Cost-minimizing risk adjustment.

Conventional risk adjustment, which sets capitation payments equal to the average cost of individuals with similar observable characteristics, is not optimal if health plans can use private information to select low-cost enrollees. "Cost-minimizing risk adjustment" minimizes the sum of capitated HMO premiums plus FFS costs by balancing the gains from HMO cost efficiency against the overpayments that result from HMO selection. Estimations using privately-insured data suggest that cost-minimizing risk adjusted premiums reduce total sponsor costs as much as 25.6% below conventional risk adjustment premiums.