The interplay between risk adjustment and risk rating in voluntary health insurance

Many regulated health insurance markets include risk adjustment (aka risk equalization) to mitigate selection incentives for insurers. Empirical studies on the design and evaluation of risk-adjustment algorithms typically focus on mandatory health insurance schemes. This paper considers risk adjustment in the context of voluntary health insurance, as found in Chile, Ireland, and Australia. In addition to the challenge of mitigating selection by insurers, regulators of these voluntary schemes have to deal with selection by consumers in and out of the market. A strategy for mitigating selection by consumers is to apply some form of risk rating. Our paper shows how risk adjustment and risk rating interact: (1) risk rating reduces the need for risk adjustment and (2) risk adjustment reduces premium variation across rating factors, thereby increasing incentives for consumers to select in and out of the market.