Economic Research Initiative on the Uninsured Conference Draft beyond Reinsurance: Risk-adjusted Health Insurance Subsidies*

Government-sponsored health reinsurance has been increasingly promoted as a strategy for addressing problems in the non-group health insurance market. While reinsurance is promising, economic analysis has identified superior schemes for better accomplishing the same goals at lower cost. Specifically, reinsurance can be considered a crude special case of risk-adjusted insurance subsidies. This paper considers economic benefits and budgetary costs of reinsurance schemes as compared to more sophisticated riskadjustment, calibrated to the current U.S. context. In particular, risk adjustment is likely to perform better at reducing insurer cream-skimming incentives. Although in the past risk adjustment had been considered too complex to implement in practice, recent experience shows that risk adjustment is now feasible, and we argue that incorporation of risk adjustment would strengthen many current U.S. health insurance reform proposals. Introduction The individual market for purchasing health insurance in the United States outside of employer-based groups is widely acknowledged as functioning poorly. In the absence of strong premium rate regulations, predictably high risk individuals such as the chronically ill are charged substantially higher premiums than healthy individuals. This undermines the social pooling of risks, causes job lock, and contributes to uninsurance problems among the very group most in need of good health care access. Furthermore, insurers engage in a variety of costly activities designed to cream-skim healthier enrollees and repel the ill. There are many potential options for government intervention to address these problems. Increasingly, health reform proposals are calling for a government-sponsored reinsurance mechanism as one solution. Reinsurance, however, can be considered a crude special case of a broader family of risk adjustment approaches. Risk adjustment has been studied in the theoretical and empirical economics literature for decades, and sophisticated variants are now being successfully used in many government settings. In general, risk adjustment schemes may use both retrospective and/or prospective information, rely on both claims data and/or diagnoses, and can be applied to entire populations or just subsets such as the highest risks. Reinsurance is a special case using only retrospective claims for the highest spenders. This implies that as compared to more sophisticated variants, reinsurance may be less effective at curtailing cream-skimming distortions, may dull insurer incentives for cost containment, and may have higher budgetary costs for achieving intended effects. This paper considers the functioning of U.S. individual health insurance markets under reinsurance as compared to more sophisticated schemes. Specifically, we analyze a standard retrospective claims-based reinsurance scheme for the top 1% of spenders, and a population-wide retrospective risk-adjustment scheme. Outcomes that we analyze include cream-skimming incentives, premiums for ill/non-ill, uninsurance, and budgetary cost.