Optimal Risk Adjustment In Markets With Adverse Selection: An Application To Managed Care

It is well known that adverse selection causes distortions in contracts in markets with asymmetric information. Taxing inefficient contracts and subsidizing the efficient ones can improve market outcomes (Bruce C. Greenwald and Joseph E. Stiglitz, 1986), although regulators rarely seem to implement tax and subsidy schemes with adverse-selection motives in mind. Contracts are often complex and “incomplete,” and it is the “inefficient” elements of the contract that are difficult to verify and hence tax or subsidize. This is precisely the reason that in health insurance markets, rather than subsidizing contracts, regulators and payers contend with adverse selection by taxing and subsidizing the price paid to insuring health plans on the basis of observable characteristics of the persons joining the plan — a practice known as “risk adjustment”…