Health Care Reform: Considerations for Risk Adjustment Under Community
Rating (Letter Report, 09/22/94, GAO/HEHS-94-173).

As part of the debate over health care reform, some have proposed
prohibiting insurers from denying coverage or charging different
premiums to persons on the basis of their health status. Under such a
"community rating" system, an insurer would have to charge each
potential beneficiary the same premium for a given insurance plan.
However, community rating could create financial incentives for insurers
to attract only healthy clients because these people would, on average,
pay more in premiums than they generate in claims. Insurers' profits
would depend more on the plan's ability to attract health beneficiaries
and would be less responsive to efforts to deliver high-quality service
at the lowest price. Risk adjustment can mitigate the undesirable
effects of community rating on insurers' incentives. This report
describes how the federal government's previous experience with risk
adjustment is relevant to implementing risk adjustment under health care
reform and identifies features of health care reform that could affect
the ability to adequately adjust risk.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  HEHS-94-173
     TITLE:  Health Care Reform: Considerations for Risk Adjustment 
             Under Community Rating
      DATE:  09/22/94
   SUBJECT:  Medicare programs
             Medical economic analysis
             Health maintenance organizations
             Risk management
             National policies
             Health services administration
             Health insurance
             Health care cost control
             Health insurance cost control
             Insurance regulation
IDENTIFIER:  Federal Employees Health Benefits Program
             Clinton Health Care Plan
             National Health Care Reform Initiative
             Health Security Act
             
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Cover
================================================================ COVER


Report to the Chairman, Committee on Finance, U.S.  Senate

September 1994

HEALTH CARE REFORM -
CONSIDERATIONS FOR RISK ADJUSTMENT
UNDER COMMUNITY RATING

GAO/HEHS-94-173

Risk Adjustment and Community Rating


Abbreviations
=============================================================== ABBREV

  FEHBP - Federal Employees Health Benefits Program
  HMO - health maintenance organization

Letter
=============================================================== LETTER


B-256283

September 22, 1994

The Honorable Daniel P.  Moynihan
Chairman, Committee on Finance
United States Senate

Dear Mr.  Chairman: 

Although most U.S.  citizens have health insurance coverage, the
Congress remains concerned that individuals with chronic health
conditions may be unable to purchase health insurance at an
affordable rate.  To remedy this problem, some have proposed
regulations that would prohibit insurers from denying coverage or
charging different premiums to different individuals based on their
health status.  Under these regulations, an insurer must charge each
potential beneficiary the same premium for a given insurance plan. 

Such a system of "community rating" will affect both beneficiaries
and insurers.  Among beneficiaries, the healthy will subsidize the
cost of care for the less healthy--raising existing premiums for some
individuals and lowering them for others.  For insurers, community
rating will create financial incentives to attract only healthier
clients because these people will (on average) pay more in premiums
than they will generate in claims.  Insurers' profits will depend
more on the plan's ability to attract healthier beneficiaries and
will be less responsive to efforts centered on providing high-quality
service at the lowest price. 

Risk adjustment can reduce the undesirable effects of community
rating on insurers' incentives.  Under risk adjustment, individuals
pay the same premium regardless of their health status, but the
premium payments received by the insurers are adjusted to reflect the
differences in individuals' expected health care costs.\1 Although
the major reform proposals call for risk adjustment, the specifics of
how best to implement risk adjustment have not been thoroughly
researched.  Consequently, current health care reform proposals do
not prescribe a specific methodology to implement the risk adjustment
process. 

Because of the congressional interest on this subject, you asked that
we examine issues concerning risk adjustment under health care
reform.  Specifically, our objectives were to describe how the
federal government's previous experience with risk adjustment is
relevant to implementing risk adjustment under health care reform and
to identify features of health care reform that could affect the
ability to adequately risk adjust.  For our review, we collected and
reviewed the literature on risk adjustment and interviewed risk
adjustment experts.  Our analysis also draws on our previous work on
risk adjustment in the context of the Medicare risk contract
program.\2


--------------------
\1 Risk adjustments are generally made prospectively, based on the
individual's expected--rather than actual--health care costs. 
Therefore, risk adjustment can protect insurers against the
predictable risk of insuring individuals with chronic conditions, but
not against random, unexpected events. 

\2 See Medicare:  Changes in HMO Rate Setting Method Are Needed to
Reduce Program Costs (GAO/HEHS-94-119, Sept.  2, 1994). 


   RESULTS IN BRIEF
------------------------------------------------------------ Letter :1

Unless payments received by insurers are risk adjusted, the goal of
community rating--to have affordable, comprehensive health insurance
available to those who need it most--may be compromised.  Community
rating creates strong incentives for insurers to avoid the less
healthy, which conflicts with the concept that community rating would
expand access to those same beneficiaries.  In addition, these
incentives conflict with another goal--having insurers compete to
provide the best quality services at the lowest price.\3

By mitigating or removing these incentives, risk adjustment can
temper the unwanted consequences of community rating.  However, the
effectiveness of the risk adjustment will depend on the
characteristics of the health care system in place.  Unfortunately,
past experience is insufficient to project which risk adjustment
methodology would be best for any given reform proposal. 

The federal government has more than a decade of risk adjustment
experience through Medicare's risk contract program for health
maintenance organizations (HMOs).  However, the various reform
proposals do not replicate many characteristics of the Medicare
program.  Therefore, the Medicare experience with risk adjustment
should be interpreted cautiously.  In Medicare's experience, a simple
risk adjustment scheme proved insufficient to remove selection bias,
leading researchers to suggest more complex methods.  Although none
of the major health care reform proposals details a specific
methodology for risk adjustment, at least two recognize the
possibility that health care reform may require a more complex
methodology than that used for the Medicare program.  Nonetheless,
because of the significant differences between Medicare and health
care reform, it is uncertain whether Medicare's risk adjustor, or any
of the more complex alternatives, would be preferable under health
care reform. 

Assessing the extent of the selection bias problem under the
different reform proposals might help determine whether a simple or
complex risk adjustment methodology might be more appropriate for a
given proposal.  However, such an assessment could be overwhelming
because many aspects of health care reform can affect selection bias. 
Some of these aspects include the size and diversity of each risk
adjusted pool of individuals, requirements that purchasing groups
include types of HMOs and indemnity insurers, and the degree to which
benefit packages are standardized.  Other features of reform
proposals could also affect the integrity of the risk adjustment
process.  For example, as the number of participants in the risk
adjusted sector grows as a percentage of all beneficiaries, selection
bias derived from excluding certain groups may decline, but the
availability of useful data for risk adjustment would also diminish. 
Further, facets of some reform proposals--for example, overall
spending limits or enhanced coverage for underserved
populations--could distort the risk adjustment process so that
payments to insurers do not closely reflect expected costs. 

Because many of these features of health care reform are still
untried, substantial uncertainty surrounds risk adjustment under
health care reform.  Although this uncertainty will undoubtedly make
risk adjustment choices less obvious, these choices need to be made. 
Otherwise, selection bias would likely persist and ultimately
undermine health reform's ability to meet its goals, such as expanded
access and containing health care costs while maintaining quality. 
The necessity--as well as the uncertainty--of risk adjustment efforts
seems to point toward a flexible system, continuously monitored and
improved as the health insurance market continues to change. 


--------------------
\3 Over some period of time, such misplaced incentives for insurers
could lead to lower quality, higher prices, and limited access for
the less healthy. 


   BACKGROUND
------------------------------------------------------------ Letter :2

Some U.S.  citizens have no health insurance.  In addition, those who
need health insurance the most--individuals with chronic
illnesses--may lose their coverage, may be priced out of the health
insurance market, or may be unable to obtain health insurance at any
price.  Responding to the inability of the sick to obtain health
insurance, several health care reform proposals would implement a
system of community rating--that is, insurers would be required to
charge the same premium to all individuals in the same "community."\4
\5 Under community rating, for each health plan the relatively
healthy members would subsidize the health care of the relatively
sick--that is, the relatively healthy would pay premiums that exceed
the expected cost of their care, while the relatively sick members
would pay premiums that are insufficient to cover the expected cost
of their care. 

Since community rating drives a wedge between what an individual pays
as a health insurance premium and the cost the insurer can expect to
incur for his or her care, it alters the incentives of both consumers
and insurers in the health insurance market.  Healthy individuals
would be less likely to want health insurance because they would
generally pay significantly more than the costs they expect to avoid. 
Under New York's recently enacted community rating requirement, for
example, some younger and healthier individuals have dropped their
health insurance coverage because of increases in premiums. 
Insurers, however, would have an incentive to enroll these healthy
individuals, again because their premiums would exceed the expected
cost of their care.\6

For the sick, the opposite would be true--health insurance would be a
bargain for them as they could expect to receive more in health care
than they would pay in premiums.  Insurers would have an incentive to
avoid such individuals--on average, these clients would generate more
in health care costs than the insurer could expect to recover from
their premiums.  While insurers could not selectively increase prices
to discourage the sick from enrolling, they could eliminate some
discretionary services likely to appeal to sicker clients, like
prescription drugs. 

Requirements that all individuals obtain health insurance could
prevent healthy individuals from opting out of the health insurance
market, but universal coverage cannot eliminate insurers' incentives
to increase profits by avoiding individuals expected to generate high
health care costs.  An uneven distribution of risk across insurers is
often referred to as selection bias, and an insurer that succeeds in
attracting only relatively healthy clients enjoys favorable
selection.  Selection bias can arise either because sicker people may
be more or less attracted to a particular health plan or because
insurers actively compete to enroll only the healthiest
individuals.\7 Competition based on selection may result in some
individuals being denied coverage; further, competition for favorable
selection could also distract insurers from competing in more
beneficial ways--for example, by offering higher quality care at a
lower price. 

Regulatory or administrative provisions may help to limit selection
bias.  For example, several proposals prohibit insurers from denying
coverage based on a pre-existing health condition.  However, such
regulations do not remove the incentive for insurers to court
favorable selection--they only make such efforts more difficult. 
Risk adjustment, however, can reduce or remove the incentive to
pursue favorable selection.\8 Under risk adjustment, insurers that
attract a sicker-than-average pool of beneficiaries will receive
payments (essentially from other insurers) that exceed what they
collect in premiums, while insurers that attract a
healthier-than-average pool will receive less than they collect in
premiums. 

The process for risk adjusting premiums involves three steps: 

  Identify the risk adjustment variables--a variety of observable
     factors that can be used to estimate the expected cost of health
     care for each individual.  Candidates for this collection of
     risk factors include age, sex, a measure of health status, and a
     measure of socioeconomic status.\9

  Estimate the relationship between each of these factors and the
     cost of appropriate health care. 

  Use these estimated relationships as a basis for transferring funds
     from insurers with (expected) low-cost risk pools to those with
     high-cost pools.\10

While the concept of risk adjustment and the basic steps to implement
it are well understood, a number of theoretical and practical issues
must be resolved in designing a risk adjustment process for any given
health care system.  A federal, state, or local authority must
specify the risk adjustment variables, collect data on these factors,
conduct the estimation, and redistribute funds among insurers.  Many
health care reform proposals recognize the need for risk adjustment
and mandate the development of a risk adjustment mechanism.  However,
none of these proposals specifies an explicit risk adjustment
methodology.  Instead, these proposals place the responsibility of
specifying the risk adjustment mechanism with government agencies or
quasi-public organizations.  The health care reform proposals differ
on the level--federal, state, or purchasing group--at which risk
adjustment would be administered.  In addition, under some proposals,
risk adjustment would apply to the entire population, but in others,
as much as 50 percent of the population may be beyond the reach of
the risk adjustment requirement.  (For a more detailed description of
the implementation issues surrounding risk adjustment under health
care reform, see app.  I.)

Decisions on how to best implement risk adjustment are complicated by
tradeoffs among desirable criteria for a risk adjustment process and
also by the limited information available on alternative risk
adjustment systems.  Many potential risk adjustment systems remain
untested, and those that have been implemented have been used under
different circumstances from those any health care reform proposal
might produce.  In addition, resolving many of these risk adjustment
issues would require judgments that may be best decided in a
political context. 


--------------------
\4 Some reform proposals allow for "modified" or "adjusted" community
rating, in which individuals' premiums are allowed to vary from the
community rate based only on age or sex (or both). 

\5 For the purpose of setting premiums, communities can be defined by
geographic area, employer, or membership in a purchasing cooperative
or other organization. 

\6 Although insurers would be prohibited from offering discounts to
healthier clients, they could provide additional services and
benefits most likely to appeal to healthy clients, such as fitness
memberships. 

\7 For example, insurers could attract healthy clients by advertising
their health plans in physical fitness publications. 

\8 Risk adjustment may advance other purposes as well--for example,
risk adjustment may be a necessary (although not sufficient) measure
to guard the financial solvency of participating health insurers.  In
addition, risk adjustment could be used to direct resources towards
particular populations.  However, this use of risk adjustment may
distort the risk adjustor's ability to guard against selection bias. 

\9 Some health care costs arise because of unavoidable, unpredictable
accidents.  Although these unforeseeable costs do not create
incentives for health insurers to seek favorable selection, the
nonrandom, foreseeable variation in health care costs--such as that
arising from chronic conditions--does create selection incentives. 
To succeed in reducing biased selection, the risk adjustment
variables need only account for the nonrandom variation in health
care costs.  However, premium contributions could also be adjusted
based on the insurer's prior or current expenditures.  This type of
adjustment, also called reinsurance, is designed to protect insurers
not only from risk arising from nonrandom variation in health care
costs but from risk arising from random events as well. 

\10 Risk adjustment could be implemented for a given individual,
family, or other designated unit.  Each reform proposal recognizes
that to minimize selection bias, the unit of risk adjustment should
correspond to the level at which choice is exercised.  For example,
if an individual can choose coverage, then risk adjustment should
occur at the individual level.  However, if families as a whole
choose coverage, then risk adjustment at the family level would also
be appropriate. 


   PRINCIPAL FINDINGS
------------------------------------------------------------ Letter :3


      GOVERNMENT'S EXPERIENCE WITH
      RISK ADJUSTMENT IS LIMITED
      IN BOTH SCOPE AND SUCCESS
---------------------------------------------------------- Letter :3.1

Selection bias has been a serious concern in both the Medicare
program and the Federal Employees Health Benefits Program (FEHBP). 
In FEHBP, premiums for a given insurance plan vary based on the past
experience (and thus the health status) of the plan's enrollees. 
This has resulted in some plans--that attract sicker
enrollees--charging substantially higher premiums than other plans
that have succeeded in attracting healthy clients.  In addition,
incentives for FEHBP insurers to attract healthy clients appear to
have discouraged insurers from offering more generous benefit
packages to federal workers.  These consequences of selection bias
have prompted some analysts to recommend that FEHBP incorporate risk
adjustment. 

In Medicare's risk contract program for HMOs, concern over favorable
selection led to the establishment of a risk adjustment system.  In
fact, that system provides the government's longest running
experience with risk adjustment (over 10 years).\11 To guard against
selection bias in this program, Medicare uses risk adjustment to
modify HMO payment rates based on beneficiaries' age, sex, Medicaid
eligibility, and whether the beneficiary is in a nursing home. 
However, despite both risk adjustment and extensive administrative
controls, HMOs in the Medicare risk contract program have continued
to benefit from favorable selection.  Responding to this problem,
analysts have urged Medicare to include a measure of health status,
in addition to demographic variables, in its risk adjustment
process.\12 \13 However, the lessons to be learned from the
government's experience with Medicare are limited by the extensive
differences between the Medicare risk contract program and the health
care reform proposals.  Consequently, Medicare's experience does not
readily address several issues under health care reform. 

Specifically, while the Medicare program provides health care to the
population aged 65 and over,\14 under health care reform, one payment
system may cover people of all ages.  This difference in the
population included may limit the conclusions we can draw from
Medicare about specific risk adjustment mechanisms.  For example, a
risk adjustor that performs well in the over 65 population may be
less successful at preventing selection bias in the overall
population.\15 Further, under the Medicare program, both
beneficiaries and health insurers can choose to remain outside the
risk adjusted (HMO) sector.  This freedom of movement can amplify the
selection bias problem, as individuals can quickly change health
plans if they become ill and insurers can exit the small risk
adjusted sector if they are not profiting sufficiently.  Under health
care reform, individuals may not have the ability to move in and out
of the risk adjusted sector, and a health plan that does not
participate in the local risk adjustment pool may find itself out of
the market in that entire geographic area.  In addition to these
differences, risk adjustment may also affect (or be affected by)
other provisions of health care reform--such as overall spending
limits, the structure of purchasing cooperatives, the availability of
necessary data, and other factors.  The regulations and the structure
of the different reform proposals may provide the only real basis for
a discussion of these issues. 


--------------------
\11 For more information about risk adjustment under the Medicare
risk contract program, see Medicare:  Changes to HMO Rate Setting
Method Needed to Reduce Program Costs. 

\12 For example, alternative measures of health status could be based
on diagnosis codes, prior use of medical services, or self-reported
health status. 

\13 For a description and an evaluation of these alternative
proposals concerning the Medicare program, see Medicare:  Changes to
HMO Rate Setting Method Needed to Reduce Program Costs. 

\14 Certain disabled people under 65 are also eligible for the
Medicare program, but 89 percent of Medicare beneficiaries are aged
65 or over. 

\15 For example, a risk adjustment mechanism based on inpatient
(hospital) data may better suit the over 65 population, in which
hospitalization is more frequent, than the under 65 or overall
populations. 


      CRITERIA TO EVALUATE
      ALTERNATIVE RISK ADJUSTMENT
      PROPOSALS
---------------------------------------------------------- Letter :3.2

In our work on risk adjustment in the Medicare risk contract program,
we identified operational criteria for evaluating alternative risk
adjustment schemes.  Specifically, a good risk adjustment scheme
would (1) be able to predict health care costs with accuracy, (2)
treat participating HMOs reasonably and fairly, (3) be difficult for
participating health plans to manipulate, (4) respect patient privacy
and confidentiality, (5) create incentives for appropriate care, and
(6) be feasible and inexpensive to administer.  Tradeoffs exist among
these criteria, making it more difficult to choose the best risk
adjustor.  For example, a more complex risk adjustment method may be
more successful in reducing favorable selection, but may do so only
at a relatively high administrative cost. 

Any evaluation of alternative risk adjustment systems using these
criteria must be made in the context of the health care system as a
whole.  For example, the potential for selection bias can affect the
choice of risk adjustment mechanism.  If the health care system is
designed to minimize selection bias (for example, if the
administrative means against selection bias are particularly strong),
then less predictive power is required of the risk adjustor, and a
simpler system, which minimizes administrative burden, may suffice. 
However, if the structure of the health care system leaves
substantial room for selection bias, greater demands will be placed
on the risk adjustment system.  In these circumstances, a more
sophisticated, complex risk adjustor may be required.  Other features
of the health care system may also affect the optimal risk adjustment
choice.  For example, if Medicaid and Medicare beneficiaries are
included in the risk adjustment sector, the risk adjustment variables
must account for factors that drive health care costs in the elderly
and low-income populations.  In addition, administrators' ability to
successfully risk adjust may depend on the availability of extensive
data on both individual risk factors and on the cost of providing
appropriate medical care.  Features of the health care system--such
as providing new services or imposing global spending limits--that
may constrain data availability could thus make risk adjustment more
difficult. 


      FEATURES OF HEALTH CARE
      REFORM COULD DETERMINE THE
      EFFECTIVENESS OF THE RISK
      ADJUSTMENT PROCESS
---------------------------------------------------------- Letter :3.3

The extent of selection bias under health care reform remains
unknown.  Medicare's experience indicates that selection bias can
persist under a health care system with administrative controls and
demographically based risk adjustment.  However, the extent of
selection bias under health care reform will depend on many features,
each of which differs among the various health care reform proposals. 
Selection bias will result when "good" and "bad" risks can be easily
distinguished and separated for insurance purposes.  This market
segmentation can result from both insurers' and consumers' choices,
but the structure of the health insurance market can restrict or
expand those choices.  For example, provisions that restrict
insurers' ability to design benefit packages that attract healthy
individuals (for example, by including health club memberships) can
cut selection bias; regulations that limit individuals' ability to
change insurers can also reduce selection bias.  In addition, if the
risk adjusted sector contains a diverse group of healthy and sicker
individuals, risk adjustment within that sector can distribute
payments based on the cost of providing care.  However, if the
healthy and sick individuals are divided into separate sectors, risk
adjustment within each sector will be insufficient to distribute
financial risk, and the pools containing the high-risk clients will
have to increase premiums to maintain these individuals' coverage. 
This phenomenon remains a serious concern in the FEHBP program.  (For
a more detailed discussion of the relationship between market
segmentation, selection bias, and consumer choice, see app.  II.)


         DATA CONSTRAINTS MAY
         LIMIT ADMINISTRATORS'
         ABILITY TO EFFECTIVELY
         RISK ADJUST
-------------------------------------------------------- Letter :3.3.1

Risk adjustment involves identifying risk-related factors (such as
age, sex, and health status) that are observable and useful in
predicting individuals' expected cost of appropriate care. 
Difficulties in implementing risk adjustment may arise because both
these concepts--the risk-related factors and the expected cost of
appropriate care--are difficult to measure.  Estimates of the
relationship between the two--when each is observed
imperfectly--accordingly become less precise.  In addition, efforts
to improve the risk adjustment process by including more and better
risk-related measures may involve tradeoffs in higher administrative
burden, less equity of burden across regions, and greater exposure to
violations of privacy and confidentiality standards.  (For a more
detailed discussion of data issues involved in risk adjustment, see
app.  III.)


         RISK ADJUSTMENT PROCESS
         CAN BE COMPLICATED BY
         SPENDING LIMITS AND
         REDISTRIBUTION EFFORTS
-------------------------------------------------------- Letter :3.3.2

Several health reform plans would establish spending limits to hold
down health care costs, and some reform proposals would provide
increased payments for hard-to-serve areas or populations.  Whatever
the benefits of these two proposals, each could disrupt the link that
risk adjustment establishes between the cost of health care and the
payments health insurers receive.  As part of the risk adjustment
process, measures of risk-related factors are assigned numerical
weights that correspond to the relationship between these factors and
health care costs.  Each factor's weight is determined by statistical
analysis.  If the weights are determined by an overall administrator,
rather than by statistical estimation, the resulting payment rates
for participating health plans will correspond less closely to
expected health care costs.  Such a disparity between payment rates
and expected costs provides an increased incentive for insurers to
pursue selection strategies. 

For example, the effect of increased payment rates for hard-to-serve
areas or populations may also affect the factor weights for risk
adjustment.  Specifically, to the extent that the increased payments
reflect any additional health care costs associated with serving
these areas or populations, the determination of those increased
payments would appropriately be done statistically through the risk
adjustment process.\16 However, if a greater share of beneficiary
premiums are diverted to hard-to-serve areas, but this reallocation
does not reflect health care costs, the risk adjustment factors will
be distorted. 

A binding spending limit (also called a global budget), combined with
universal care, can intensify selection incentives.  When universal
care and global budgets are combined, one provider's gain is
another's loss--for every provider who successfully avoids a
high-cost patient, another provider must treat one.  Therefore,
having an accurate risk adjustor to remove the incentive to avoid the
high-cost patient can become more important.  However, the global
budget may make it more difficult to calculate the risk adjustor
accurately. 

When the global budget becomes binding, payment reductions must be
distributed so that insurers are still compensated accurately for the
cost of providing appropriate care to sicker individuals.  Whether
these limits are structured to reduce plan payment rates by a fixed
percentage or by a fixed amount per individual, they may distort the
relationships between risk adjusted payments and the cost of
appropriate care.  In addition, the global budget may constrain some
sectors of the health care system (hospitals or physicians, for
example) more than others.  Treatment that requires more extensive
resources from these sectors will be constrained, and therefore the
limited payment received by the insurer for treating such cases may
be insufficient to cover the cost of appropriate care for that
individual.  In this case, then, risk adjustment will not remove the
incentive for the insurer to discourage such people from enrolling,
and insurers who enroll large numbers of such people will be at a
financial disadvantage compared to other insurers. 


--------------------
\16 However, incorporating these additional services into risk
adjustment may be difficult.  Currently, the services associated with
these additional costs have often gone unprovided.  Therefore, data
necessary to incorporate this cost into the risk adjustment process
are not yet available. 


   CONCLUSION
------------------------------------------------------------ Letter :4

In a community rating environment, payments to health insurers should
be risk adjusted.  Without an effective risk adjustment system,
selection bias will ultimately undermine the health care system's
ability to achieve its goals--including expanded coverage and cost
containment.  However, choosing among available risk adjustment
methods will be difficult in the context of health care reform
because the new health care system is not yet developed.  Although no
one aspect of health care reform will forestall effective risk
adjustment, its success will depend on numerous features of the
health care system in combination.  Therefore, anticipating how
effective any risk adjustor will be under any given reform proposal
is impossible.  Given this uncertainty, those responsible for
choosing a risk adjustment mechanism should consider the
interdependence between risk adjustment and specific features of the
health care system.  In doing so, they should also recognize the
desirability of considering alternative risk adjustment methodologies
on a continuous basis and particularly as the new health care system
evolves. 

As agreed with your office, unless you publicly announce its contents
earlier, we plan no further distribution of this report until 30 days
after its issue date.  At that time, we will send copies to
interested congressional committees and make copies available to
others on upon request.  If you or your staff have any questions
about this report, please contact me at (202) 512-7119.  Major
contributors to this report are listed in appendix IV. 

Sincerely yours,

Sarah F.  Jaggar
Director, Health Financing
 and Policy Issues


HEALTH CARE REFORM PROPOSALS CALL
FOR RISK ADJUSTMENT, BUT REFLECT
UNCERTAINTY ABOUT ITS POTENTIAL
EFFECTIVENESS
=========================================================== Appendix I

Many health care reform proposals would impose some form of
community-rated premiums, so that health insurers could not charge
different prices to members of the same group.  Further, because
these proposals generally recognize that community rating can create
incentives for insurers to avoid high-cost individuals, they
incorporate provisions for risk adjustment.  However, despite this
general agreement that risk adjustment is necessary, none of these
proposals specifies an explicit risk adjustment mechanism.  In
addition, these bills vary in how they would implement a risk
adjustment system, how much they would rely on administrative or
regulatory means to reduce selection bias, and how much of the
insured population would be subject to risk adjustment. 


   MAJOR HEALTH BILLS DO NOT
   SPECIFY RISK ADJUSTMENT FORMULA
--------------------------------------------------------- Appendix I:1

The health care reform proposals do not specify the variables to be
used for risk adjustment.  Instead, these bills assign the task of
developing a risk adjustment formula to some government or
quasi-governmental entity--for example, the Department of Health and
Human Services or the National Association of Insurance
Commissioners.  At least two proposals suggest that the risk
adjustment formula might include demographic characteristics, health
status, geographic area of residence, socioeconomic status, and the
proportion of residents in a given area who receive welfare benefits
from Supplemental Security Income or Aid to Families with Dependent
Children.  However, although both proposals specifically mention this
list of variables, neither of these two proposals specifies how
health status or demographic characteristics are to be measured. 


   HEALTH CARE REFORM PROPOSALS
   DIFFER IN HOW THEY ASSIGN RISK
   ADJUSTMENT RESPONSIBILITIES
--------------------------------------------------------- Appendix I:2

While each of these major health care reform proposals calls for risk
adjustment, the bills differ on several key implementation questions. 
Specifically, the proposals differ in the level--federal, state, or
local--at which risk adjustment would be developed and implemented. 
Although some proposals would develop a risk adjustment mechanism at
the federal level, they generally allow states considerable
flexibility--for example, several proposals would allow states to use
a different set of risk adjustment factors from those identified at
the federal level.\17 Furthermore, some proposals specifically allow
for adjustments to the risk adjustment formula to increase the access
of traditionally underserved populations to health care. 


--------------------
\17 Under most of these bills, states must gain the permission of the
federal government before exercising this flexibility. 


   THE EXTENT OF RISK ADJUSTMENT
   VARIES ACROSS THE REFORM
   PROPOSALS
--------------------------------------------------------- Appendix I:3

The various health care proposals also differ in the extent of the
population subject to risk adjustment.  For example, under several
bills, the risk adjustment mechanism would be applied only to that
segment of the population enrolled in the purchasing groups that the
bills create.  Between 20 and 50 percent of the population would
likely obtain health insurance outside of the purchasing groups and
thus would be beyond the reach of both the risk adjustment and
community rating requirements.  In contrast, several other proposals
call for risk adjustment of insurance premiums for the entire
population. 


   PROPOSED BILLS ALSO RELY ON
   REGULATIONS TO LIMIT SELECTION
   BIAS
--------------------------------------------------------- Appendix I:4

The major health care reform proposals would rely on regulatory or
administrative means, in addition to risk adjustment, to limit
selection bias.  The comprehensiveness of these administrative means
would affect the seriousness of the selection bias problem and would
thus help to determine how accurate the risk adjustor must be.  For
instance, most reform proposals would (1) prohibit or reduce
insurers' ability to limit or deny coverage based on a pre-existing
medical condition, and/or (2) limit insurers' ability to use
marketing to attract healthy clients and discourage sicker ones. 


DIVERSITY OF POPULATION AND RANGE
OF CHOICES IN RISK ADJUSTED SECTOR
WILL AFFECT EXTENT OF SELECTION
BIAS PROBLEM
========================================================== Appendix II

The size of the risk adjusted sector (state or purchasing group, for
example) is not necessarily crucial to the risk adjustor's success. 
Because risk adjustment is designed to capture only nonrandom
variation in health care costs, increasing the size of the risk
adjustment pool will not by itself cut selection bias.\18 However,
the diversity of the population to which risk adjustment applies will
affect the potential for selection bias.  If populations within risk
pools are diverse, the resulting selection bias can be mitigated by
risk adjustment within that pool.  However, if population diversity
extends largely across risk pools, those pools containing the
high-risk clients will have to increase premiums to maintain
coverage. 


--------------------
\18 However, increasing the size of the pool may help insure health
plans against random risks.  A reinsurance mechanism, designed to
protect insurers' financial solvency against random risk, may thus be
more important for areas and insurers with small populations. 


   CORPORATE OPT-OUT PROVISIONS
   AND GEOGRAPHIC BOUNDARIES MAY
   AFFECT DIVERSITY OF RISK POOL
-------------------------------------------------------- Appendix II:1

Several health care proposals would allow or require corporations
over a certain size to provide insurance outside a regional
purchasing group.  These corporations would have an incentive to opt
out of the regional purchasing groups only if they expect to save
money by doing so.  Companies with healthier-than-average workforces
would generally have this incentive as their employees will use fewer
health care services than the average person in the risk adjusted
purchasing group pool.  Therefore, a system that allows for greater
choice in purchasing group participation may create more
opportunities for selection bias.  If some firms can opt out, or if
joining the purchasing group is completely voluntary, then the firms
with lower health costs are more likely to be concentrated in the
corporate plans, and the firms and individuals with higher costs may
all end up in the regional purchasing group.  Under these
circumstances, risk adjustment within the purchasing group is not
sufficient to distribute risk across health plans in the overall
health care system.  In addition, firms that opt out of the
purchasing group (and negotiate lower community rates than available
in the purchasing group) may base future employment decisions--about
both hiring and retention--on expected health care costs, preserving
a distortion present in the current employer-based system.  This
result would conflict with a goal of several health reform
proposals--reducing "job lock" among employees. 

Another factor affecting the inclusiveness in the risk adjustment
pool is the geographic area over which this pool is defined.  Larger
geographic areas are likely to be more diverse in health status and
utilization patterns, increasing the demands on the risk adjustment
system.  However, smaller purchasing groups may make risk adjustment
within each individual purchasing group--no matter how
sophisticated--insufficient to adequately reduce incentives for
selection.  If health status is relatively homogeneous within the
purchasing group, but diverges across purchasing group boundaries,
purchasing groups of higher cost consumers will have to charge higher
premiums to maintain coverage and health plans may choose not to
participate in higher cost risk pools or health purchasing groups.\19


--------------------
\19 For a more extensive discussion of geographic boundary issues in
health care reform, see Health Care Alliances:  Issues Relating to
Geographic Boundaries, (GAO/HEHS-94-139, Apr.  8, 1994). 


   RESTRICTIONS ON CONSUMER CHOICE
   MAY AFFECT EXTENT OF SELECTION
   BIAS
-------------------------------------------------------- Appendix II:2

Segmentation within the risk adjustment pool could result not only
from the actions of insurers, but also from the voluntary choice of
consumers.  Sicker consumers may flock to one insurer based on its
reputation, choice in physicians, or benefits.  For this reason, the
extent of the selection problem will depend not only on the
population within the risk adjustment pool but the choices available
to consumers.  As a result, the type of health plans available in a
given local area may increase or decrease the potential for selection
bias. 

For example, traditional fee-for-service plans, which offer fewer
restrictions on physician choice, may attract a sicker clientele than
a staff model HMO, where patients are treated in clinics by staff
physicians.  Similarly, health plans that contract with specialized
academic medical centers may attract the more severely ill, creating
a greater need for risk adjustment.  Therefore, the diversity in the
type of plans available in a given geographic area may influence the
degree of selection bias there.  If a geographic area contains many
small staff-model HMOs and one large fee-for-service plan, we may
expect to see more selection bias in this purchasing group than in a
comparable area served by an array of health care plans, including
Independent Practice Association managed care plans and HMOs with
point-of-service options.  Under a point-of-service plan, HMO
beneficiaries have the option of receiving care outside of the HMO
for an additional fee.  Point-of-service plans may reduce the
potential for selection bias if they reduce the reluctance of sicker
individuals to join HMOs. 

Selection bias can also be influenced by individuals' ability to
change their health insurers.  Selection bias can arise when
individuals change health plans because of changes in health
status--for example, an individual enrolled in an HMO who is
diagnosed with a serious illness may decide to join a fee-for-service
plan with no restrictions on the choice of specialists.  Restrictions
on when an individual can change health insurers can help contain
selection bias by limiting this switching behavior.\20 Such
regulations have disadvantages, however.  Disenrollment restrictions
could prevent consumers from leaving a poor-quality health plan, and
could also discourage some consumers from joining a managed care plan
or a newer, less established health plan. 

Selection bias can also be affected by variation in insurers' benefit
packages.  Health insurers can manipulate benefit packages to create
opportunities for favorable selection.  When a health insurer has
information on consumers' willingness to pay for extra benefits, the
insurer can use this information for selection purposes.  For
example, sicker people (who expect to use a lot of prescription
drugs) are more likely to look for a health plan with a more generous
prescription drug benefit--however, health plans will have an
incentive to discriminate against people who want such a benefit. 

Although variation in benefit packages can allow insurers to better
respond to consumer needs, benefit package variation may also
exacerbate favorable selection and reduce price competition between
health plans.  Because of these variations in individuals' demands
for different services, benefit package variations may also make
consumers less responsive to differences in the prices of various
plans.  For example, the parents of a child with a psychiatric
disorder will likely restrict their choice of health plan to those
including family mental health benefits.  The FEHBP program has seen
insurers become less willing to offer more generous benefits--such as
mental health coverage--out of fear that such benefits will attract a
sicker population, driving up prices and limiting the plan's appeal
to federal workers. 

Several of the major health care reform bills would impose some
degree of benefit package standardization--most with a minimum
benefit package.  If the minimum benefit package is relatively
generous, this may help limit selection bias because insurers will be
less able to discriminate among consumers based on their willingness
to pay for certain services.  However, a more generous benefit
package would also be more costly--therefore, gains from reducing
selection bias this way are not free. 


--------------------
\20 For example, federal employees are allowed to change their health
insurer only once a year, unless there is a change in family
composition. 


DATA CONSTRAINTS MAY LIMIT
ADMINISTRATORS' ABILITY TO
EFFECTIVELY RISK ADJUST
========================================================= Appendix III

To discourage health insurers' efforts to court favorable selection,
the risk adjustment process must sufficiently narrow the difference
between the cost of a sicker person's care and the premium received
by the insurer.  If the difference between payment received and the
cost of care is small, it may be more costly for the insurer to
attempt a selection strategy (through marketing, for example) than
simply to accept clients without regard to health status.  Given this
goal, risk adjustment administrators might want to get more rather
than less data, as they might reasonably assume that including a
larger set of risk-related factors in the risk adjustment process
will result in improved predictions of health costs.  However, these
authorities must also recognize that adding data to the risk
adjustment process involves important tradeoffs. 

Clearly, adding data to the risk adjustment process will mean a
greater administrative burden.  For example, such additional data
could be obtained by survey, more complete record taking, or
construction from currently available data sources.  Gathering data
through any of these methods would increase administrative costs. 
Further, as additional data are included in the process, the costs of
ensuring data accuracy would also increase. 

Applying risk adjustment in different geographic regions also
presents data issues.  Across the nation, some costly health ailments
occur more frequently in some geographic areas than in others. 
Therefore, the optimal set of risk-related factors is likely to vary
across regions.  For example, a risk factor that identifies people
with black lung disease may prove to be an important indicator of
expected health costs in West Virginia, but not in California. 
Further, as the optimal risk factors vary across regions, so will the
corresponding administrative costs associated with gathering the risk
adjustment data.  In these circumstances, risk adjustment authorities
may need to address a conflict between a process that imposes a
similar administrative burden across regions versus one designed to
achieve greater predictive ability in each region. 

One last tradeoff may exist between the need to use data on certain
risk-related factors and social concerns about privacy and
confidentiality.  For example, data on individuals' health or
socioeconomic status could be the subject of such concerns.  The need
to use such data for risk adjustment could arise because of a
legislative mandate--but even without a mandate, the inclusion of
such data may be necessary for the risk adjustment process to predict
costs well enough to deter participating plans from pursuing
selection strategies.\21


--------------------
\21 For example, researchers have concluded that incorporating some
measure of health status in the risk adjustment process for the
Medicare risk contract program will be necessary to deter
participating plans from pursuing favorable selection. 


   MEASURING THE COST OF
   APPROPRIATE HEALTH CARE
------------------------------------------------------- Appendix III:1

The concept of appropriate care is central to risk adjustment. 
Ideally, the risk adjustment process should result in setting plan
payment rates at appropriate care cost levels.  This would discourage
the provision of unnecessary treatment.  Unfortunately, while setting
reimbursement at appropriate care levels may discourage
overutilization, it cannot control underutilization and thus cannot
ensure that appropriate care is provided.\22 In any event, direct
measures of the cost of appropriate care are not yet available. 

Because there is no consensus on what constitutes appropriate care,
no certainty can be associated with any estimates of its cost. 
Observed or reported costs may overstate or understate what costs
would have been for appropriate care.  From a practical standpoint,
even if appropriate care could be adequately described, there may
still be reporting or accounting-related obstructions to observing
the cost of appropriate care.  For example, if a hospital reallocates
the costs of those who cannot pay among those who can, then the
actual costs of appropriate care will not be directly observable. 

Absent reporting or accounting complications, just how closely
observable costs will correspond to the costs of appropriate care
depends on the structure of health care markets.  In a highly
competitive market, price-conscious consumers and suppliers would
limit providers' ability to charge prices that substantially exceed
their costs.  If, however, some providers are able to exercise
monopoly power in their pricing of services, then observed charges or
billings would not be an accurate reflection of actual costs, even if
those costs were for appropriate care.  Because the current market is
less than competitive, observable prices are unlikely to fully
reflect the cost of appropriate care.  If the market were to become
even less competitive under health care reform, this divergence could
widen. 

In addition, if the risk adjustment process is to successfully link
individual characteristics to the cost of appropriate care, the cost
data should be obtained from a market that is at once representative
of and isolated from the risk adjusted market area.  A representative
data set ensures that risk adjusted payments will reflect the
characteristics of the affected market.  Finding a representative
sample may be more or less difficult for some markets, depending on
the characteristics of individuals inside and outside the risk
adjusted sector. 

Cost data used in the risk adjustment process should be obtained from
markets outside of the risk adjusted sector.  (Obviously, the larger
the population in the risk adjusted sector, the more difficult it
will be to obtain such data.) The separation is necessary to help
ensure that the risk adjustment data have not been affected or
determined by previous risk adjustment efforts.  Specifically, and
depending on the relationship between insurers and providers, risk
adjusted payment rates of the previous period could affect the costs
that are then used to risk adjust payment rates for the next period. 
This could occur because insurers might arrange to reimburse
providers only for amounts not to exceed those implied by the
adjusted payment rates, and providers might insist on reimbursements
that are no less than those implied by the adjusted payment rates. 
In effect, the adjusted payment rates could effectively establish
both upper and lower limits on costs inside the risk adjusted
sector.\23 The existence of such limits would imply that costs would
be unresponsive to changing market conditions and therefore may
diverge further from appropriate care.  Although this possible
inbreeding of risk adjusted payment rates need not cause irreparable
harm to the operation of a new health care system, it could exact a
hidden cost by discouraging the rapid adoption of new innovations or
by preserving an inefficient alignment of health care resources. 


--------------------
\22 Quality assurance may be achieved through other means,
however--such as performance review and published quality reports. 

\23 Typically, however, each risk adjusted payment rate would not
correspond to a specific service.  Rather, each rate would relate to
a group of services taken as a whole, and this allows the desirable
consequence of some price flexibility among specific services within
each group, even when reimbursement rates effectively limit charges
for the group as a whole.  Fewer groups that each offered of a
greater variety of services would translate into greater price
flexibility.  However, fewer groups would be less desirable to the
extent that they represent less precise risk adjustment of payment
rates. 


MAJOR CONTRIBUTORS TO THIS REPORT
========================================================== Appendix IV

Scott L.  Smith, Assistant Director, (202) 512-7119
Sarah L.  Glavin, Project Manager, (202) 512-7180
Julie C.  Cantor-Weinberg, Evaluator

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