Can Risk Adjustment Save the Public Option?

Ezra Klein has a truly excellent post on adverse selection and the public option. He concludes with, “The most important factor here will be the strength of the risk adjustment in the exchanges, so keep an eye on that.”

I wonder how optimistic we can be about the degree of variation in spending predicted by risk adjustment models. I think the answer is “not very.” From the literature on health care risk adjustment (via this post):

Statistical models developed by scholars have relatively low predictive power. Predicting ten percent of the variation in [health] expenditure is considered good (e.g., Medicare Advantage’s risk adjustment model). That means ninety percent of the variation is unexplained by the model or chalked up to random error. An individual ought to be a better predictor of his or her health expenditures than a model that cannot include measures unobservable to the researcher. (How much better? I don’t know.)

Expenses for some specific services are more predictable. Drug expenses, for example, are persistent because individuals tend to use the same medications year after year. The best statistical models of drug spending can predict about 55% of the variation in next year’s drug expenses, leaving 45% to random error.

That puts a reasonable cap at 55%, but only for very persistent services, like drugs. Expect the best overall risk adjustment to be no worse than 10% and no where near as good as 55%.

Private insurers should not be so worried but taxpayers should. The public plan looks game-able.(*)

(*) A wonky note: It isn’t game-able because the risk adjustment model is of low power. It is game-able because insurers likely have access to information not observable to researchers and omitted from the risk adjustment model, which makes it lower power than it could otherwise be. The risk adjustment model was developed in a political environment in which the insurers were participants.

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