What Is Risk Adjustment?

I think I know what it is, and if I’m right it’s very important to health care reform, but it hasn’t gotten a lot of attention.
Risk adjustment is the solution to the following problem. Imagine you tell all the health insurers that they have to accept the healthy and the sick, and they have to charge each the same insurance premium. You may not have to imagine for much longer; this is at the core of all the proposed health care reform bills. (In the Finance Committee bill you can discriminate based on a small number of factors, like age and tobacco usage, but that’s it.)
If you’re a profit-maximizing insurer, what do you do? You try to cherry-pick the healthy, since the revenues will be the same as for the sick and the costs will be lower. If you can do this successfully — say, by only advertising in gyms and in Runner’s World, or maybe by offering additional benefits that only the healthy will want — then you can dump the sick on someone else. That someone else will eventually (after all the private insurers get smart or go out of business) be the public option or the non-profit cooperative, whichever we end up with, which will end up losing money; the net effect is a transfer from taxpayers to private insurers. Now, the fact that insurers participating on exchanges have to take everyone should mitigate this problem, but it won’t go away. In effect, insurers will compete by marketing in ways that attract the healthy and hide from the sick, instead of competing to offer better health care at lower cost.
Risk adjustment is a transfer mechanism whereby money flows in the reverse direction, from insurers with healthy customers to insurers with sick customers. It requires some means of calculating the expected healthiness of a pool of people and the fair transfer payment. You can’t (I don’t think) base your transfers on actual healthiness, because then you are penalizing insurers that are actually good at making people more healthy. So the transfers need to be based on some measure of how sick the customers were when the insurers got them at the beginning of the year.
I haven’t found much on the blogs (maybe I’m reading the wrong blogs); when I searched Ezra Klein, my first resource on health care, for “adjustment,” I only came up with these three posts. What I really want to know is how risk adjustment will work under our proposed health care reform. But in the Baucus Bill, this is all I found:
“Risk-adjustment. All plans in the individual and small group markets would be subject to the same system of risk-adjustment. Risk-adjustment will be applied within rating areas (described below).
“The Secretary would be required to pre-qualify entities capable of conducting risk-adjustment and the states would have the option to pick among those entities. The entities pre-qualified by the Secretary cannot be owned or operated by insurance carriers. The Secretary of HHS would define qualified risk-adjustment models which can be used by states. States can also choose to develop their own risk-adjustment model but it must produce similar results and not increase Federal costs. After risk-adjustment is applied, reinsurance and risk corridors (described below) would apply.”
So it seems like the government will designate certain organizations that are allowed to do the risk adjustment calculations, and states can pick between them. (This reminds me of nationally recognized statistical rating organizations, but that’s perhaps an overreaction.)
There is also a reinsurance mechanism under which all insurers in a state have to pay an amount proportional to their insurance premiums into a reinsurance fund, which then pays out to insurers based on how many high-risk customers they have. That is probably a good thing, but it only applies for three years (2013-2015), and it doesn’t eliminate the incentive to cherry-pick; since contributions into the fund do not come from insurers with disproportionately healthy customers, you are still better off attracting the sick.
The overall goal here is to channel private-sector competition in a socially beneficial way. It does seem simpler to just have single payer and be done with it (then you don’t need any of these rules), but the basis of our proposed system is getting insurers to compete in some ways (lower administrative costs, lower medical costs through intelligent use of negotiated payment schedules) and not in other ways (cherry-picking). As far as I can tell, the bill points in the right direction, but it still seems terribly vague to me. Am I just missing something that’s in a different part of the bill?
By James Kwak