Optimal cost sharing to avoid risk selection in health insurance markets

In the absence of a perfect risk adjustment scheme, cost sharing can reduce risk selection in community-rated health insurance markets. However, cost sharing also reduces incentives for efficiency. In this paper, we develop a model in which insurers determine the cost efficiency of health care. They have incentives for risk selection because there are two risk types which differ in their expected health care costs. We derive the optimal cost sharing function and show that costs should be shared where the cumulative cost reimbursement for high risk types compared to low risk types is comparatively large and where there is a low concentration of individuals. Using individual health cost data from a Swiss health insurer, we show that an optimal cost sharing scheme should reimburse costs only up to a limit. JEL-classification: H42, I18.