Risk Adjustment Mechanisms in Market-Based Health Reform

Andrew Samwick writes:

Risk Adjustment Mechanisms, Again | Capital Gains and Games: I read this article by Reed Abelson in The New York Times, and I give him one thumb up and one thumb down.  He is correct that the media as a whole, reflecting the larger health care reform debate, has ignored the essential question that he poses in the title of the article, "Health Insurance Exchanges: Will They Work?"  But the article ignores the key dimension along which we need them to work -- establishing a risk-adjustment mechanism for all health plans in a given geographical area so that insurers are protected from adverse selection.

This is not some obscure detail -- the risk-adjustment mechanism is the key to getting a private market to function properly.  In the current system, a potential competitor to existing insurance companies faces the risk that the small piece of the population it can compete away from established insurers will have characteristics that make them more expensive to cover.  This is the classic problem of adverse selection.  Given this risk, we have less competition among health insurers.  Without competition, existing insurers get large market shares (which helps them to some extent on the adverse selection problem).  Because they are big, they have more market power than we would like.  They also don't look to serve smaller groups or individuals to the extent we would like. 

Mandatory participation in the risk-adjustment mechanism should be required for any health insurance plan.  If the Health Insurance Exchange is the means by which that happens, then I'm all for it.

I agree with Andrew that private market-based health insurance systems cannot function well without effective risk-adjustment mechanisms.

The thing that frightens me is that I am not sure how I would go about designing a system with an effective risk-adjustment mechanism. The private market might meltdown under the pressure of guaranteed issue and community rating even with mandated purchase. Which is one reason to want a public plan there to backstop it if it does.

Jeebus! Health care-reform scares me...