This is going to be geeky, even for me.
Yesterday, we talked about a new paper about the variance of the residuals after risk adjustment. The TLDR of that paper is that risk is risky for insurers and therefore insurers will either charge higher premiums to compensate for residual risk or find ways to screen for risk on the residual.
This got me thinking last night. I’m done with my comprehensive exams and can devote head space to fun projects again. One of the projects that I’m revising this morning is reinsurance. Reinsurance is a source of funds that pay for some segment of high cost claims. The ACA has an unusual reinsurance program in that it is not the only risk equalization measure. The ACA also has substantial risk adjustment. This produces weird incentives.
Let’s imagine a state has a reinsurance program where it pays 50% of the claims between $50,000 and $250,000. The maximum payment is $100,000. Let’s work through a simple example. Imagine an idiosyncratic event such as a failed assassination attempt by a cat who was quite disappointed that you were five minutes late feeding them, and the recovery leads to a $200,000 allowed amount on the claim, the insurer pays the first $50,000, and then splits the next $150,000 in half. The insurer will be on the hook for a total of $125,000. This is straightforward. Incentives aren’t particularly weird here.
Now let’s take another $200,000 claim in the ACA. Let’s imagine that this is for maintenance therapy for someone with well controlled hemophilia. The insurer again pays the first $50,000 on the claim, and then splits the next $150,000 so that the net spend for the insurer is $125,000. This is just like the cat assassination scenario. HOWEVER THERE IS SOMETHING ELSE GOING ON. Risk adjustment comes into play for predictable expenses. Risk adjustment is a transfer from insurers that cover populations that code as predictably low cost to insurers whose populations code as predictably expensive. A hemophilia diagnosis is worth about 73 times the standard statewide average premium. This means the insurer gets a transfer receivable between $400,000 to $600,000 depending on the state.
This is weird.
The insurer faces a $200,000 claim but gets at least $400,000 from risk adjustment! This is okay-ish as risk adjustment is supposed to be about group fit. But it creates a profitable residual for the insurer for this particular individual which is what the paper we talked about yesterday plays with. Risk adjustment assumes that on average, an insurer that gets lucky with an individual with a profitable residual will also get unlucky with a patient in the same risk adjustment bucket who costs more than the average payment. The residuals are assumed to sum to zero over a large enough group. But there is more.
The insurer also gets a $75,000 payment from the state reinsurance fund. NOW THAT IS MESSED UP!
Reinsurance is supposed to eat risk. For a profitable residual individual, the insurer faces absolutely no tail risk. In this scenario, reinsurance is a pure transfer to the profit side of the insurer ledger without buying out risk or anything else.
This is problematic.
States that have reinsurance programs should modify their programs so that the reinsurance payment is only paying for the residual after risk adjustment. In the scenarios I laid out above, reinsurance would still kick in for the cat assassination attempt but it would not kick in for the individual with well managed hemophilia. Instead, states should, for the same budget, devote more funds to conditions that poorly risk adjust or don’t risk adjust at all such as one off genetic diseases, and conditions with high residual variance like hemophilia. Doing that reduces selection incentives within a risk adjustment category.