Risk selection and optimal health insurance-provider payment systems

This article presents a model of the important health-policy dilemmas of risk selection and moral hazard. When providers can increase revenues by selecting favorable risks, capitation or purely prospective payment is unlikely to be optimal. A second best payment system may involve mixed levels of both demand- and supply-side cost sharing: consumers may prefer to pay deductibles and co-payments rather than to have their healthcare providers receive large financial rewards for skimping on care or discriminating against expensive-to-treat patients. Risk adjustment can improve the terms of the social trade-off between inefficient utilization and inequitable coverage. The role of professional ethics is also considered.