Abstract:

Much of the risk adjustment literature focuses on its effects on insurers’ incentives to inefficiently manipulate insurance contracts to “cream-skim” the healthiest enrollees in the market (Glazer and McGuire 2000). However, when prices are set competitively as in the Exchanges established by the ACA, risk adjustment can also ameliorate another important type of selection problem, in the extreme case known as market unraveling or death spirals, where consumers inefficiently sort between plans due to the correlation between costs and demand. In this paper, I study how imperfect risk adjustment affects prices, sorting, and welfare in competitive health insurance markets. First, I build on the model of Einav et al. (2010) to show graphically and in a theoretical model that imperfect risk adjustment causes plan prices to be based on the portion of costs not predicted by the risk adjustment model (“residual costs”), rather than total costs. This adjusting of costs has the potential to substantially weaken the connection between demand and costs that is the source of the adverse selection problem, and the extent to which it will do so depends on the correlation between demand and the costs predicted by the risk adjustment model (“predicted costs”). In a setting where consumers are required to choose between two plans, and one plan is adversely selected, if predicted costs are positively (negatively) correlated with demand for that plan, risk adjustment will cause the prices of the two plans to converge (diverge), resulting in more (fewer) consumers choosing the adversely selected plan. I then use administrative health insurance claims data from a large employer to estimate the joint distribution of preferences, total costs, and predicted costs for a large sample of employees. I use the estimates to simulate competitive equilibria under several common forms of risk adjustment in a setting similar to the Exchanges. I find that in this setting when there is no risk adjustment, the market completely unravels and the entire market enrolls in the less comprehensive plan. However, when diagnosis-based risk adjustment similar to that being implemented in the Exchanges is implemented, a substantial portion of the market unraveling is undone, with over 80% of individuals enrolling in the more comprehensive plan. Estimates suggest that this implies a substantial welfare gain of over $700 per person, per year in this setting.