The Welfare Implications of Risk Adjustment in Imperfectly Competitive Markets

Risk adjustment is a common policy for mitigating the effects of adverse selection when government regulation limits insurer ability to rate consumers according to their expected risks. I study the social welfare implications of risk adjustment. I first show theoretically that risk adjustment may reduce social welfare because it can increase the expected risk of consumers who select into the insurance pool. I then assess how risk adjustment affects social welfare in the Affordable Care Act (ACA) insurance exchanges. Using consumer-level data from the California exchange, I estimate demand for insurance and obtain estimates of marginal cost that I relate to premiums to account for adverse selection. I compute equilibrium premiums under alternative scenarios and find risk adjustment raises premiums for less costly exchange plans. However, there is minimal net effect on social welfare because the ACA’s price-linked subsidies shield consumers from premium increases. I conduct policy simulations using the estimated model and find the impact of risk adjustment is sensitive to the subsidy design. If ACA price-linked subsidies were converted to fixed subsidies as proposed in some legislative alternatives to the ACA, risk adjustment would decrease annual per-capita consumer surplus by $200 and social welfare by $400.