Contracting over liability: medical malpractice and the cost of choice.

• Author: Arlen, Jennifer

Contractual liability proponents claim that states can best reform malpractice liability by allowing patients to contract over and out of liability. Proponents assert that informed patients would be better off if they were allowed to contract over liability than they would be if states reformed malpractice liability directly because informed patients would contract for the rules that maximize their welfare. Proponents also claim that states reforming malpractice liability could only benefit patients by including a right to contract out of liability. This Article demonstrates that these claims are incorrect. Informed patients who value state-imposed malpractice liability can be hurt by the introduction of contractual liability, because contractual liability produces lower deterrence benefits at a higher price. Four inefficiencies make contractual liability a less beneficial and more costly form of liability than state-imposed malpractice liability: collective goods problems, time inconsistency, adverse selection, and network externality problems. Adoption of contractual liability therefore would hurt patients who value liability because it would force them to use a less valuable and more expensive form of liability, and create inefficient incentives for patients to waive liability that would have been optimal if imposed by the state. This conclusion holds whether patients negotiate liability contracts directly with individual physicians or are presented with standard form contracts governing malpractice liability offered by their health insurers.

INTRODUCTION I. THE CLASSIC ECONOMIC ARGUMENT FOR CONTRACTUAL MALPRACTICE LIABILITY A. Causes of Medical Error and the Goals of Malpractice Liability B. The Traditional Economic Argument for Contracting over Malpractice Liability C. Requirements for Optimal Contracting over Liability 1. Costs of Contractual Versus State-Imposed Liability 2. Deterrence Benefits of Contractual Versus State-Imposed Liability a. Postcontractual Care b. Precontractual Care 3. Perceived Strength of the Claim for Contract D. Inapplicability of These Classic Analyses to Malpractice Liability II. MALPRACTICE REFORM THROUGH NEGOTIABLE INDIVIDUAL CONTRACTING A. The Need for and Benefits of Medical-Entity Liability Reform B. Will Patients Contract for Medical-Entity Liability Reform? III. INDIVIDUAL NEGOTIABLE CONTRACTING OUT OF REFORMED LIABILITY A. Collective Goods and the Free-Rider Problem B. The Inability to Induce Optimal Precontractual Care C. Adverse Selection D. Summary IV. CONTRACTING WITH COMMITMENT THROUGH MCOS A. The Superiority of MCO Contractual Liability over Individual Contracting B. MCO Contractual Liability Increases Adverse Selection 1. Structure of Health Insurance Pricing and Benefits of Pooling 2. Price-Distorting Effects of Adverse Selection 3. Adverse Selection Under MCO Contractual Liability V. CONTRACTING INTO EXCESSIVE VARIATION IN STANDARDS OF CARE A. Learning and Network Externalities of Varying the Standard of Care B. Will Patients Contract for Optimal Variation? CONCLUSION INTRODUCTION

Each year, more than a hundred and fifty thousand people are killed and more than a million people are injured by medical error, much of which is preventable. (1) Indeed, more people are killed each year by medical negligence than are killed by either automobile accidents or workplace injuries. (2)

Malpractice liability is potentially one of the most effective mechanisms for reducing medical error. Well-designed malpractice liability can optimally deter error by giving medical providers direct financial incentives to make cost-effective investments in patient safety. This benefits patients and medical providers alike. (3)

In its current form, however, medical malpractice liability is not as effective as it could be. It must be reformed. This raises two questions: (1) what is the best process for reforming the system, and (2) what provisions should be included in any state-adopted reforms?

At present, a heated battle rages between proponents of two opposing answers to these questions. One group seeks to reform malpractice liability from within. (4) The other wants to replace malpractice liability with liability imposed by contracts executed between patients and medical providers, either individual medical providers (5) or health insurers. (6)

Proponents of contractual liability assert that all patients would benefit if states allowed patients to contract over liability because some patients would benefit from the right to contract and none would be hurt, as long as contracting is voluntary and patients know the expected benefits and costs of liability. Proponents' claim that informed patients (7) cannot be hurt by contracting over malpractice liability rests on the assumption that patients obtain the full benefit of state-imposed liability, and bear the same cost, when they impose liability by contract. Thus, any informed patient who would have derived a net benefit from state-imposed liability would impose the same liability rule by contract and obtain the same net benefit. Only those patients who would not have been well served by state-imposed liability would use their right to contract to alter or eliminate liability. Contracting would allow these patients to select a liability rule that they prefer. (8)

The claim that informed patients would be unambiguously better off if allowed to contract over liability has won the day with many scholars. Indeed, even most opponents of contractual liability accept the proposition that informed rational patients cannot be hurt by the right to contract over liabality; (9) they focus their objections on information or behavioral problems (10) that proponents claim do not, or need not, exist. (11) Embracing proponents' view, a growing number of scholars--including some in the current administration--promote the idea that patients should be allowed to contract over liability. (12) The most ardent proponents want states to delegate the entire task of reforming malpractice liability to contract by allowing patients and their individual medical providers to contract for the reforms they prefer. (13) More moderate proponents want contracting to be a component of state-adopted malpractice liability reform, contending that states should reform malpractice by imposing liability for all actionable errors on Managed Care Organizations (MCOs) (14) and then permit MCOs to contract with patients to alter or eliminate liability." (15)

Notwithstanding scholars' widespread acceptance of the core economic argument for contractual liability, proponents have never demonstrated the validity of their foundational claim that informed patients necessarily benefit from the right to contract over malpractice liability. Specifically, they have never shown that (1) informed patients will contract for optimal liability reforms or that (2) no informed patient would be worse off under contractual liability because informed patients can get as much benefit from contractual liability as they can from liability imposed by the state by fiat.

This Article employs economic analysis to assess the validity of proponents' claims that patients necessarily benefit from the right to contract over malpractice liability and its reform, provided they know the costs and benefits of imposing liability. It shows that these claims are incorrect. Informed patients (16) would not necessarily use the right to contract to adopt optimal liability reforms. Moreover, a state adopting effective liability reforms would hurt citizens who benefit from state-imposed liability if it allowed them to contract out of it.

As proponents recognize, informed patients necessarily benefit from the right to contract only if patients have optimal incentives to contract over liability. This implies that patients must obtain the same benefit, at the same cost, when they impose liability by contract as they could get from liability imposed by a welfare-maximizing state by fiat. (17) Contractual liability proponents have always assumed that this requirement is met. This Article shows that it is not. Informed patients get less benefit, at a higher cost, from contractual liability than from state-imposed liability as a result of a host of inefficiencies plaguing malpractice liability contracts. These inefficiencies, which include collective goods problems, time-inconsistency problems, adverse selection, and network externalities, lower the benefit and increase the cost to patients of contractual liability relative to state-imposed liability.

Contractual liability proponents assume that each patient obtains the same net benefit from a liability rule whether it is imposed by fiat or by contract because they assume that contracting simply increases the choices available to patients without altering value of liability to patients. This assumption is incorrect. Contractual liability is a materially different form of liability than state-imposed liability, with different benefits and costs. Traditional malpractice liability is imposed collectively and automatically by all patients on all providers throughout time. By contrast, contractual liability is imposed by individual patients on a specific set of providers at the moment of contracting, and only by request. These structural differences affect the benefit to patients of imposing liability because both investments in medical care and malpractice liability are collective goods; they also affect current and future patients. By contrast, contractual liability is not imposed collectively--it only reaches a subset of current providers, and only as of the moment of contract. Moreover, all else being equal, the cost to patients of liability is lower when it is imposed automatically by the state than when patients must contract into it because medical providers contracting for liability would charge an inefficiently high price for it as a result of adverse selection...