Can the market risk adjust itself?

One of the key concerns about private plans participating in Medicare (or private plans in general) is that they may “cream skim,” or establish benefits and policies that select for healthier than average enrollees. More precisely, under Medicare, if a plan can enroll a beneficiary for which it receives a government payment (subsidy) that is above the cost of financing care for that beneficiary, it will earn additional profit at taxpayer’s expense.

Taxpayers should not be happy about this. What can be done? The standard economist’s answer is risk adjustment, that is, to pay plans more for sicker enrollees, less for healthier ones. The key is to pay just the right amount more and less so that the plan is indifferent to enrolling a sick vs. healthy individual. The extra payment for the sick and the lower payment for the healthy do not create any incentives for the plan to behave any differently than if all beneficiaries were equally healthy.

But any economist who knows enough to suggest risk adjustment as a solution to cream skimming also knows that it may be insufficient. The government is not likely to be able to know enough to risk adjust around all cream skimming. The profit motive is compelling. Plans will likely find a way to achieve favorable selection, enrollment of “good risks” relative to payment.

The problem here is that the government, with incomplete information, is telling the plans what they’ll be paid instead of the plans, which have more information, revealing their differential costs for sick vs. healthy beneficiaries. How does one get plans to reveal their costs? The standard answer is bidding.

I’ve already written about how plans could bid for government subsidies. The way that system is normally described is for plans to bid the cost of a standard, minimum set of benefits for an average risk (average health) beneficiary. The government then sets subsidies at the lowest bid and pays all plans that rate. (Traditional Medicare can be one of those plans.) Costlier plans or plans offering richer benefits must charge more to beneficiaries in the form of a premium. The incentive to keep costs low is clear. Quality monitoring and bonuses/penalties could inject incentives to provide adequate services. Low-income subsidies can protect the poor.

One normally adds that subsidies will also be risk adjusted, which under Medicare today amounts to a scaling of the average-risk subsidy (the one the plans bid on). In math, for a specific beneficiary, plans are paid an amount equal to

S = (beneficiary health risk adjustment scale factor) x (subsidy for average risk beneficiary).

But that risk adjustment scale factor need not be set by the government, as it is today under Medicare Advantage. Plans could bid on that too. The simplest way is for plans to bid a multiplier. If the current way of computing the beneficiary-specific subsidy is given as S in the equation above, plans could bid on a multiplier r that scales it:

S’ = r x S.

The actual r chosen by the government could be the one that minimizes taxpayer costs, or cost to the Medicare program. That is, the beneficiary-specific subsidy would be the lowest according to the competitive bids on the average risk subsidy and the competitive bids on the risk-adjustment multiplier. If a beneficiary wished to enroll in plan that cost more or offered richer benefits, (s)he would have to pay the marginal cost. (For this to work, i.e., for there to be some plan for which the beneficiary-specific, risk-adjusted subsidy was sufficient, the bidding would probably have to occur in stages: Stage 1, the subsidy for the average risk beneficiary is bid and set; Stage 2, the risk-adjustment multiplier is bid and set, with plans taking into consideration the average subsidy from stage 1.)

One can imagine more complex schemes like breaking up the risk adjustment schedule into segments (ranges of health risk) and having plans bid on a set of multipliers that apply to the set of segments. But those are details. The key is to recognize the distinction between harnessing a market signal (a bid) and setting values by fiat. The former puts the market to work, forcing it to reveal relevant cost information. The latter is a best guess with incomplete information. Taxpayers and beneficiaries should want the former. Provided there is sufficient competition, it would produce the lowest-cost system that minimized cream skimming. The incentive for plans to “game” the system, designing benefits to shed or deter high-risk enrollees would be relatively low.

The other important thing to recognize is the crucial role of government. It establishes the structure in which to capture the market signal conveyed through bids. That structure is critical. Without it (i.e., in what some might call a more “free market” system), the market signals are indecipherable. A market without structure is cacophony. There may be competition, but that’s all there is. There is no bidding that drives the system in the direction we would like it to go, with lower cost, higher quality, and fewer perverse incentives to game the population risk profile.

An apt analogy might be to a human and a computer. The former possesses the creativity and perspective to understand what ought to be done. The latter possesses the raw power to calculate rapidly. We would not put the computer in charge of what problems to solve, of what questions to ask. We ought not put the human in charge of rapid arithmetic. Similarly, the market can be exploited as a computing machine. It can tell us what the optimal price or risk adjustment multiplier is, but only if we set up the problem so it produces that answer. Garbage in, garbage out.

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