NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

How does Risk Selection Respond to Risk Adjustment? Evidence from the Medicare Advantage Program

Jason Brown, Mark Duggan, Ilyana Kuziemko, William Woolston

NBER Working Paper No. 16977
Issued in April 2011
NBER Program(s):   AG   HC   PE

Governments often contract with private firms to provide public services such as health care and education. To decrease firms' incentives to selectively enroll low-cost individuals, governments frequently "risk-adjust" payments to firms based on enrollees' characteristics. We model how risk adjustment affects selection and differential payments---the government's payments to a firm for covering an individual minus the counterfactual cost had the government directly covered her. We show that firms reduce selection along dimensions included in the risk-adjustment formula, while increasing selection along excluded dimensions. These responses can actually increase differential payments relative to pre-risk-adjustment levels and thus risk adjustment can raise the total cost to the government of providing the public service. We confirm both selection predictions using individual-level data from Medicare, which in 2004 began risk-adjusting payments to private Medicare Advantage plans. We find that differential payments actually rise after risk adjustment and estimate that they totaled $30 billion in 2006, or nearly eight percent of total Medicare spending.

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