies on health insurance. Here’s a brief breakdown:

• Insurance companies (Payers) collect monthly premiums from patients (members), often subsidized by employers as part of workplace benefits.
• The fundamental assumption of insurance is risk pooling: many pay into the system, but only a small fraction of members require expensive medical care.
• The system works as long as the majority of members remain healthy and only a small percentage need costly treatments.

However, this model faces multiple breaking points:

1. What if fewer healthy people enroll in insurance?
2. What if more people require care than anticipated?
3. What if patients need extremely expensive treatments?
4. What if some insurers selectively enroll healthy individuals, leaving other companies burdened with higher-risk members?

These challenges aren’t hypothetical—they are current realities.

• 50% of U.S. adults have at least one chronic condition.
• Younger, healthier populations are opting out of insurance due to high costs.
• Medicare and Medicaid primarily cover populations most likely to require care.

The result? Premiums rise, care gets rationed, and the system becomes less sustainable.

The Agency Problem

As if the health insurance system wasn’t complicated enough, there’s also the Agency Problem. The Agency problem (or Agency effect) is well-defined in economics and management circles. Here is the definition of it as applied to the healthcare industry.

Definition: The Agency Problem (or Agency Effect) arises when agents (insurance companies) prioritize their own interests over those of the principals (patients) due to misaligned incentives. This economic and management theory applies directly to healthcare:

Key Aspects of the Agency Problem in Healthcare

1. Misalignment of Interests – Insurers prioritize profits, sometimes at the expense of patient care.
2. Information Asymmetry – Insurance companies possess more knowledge than patients about their own processes, making transparency difficult.
3. Moral Hazard – Since insurers bear the financial risk, they may limit access to care to reduce expenses.
4. Principal-Agent Problem – Decisions may favor corporate cost-saving measures over optimal patient outcomes.

How It Plays Out

Let me explain this in the context of the healthcare reimbursement cycle. The patients pay the premiums to the insurance companies with the hope that they are well taken care of when they fall sick. The insurance companies collect the money and save it to pay for the treatment received by the patient. The hospitals (providers) must provide good treatment to the patients and when raising the bill for the treatment to the payers they must convince the payer that everything was done in the best interest of the patient and their bill needs to be reimbursed. The insurance company cannot simply pay the provider’s bills in good faith, they need to make sure that their member’s money is spent on the right causes, so they need to check if the treatment provided to the patients is valid and effective. The more they bargain with the providers the more money saved for the members. But somewhere this crosses the line and the bargaining ends up adding to the top line of the insurance companies instead of benefiting the patients. This dynamic often leads to delayed treatments, claim denials, and financial distress for patients.

The Agency Problem is Everywhere

At this point, it might seem like insurance companies are the primary culprits. But even without insurance companies, the Agency Problem would still exist within healthcare.

For example, if patients went to doctors directly is there not an agency problem? There is. The patients see the doctor, the doctor treats them with medication and the patient gets well and pays the doctor and never goes back to them. The doctor loses revenue.

A perfectly healthy population would collapse the healthcare industry!

It is just like the typical dilemma of dating websites. If users of dating site find a date or soul mate, unsubscribe from the dating site, and never come back, who is losing revenue? On the other hand, if they never found a date from this website they are still going to quit the site. So, what is a working business model for such a business? You need customers who visit the site, find a date, be happy – momentarily, then break up with the date after a reasonable amount of time, and come back to the site as a repeat customer.

So, the agency problem would exist even if there was no insurance company. Thankfully doctors take the Hippocratic Oath and are predominantly ethical in their practice of medicine, otherwise, we would have an even messier system than today.

What Happens Next?

The Agency Problem has grown over decades, making the healthcare system increasingly inefficient. In Part 3, we will dive deeper into how this problem has evolved and why reforms remain elusive.

Stay tuned!