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July 1, 1993

Federal Reserve Bank of Cleveland

Enterprise Liability: A Prescription
for Health Care Reform?
by Charles T. Carlstrom

JTew issues facing society touch as
many lives as health care. Although most
Americans would probably agree that
the quality of available medical services
in the United States is first-rate, many
question whether the price being paid
for that quality is too high. Recognizing
this, President Clinton, who made health
care reform a central promise of his campaign, appointed a blue-ribbon task
force headed by First Lady Hillary Rodham Clinton to look into ways of containing skyrocketing costs while
increasing access to the nation's doctors
and hospitals.
The task force has not yet made its
final recommendations public, but it is
quite possible that they will incorporate
changes in the current medical liability
laws. Many people believe that the malpractice system now in place is a significant factor in the spiraling cost of
health care, and not just because of the
direct costs of malpractice insurance.
There is also a concern that the system
encourages doctors to overprescribe
certain tests and procedures simply to
protect themselves from the possibility
of future lawsuits, a practice known as
defensive medicine.
The commission has discussed two possible malpractice reforms at length.
The first is enterprise liability, which
would 1) transfer liability in malpractice
cases from the doctor to the patient's
health care plan and 2) institute no-fault
malpractice insurance. The second

ISSN 0428-1276

proposal would place caps on malpractice awards.
Although limiting malpractice awards
has emerged as the clear favorite, enterprise liability remains an option for the
future. In fact, President Clinton is
reported to be considering some demonstration projects to assess its longterm viability.
Given the possibility that the administration may eventually endorse enterprise liability, it is important to examine
the probable effects of this type of malpractice reform. In this Economic Commentary, I analyze the plan's costs and
benefits, focusing particularly on its
likely impact on the quality of medical
care. I also take a brief look at the consequences of capping malpractice
awards (see box on page 2).
• HealthCare
and Malpractice Costs
Over the last decade, the inflationadjusted cost of health care has shot
up 41 percent. Malpractice premiums, which currently cost doctors
more than $7 billion a year, are thought
by some to be a major contributor to the
increase. But this view is clearly
overstated. While malpractice insurance is expensive, it still amounts to
only 1 percent of the nation's total
health care bill.
About 55 percent of these premiums go
toward direct administrative costs,
including attorney and expert witness

In the last decade alone, the real cost
of health care in the United States ballooned by 41 percent. Some members
of the medical establishment have
blamed soaring malpractice premiums
—which currently cost doctors more
than $7 billion a year—for much of
the increase. This article examines
that claim and takes a look at how
one malpractice reform proposal, enterprise liability, would likely affect
both the cost and the quality of medical services in this country.

fees. The savings that could emerge
from controlling these costs, however,
would likely be dwarfed by the additional $4 billion to $25 billion estimated to be spent each year on defensive medicine.5
Clearly, malpractice reform is not a
panacea for the nation's health care ills.
However, because as much as 5 percent
of the total U.S. health care budget is
devoted to defensive medicine and malpractice insurance, it is important to
determine whether such reform could
indeed effectively control these costs.
The answer takes on further significance because many believe that changing the present system could jeopardize
the quality of medical care that
Americans have come to expect.

• The Potential Benefits
of Enterprise Liability
Critics of the current system say that
reining in malpractice costs is not only
overdue, but that the system is administered so poorly that potential changes
would have almost no effect on the
quality of health services. They contend that most malpractice awards have
little to do with actual malfeasance.
Joseph Newhouse and Paul Weiler,
who rank among the nation's leading
health policy experts, argue for two
major changes in the current malpractice insurance system (see footnote 3).
First, they contend that legal liability
should be shifted from the individual
physician to the patient's health care
provider. Second, they would institute
no-fault insurance covering all medically caused injuries, not just those
caused by negligence. Taken together,
these changes are known as enterprise
The idea behind transferring liability
from doctors to patients' health care
plans is to eliminate the high cost of
defensive medicine. Currently, doctors
have an incentive to order excess tests
— which they do not pay for — to help
reduce the likelihood of being named
in a malpractice suit. Shifting malpractice liability from the physician to the
party that pays for the tests means that
a patient's insurance company would
absorb the costs and reap the benefits
of any testing. Thus, insurers would be
less likely than doctors to agree to procedures having little potential medical
Making health plans liable for malpractice damages would also lower administrative expenses by reducing the number
of claimants in such suits. Now, most
malpractice cases involve a patient
who is suing not just his doctor, but the
hospital, the anesthesiologist, the nurse,
and any number of other individuals
directly or indirectly associated with
his medical care. Under enterprise liability, the insurance company would be
the only defendant.
Newhouse and Weiler's second proposal, expanding liability to include all

medically caused injuries and not just
those caused by negligence, is modeled
after workers' compensation. Here,
liability for all on-the-job injuries falls
on the employer, who pays a premium
to cover the costs of administering the
system. The plan is considered no-fault
in that payment does not depend on
whether the injury was caused by negligence on the part of the firm or the
Newhouse and Weiler believe that this
change would also reduce administrative expenses, for two reasons. First,
plans such as workers' compensation
usually provide a standard scale of
damages for certain types of injuries.
Second, no-fault insurance would eliminate the high cost of proving negligence in court while reducing the uncertainty about whether the claimant
will be held responsible for the injury.
Reducing uncertainty and increasing the
uniformity of judgments would likely
dampen the injured party's incentive to
go to trial to bet on a particular outcome.
Newhouse and Weiler contend that, taken
together, these two changes would dramatically cut administrative costs, from
55 percent of total malpractice premiums to closer to the 20 percent associated with workers' compensation. The
bulk of the savings would probably be
due to the no-fault provision of enterprise liability rather than to the transfer of liability away from doctors.
• Malpractice and
Health Care Quality
In the eyes of many, the major problem
with instituting enterprise liability is
that the present system, though imperfect, increases the safety of medical
care by punishing negligent doctors.
Simply transferring liability from the
physician to a health plan, critics argue,
could erode this protection.
But the effect of this change alone would
depend on whether physicians have better information about their own abilities
than do patients or their health insurance companies. In a world where all
parties have free access to information,
legal placement of liability would make
no difference. The party that actually

An alternative to enterprise liability
being considered by the Clinton administration is capping malpractice
awards. The argument behind this
type of tort reform is that juries frequently award settlements that are
not commensurate with, and sometimes far outstrip, the damages actually incurred by the injured party.
Proponents believe that capping malpractice payments will reduce administrative costs both by eliminating the lengthy and expensive
appeals process that "excessive"
judgments often go through and by
increasing the number of malpractice cases settled out of court. The
hope is that by reducing the uncertainty surrounding juries' possible
decisions, the incentive to go to trial
to bet on a particular outcome will
be diminished.
There are two problems with this
plan. First, just as juries' judgments
are considered arbitrary, so too are
the limits on monetary damages that
the caps would impose. If caps are
set too low or are allowed to erode
over time, then a patient's recourse
for receiving poor medical care
would be restricted.
Second, it is doubtful whether caps
would have any significant impact
on the cost of medical care. While
directly attacking malpractice premiums — which currently constitute I
percent of the nation's total health
care bill — the plan does little to
reduce doctors' incentive to engage
in defensive medicine. That's because the major cost of losing a malpractice case is not necessarily the
size of the judgment, but the effect
that a guilty verdict can have on a
doctor's reputation. Thus, even if
caps succeeded in cutting malpractice premiums by 33 percent, the net
reduction in the nation's total health
care bill would still amount to only
0.33 percent.

bears the ultimate liability would be independent of the party decreed liable by
the courts. Even if doctors were not
held legally liable, those prone to making mistakes would still pay because the
demand for their services would fall and
their malpractice premiums would rise.
With full information, it would not matter whether doctors or health insurers
were liable for malpractice damages.
Under enterprise liability, doctors would
no longer have to charge extra to cover
expected malpractice costs, and insurers
would pay out less in medical claims.
The cost of health insurance would
remain the same, however, since the
additional "profits" collected by the
health plans would in essence be used
as premiums to pay future malpractice
Unfortunately, full information is an
unrealistic assumption in the field of
medicine. It is likely that physicians are
more aware of their own skills than are
patients or patients' insurance companies. Because of this, moral hazard problems could arise if liability is switched
from doctors to insurers. Moral hazard
is the idea that a person's behavior is
affected by liability. In the medical
realm, the fear is that the quality of
care would suffer because doctors
would behave differently once the
threat of being sued was removed.
• Moral Hazard Considerations
Moral hazard problems associated with
enterprise liability could affect health
care quality through several channels.
First, doctors may no longer have the
same incentive to select a specialty
according to their comparative advantages. For instance, while many doctors may have the knowledge necessary to be good surgeons, few have the
physical skills (dexterity) required. Under the present system, expected malpractice costs would lower anticipated
earnings for less adroit doctors and
thus discourage them from choosing
surgery as a specialty.
Another more ominous possibility is that
enterprise liability may cause doctors
to exercise less care or to take unnecessary risks when treating patients. For

example, malpractice liability may
govern how hard doctors push themselves. A surgeon who has been in the
operating room all day and who is both
mentally and physically spent currently
has an incentive to postpone any additional surgery or to defer to colleagues,
since a mistake could mean being hit
with a large malpractice suit. Personal
liability provides an incentive to set
appropriate personal limits.
Malpractice liability can also influence
the amount of time a physician spends
keeping up with medical advances. To
maintain quality, a good doctor must
spend time reading the latest medical
journals and attending professional
conferences. Although this limits income
by reducing the amount of time that
can be devoted to seeing patients, it is
one way to help minimize the chances
of being sued for malpractice.
Moral hazard problems are pervasive
not only in medicine, but whenever
people are not held liable for damages
caused by their own actions. Insurance
companies, in particular, are well aware
of this. One reason automobile insurance firms require deductibles is so
that insured drivers will bear some of the
costs associated with their actions and
hence will be motivated to drive more
• Reputation Effects
While the moral hazard complications
cited above are worth considering, they
may in fact overstate the likelihood that
medical care would suffer under enterprise liability. Proponents argue that, currently, malpractice insurance creates
moral hazard problems for doctors in
much the same way that automobile
insurance does for drivers.
Although insurance reduces the amount
of damages actually paid by a negligent
physician, it is clear from the costs associated with defensive medicine that it
does not eliminate all of the burden.
That's because the cost of being found
guilty in a malpractice suit is not simply a
matter of how much money is awarded
to the injured party. The loss of reputation that negligent doctors must endure,
coupled with the fact that future malprac-

tice premiums could become prohibitively expensive, can threaten the livelihood of some practitioners.
If reputation rather than direct financial
loss governs a doctor's behavior, then
the obvious question is, would the risks
associated with losing one's reputation
be as great under enterprise liability?
For reputation effects to work, others
must be aware when a doctor has made
a mistake. Under the current system,
malpractice suits are the obvious conduit of this information — particularly
if the doctor is found guilty.
No-fault malpractice insurance, however, would eliminate the need to prove
negligence in court. This means that
the amount of information available to
the public and to other health plan
administrators regarding the quality of
a physician's care would be reduced.
But there is another avenue through
which reputation effects can operate.
Since enterprise liability would make a
patient's health plan liable for malpractice damages, it would encourage the
trend toward health maintenance organizations (HMOs), where doctors work
for specific plans. Plan administrators,
fearful of being sued, would likely institute intensive monitoring and screening
of their doctors to weed out the bad
ones. Chip Kahn, executive vice president of the Health Insurance Association
of America, maintains that "insurance
companies would have to be breathing
down physicians' and hospitals' necks
even more than they do now." Frederic
Entin, general counsel of the American
Hospital Association, echoes that sentiment, arguing that enterprise liability
would reduce the autonomy of doctors
and hospitals in practicing medicine
(see footnote 1).
• Conclusion
There is reason to believe that enterprise liability could reduce malpractice
costs by eliminating both extended litigation and the current incentive doctors have to engage in defensive medicine. The savings may not be as large
as proponents assert, however, since
health plans will have to devote more

of their resources to screening and
monitoring their staff.
There are other costs associated with
enterprise liability that have not been considered here. One is that it may reduce
mobility among the best doctors. With
no malpractice cases to provide a public signal of a doctor's abilities, performance evaluations by HMOs and
individual health plans would become
increasingly important. These reports
would probably remain private, however,
possibly making it harder for the most
able practitioners to change jobs and
thus reap the rewards of their expertise.
The arithmetic dictates that malpractice
reform is but a small step toward reducing the cost of health care in this country.
Even if enterprise liability were to lower
administrative expenses from 55 percent
of malpractice premiums to 30 percent,
and with the costs of defensive medicine
cut in half, the U.S. health care bill would
still fall only 0.5 to 2.0 percent.
Despite these figures, it is likely that
some type of malpractice insurance
reform will eventually be prescribed.
While clearly more than a placebo, this
treatment is best viewed as one small
dose of what will ultimately be a much
larger — and perhaps even more unpalatable — regimen.

Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, Ohio 44101

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• Footnotes
1. See Hilary Stout, "Clinton Mulls Barring
Lawsuits against Doctors," The Wall Street
Journal, April 29, 1993.
2. See David Rogers, "Initial Clinton Medical Malpractice Reform Plan Pulled after
Resistance by Entrenched Interests," The
Wall Street Journal, June 15, 1993.
3. See Joseph P. Newhouse and Paul C.
Weiler, "Reforming Medical Malpractice
and Insurance," Regulation, vol. 14, no. 4
(Fall 1991), pp. 78-84.

Charles T. Carlstrom is an economist at the
Federal Reserve Bank of Cleveland. The
author is grateful to Katherine A. Samolyk
and Rebecca Wetmore Humes for helpful
comments and suggestions on earlier drafts
of this paper.
The views stated herein are those of the
author and not necessarily those of the Federal Reserve Bank of Cleveland or of the
Board of Governors of the Federal Resen'e

4. Ibid.
5. This estimate is from a study by LewinVHI, a consulting firm (see footnote 1).
6. If the patient does not have health insurance, then Newhouse and Weiler propose
that the hospital where the injury took place
be held liable.
7. An exception to this rule could occur if
the patient has secondary insurance. It is not
clear how Newhouse and Weiler's proposal
would handle this situation.
8. However, they also point out that administrative costs under enterprise liability would
probably always be higher than under workers' compensation. This is because it is more
difficult to ascertain whether an injury is
due to an underlying condition or to poor
medical care than it is to determine whether
an injury occurred at work.
9. The cost of health insurance could fall
slightly if transferring responsibility from
doctors to health plans successfully reverses
the administrative costs of malpractice

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