Community Rating in Health Insurance: Trade-Off between Coverage and Selection

Abstract

We analyze the role of community rating in the optimal design of a risk adjustment scheme in competitive health insurance markets when insurers have better information on their customers' risk proles than the sponsor of health insurance. The sponsor offers insurers a menu of risk adjustment schemes to elicit this information. The optimal scheme includes a voluntary reinsurance option. Additionally, the scheme should sometimes be complemented by a community rating requirement. The resulting inefficient coverage of low-cost types lowers the sponsor's cost of separating different insurer types. This allows the sponsor to redistribute more rents from low-cost to high-cost consumers.

Keywords: health insurance, cherry picking, risk adjustment, mechanism design

JEL Classification: I13, D02, D47