How does risk selection respond to risk adjustment? New evidence from the Medicare Advantage Program

To combat adverse selection, governments increasingly base payments to health plans and providers on enrollees' scores from risk-adjustment formulae. In response to evidence of plan overpayments due to selection, in 2004 Medicare began to risk-adjust capitation payments to private Medicare Advantage plans. But because the variance of medical costs increases with the predicted mean, incentivizing enrollment of individuals with higher risk scores can increase the scope for enrolling "over-priced" individuals with costs significantly below the formula's prediction. Indeed, after risk adjustment, MA plans enrolled individuals with higher scores but significantly lower costs conditional on their score, and overpayments actually increased.