Risk adjustment for health insurance: Theory and implications

This paper explores the potential for welfare-improving public risk adjustm ent in health insurance markets characterized by adverse selection. The opt imal risk adjustment system is derived in a theoretical model under a range of assumptions regarding government information and market equilibrium. Sp ecial attention is focused on the interaction br ta een risk adjustment and the private transfers that can occur in markets characterized by adverse s election. Risk adjustment has the potential to improve both equity and effi ciency; however, it can also have the effect of crowding out private transf ers.