Does Supplemental Private Insurance Increase Medicare Costs?

The Medicare program was created in 1966 to provide for the health care needs of the elderly. Due in part to the failure of the program to cover certain services such as prescription drugs, the market for private supplemental insurance developed rapidly. In addition, employers found that retiree health benefits were an inexpensive form of deferred compensation to offer workers. The emergence of private insurance to supplement Medicare, while providing insurance for uncovered services, also decreased the price sensitivity of elderly consumers for services that were covered by Medicare. This, in turn has induced demand for covered services beyond those that would have existed if Medicare were the only insurance available to the elderly. In this paper, the authors estimate the magnitude of induced Medicare expenditures due to the presence of private supplemental insurance. They use a unique source of data, the 1990 Health Supplement to the Panel Study of Income Dynamics. These data contain linked Medicare claims for elderly PSID respondents from which direct measures of expenditures for Medicare-covered services have been created. In addition, due to the panel nature of the PSID (23 consecutive years) the authors have instruments that permit controls for the potential endogeneity of the purchase of private supplemental insurance. Therefore, the authors are able to distinguish induced expenditures due to insurance from higher expenditures due to potential selection effects of persons purchasing private insurance. These estimates are the first to be able to measure the induced demand effect of private supplemental insurance on Medicare program expenditures. As such, they provide a quantitative measure of how the private sector may induce significant expenses in public programs.