Risk Adjustment - Is Full Efficiency and Full Equity too good to be True?

Presenter: Ralph Bradley, US Bureau of Labor Statistics

Abstract

Glazer and McGuire (2000) propose a risk adjustment scheme that has all consumers paying the same premium and receiving the optimal ex post allocation of the medical good. Their proposed risk adjustment scheme results in both full equity and full efficiency. This is a strong and unusual result that is confirmed in Jack (2006). This study finds that this scheme might not always be feasible as those with low risks could be worse off when the unregulated equilibrium is replaced with their proposed risk adjustment scheme. The low risk population could then block this scheme. I suggest an alternative risk adjustment scheme that will make both the low risk and high risk populations better off than the unregulated equilibrium. However it brings neither full equity nor full efficiency. In my proposal I allow for a fee that is charged to one who does not sign up for the fully optimal plan, and this fee finances a payment to to those who do sign up for the optimal plan. This fee/subsidy option helps relax the incentive compatibility constraints when the low risk population is choosing a health plan. In both Glazer and McGuires's and Jack's model, there is no uncertainty so that asymmetric information produces an unregulated separating equilibrium that misallocates the medical good instead of misallocating the sharing of risk. Like the original Rothschilds and Stiglitz model for adverse selection, in my model there is uncertainty and the unregulated equilibrium misallocates risk sharing instead of the medical good.