By JONATHAN HALVORSON

Risk adjustment in health insurance is at first glance, and second, among the driest and most arcane of subjects. And yet, like the fine print on a variable-rate mortgage, it can matter enormously. It may make the difference between a healthy market and a sick one.

The market for individual health insurance has had major challenges both before and after the Affordable Care Act’s (ACA’s) risk adjustment program came along. Given recent changes from Washington, like the removal of the individual mandate, the market now needs all the help it can get. Unfortunately, risk adjustment under the ACA has been an example of a well-meaning regulation that has had destructive impacts directly contrary to its intent. It has caused insurer collapses and market exits that reduced competition. It has also led to upstarts, small plans and unprofitable ones paying billions of dollars to larger, more established and profitable insurers.

Many of these transfers since the ACA rules took effect in 2014 have gone from locally-based non-profit health plans to multi-state for-profit organizations. The payments have hampered competition not just in the individual market, which has never worked very well in the U.S., but in the small group market, which arguably didn’t need “help” from risk adjustment in many states.

The sense of urgency to fix these problems may be dissipating now that the initial rush for market share under the ACA is over and plans have enough actuarial data to predict costs better. There has been an overall shift to profitability. But it would be a serious mistake to think that just because fewer plans are under water, the current approach to risk adjustment isn’t distorting markets and harming competition.

The Needle and the Damage Done

Numerous problems have been reported and discussed since 2016 when the damage became widely evident, but despite a few tweaks to the model in the right direction, little has changed until now. With the latest CMS guidance, states have two new openings to reduce the harm from the federal risk adjustment process. I’ll describe them below, but first I want to be clear that these criticisms are not intended to do away with attempts to create a fairer marketplace.

The principle of risk adjustment is great in theory: make plans compete on providing the best, most efficient service rather than by “cherry-picking,” or deliberately enrolling the lowest risk members (in other words, the healthiest ones). Cherry-picking doesn’t improve the quality of care and insurers who do it focus on appealing to the healthy at the expense of the sick. Under the ACA, the idea is to remove this problem by having insurers whose enrollees are sicker get subsidized by insurers whose enrollees are healthier.

The reality of risk adjustment has been mixed. In Medicare Advantage (MA) the formula is similar, but it has not precipitated a crisis among insurers because it is not a zero-sum game in which money from one plan is handed to its competitors. Instead, plans are measured against a benchmark and the risk adjustment payments to plans with higher risk populations come from the federal government.

Both ACA and MA plans have an incentive to identify all the risk factors they can for both clinical (to help identify their enrollees’ conditions) and financial reasons. Risk is typically measured by the diagnoses included on medical claims, but active measures can be taken to find risks that haven’t appeared on claims. The insurers that are more aggressive than average at recording risks get an advantage in higher payments. CMS has long recognized that MA plans will report more health conditions than doctors report for a comparable traditional Medicare population, and so CMS deflates the risk adjustment payments for MA plans by a few percentage points every year (5.9% in 2018).

However, there is a difference for an insurer between failing to keep up with a national risk inflation factor (the MA approach) and having to give 5% or 10% or more of the premium it earned to its local competitors (the ACA approach). The latter is inherently more volatile and allows aggressive coding to become a competitive weapon. This weapon can be wielded more effectively by large, well-funded organizations that have sophisticated data systems to analyze potential missing diagnoses, a large field operation to seek out and confirm diagnoses, and a member population that has been with the plan for a long time so that there is a rich claims history to mine. In short, it tends to favor incumbents. This problem could be greatly reduced by using multi-payer claims databases so that a person’s risk score truly reflects all the data and doesn’t change when a person moves from one plan to the next, but that approach runs into legal, regulatory and competitive barriers that are not easy to bridge.

The problems of risk adjustment in the ACA have been more profound and damaging to competition than this data-capture dynamic alone, however. To start, the risk adjustment model makes a small allowance for what’s called induced demand, or the fact that when people pay less out of pocket for their health benefits they tend to use more services, and in the process more diagnoses become known to the system. The model assumes this greater use of care has nothing to do with the underlying population being sicker.

We know, however, that different plan designs attract different people even if the insurers are not trying to cherry-pick healthier populations. A small network plan with less doctor choice is likely to attract healthier and less wealthy people who are more sensitive to premium price differences. Do we want to penalize these plans and the people in them? Insurers must increase premiums to compensate for the money they will lose in risk adjustment. In doing so, we are penalizing one of the main cost control vehicles plans have available to exclude the most expensive providers, as well as an important method of aligning a plan’s network with value-based contract models, and one of the best methods new upstart plans have of breaking into a market and increasing competition.

In general, the model doesn’t distinguish between disruptive innovation and old-fashioned cherry picking. This is no easy matter and I don’t claim to have a solution for how to do it, but the absence of a competition-sensitive distinction should reduce the magnitude of the adjustment amounts out of modesty. Another marker of competition is profitability, which the current model fails to account for. Why are smaller plans that are struggling to survive paying larger plans that are already profitable? Or even if both plans are unprofitable prior to risk adjustment (as occurred frequently in the early years of the ACA), some sensitivity of the potential for risk adjustment to drive an insurer into insolvency should be included in the transfer calculation, as long as the insurer isn’t cherry-picking.

There are many other concerns with the model, but the last I will mention is that it fails to account for policy differences between states. New York, for example, allows multiple children as dependents on a single contract, while the federal risk adjustment formula allows only one dependent in the member count. The higher premium for the entire family is included in the risk adjustment process, so it inflates the premium per allowed member and increases the size of the transfers from one plan to another. This amplifies any advantages a plan may have in risk coding.

These technical issues have real consequences. To stick with New York, two major departures of new entrants were caused in part by risk adjustment. CareConnect conducted a tactical exit by its parent, Northwell Health. Previously, Health Republic, one of the largest co-ops formed in response to the ACA, entered bankruptcy. At the time they left the market, they had grown rapidly and provided serious competition to giant incumbents in the state, including Blue Cross Blue Shield plans and United Healthcare. Both cited past and ongoing losses from risk adjustment as reasons for leaving, having paid hundreds of millions to their largest competitors, and over 20% of their entire revenue in some years. Health insurance is an industry that typically sees only a 3-5% profit margin, so paying out 15-20% or more to risk adjustment in multiple years is a catastrophic loss for plans that are not deliberately cherry-picking the healthiest enrollees and are pricing aggressively to grow market share.

After a great deal of unnecessary harm to the markets, CMS has come to recognize many of these issues and is giving states leeway to modify what plans pay each other as a result of risk adjustment. States have always had the ability to apply for approval from CMS to conduct their own risk adjustment programs but given the numerous constraints and expenses in doing so, only Massachusetts attempted it. And after a couple of years it gave up. New less costly or more immediately accessible options from CMS are welcome.

Option 1: Federally-Managed Risk Adjustment with a State-Specific Discount

In April 2018, CMS created an approach for “state flexibility” in which a state may apply to CMS for a modification to the federal risk adjustment model. On this approach, a state would present its case for why the federal model results in inaccurate and harmful payments between plans, and estimate a percentage by which the federal model’s results should be reduced for the state. The reasoning could refer to unique regulations in the state that distort the model’s measurements and other factors like those mentioned above.

CMS also now recognizes that the individual and small group markets may not need the same sort of risk adjustment. The small group market may have differences in plan design and competitive dynamics that mitigate the need for risk adjustment every time differences in measured risk appear, and so CMS will allow reductions of transfers in the small group market of up to 50%. CMS is making a striking claim here. It is essentially acknowledging that there may be self-correcting features of the market that accommodate differences in the health of members across plans while maintaining vigorous competition, so that these differences don’t all need to be transferred away through risk adjustment.

To paint a picture of how this could work: a small group plan with a very wide network and rich benefits may be attractive to firms with older than average employees who have established doctor relationships over a metropolitan region and who place high priority on being able to keep seeing their docs (older almost always means sicker), but that same insurance product may also attract firms that employ relatively healthy well-paid professionals who can afford to pay the premium for a high-end product, thereby mitigating the increased risk and cost, and creating a stable risk pool and a product that can profitably attract business in the small group market. This product could compete against a smaller network product with higher out of pocket costs at a lower price point, which tends to attract different types of firms with different priorities on cost and access. Employees in the second set of firms could on average be younger (healthier) and poorer than those in the other product, with a risk pool that is also stable, and a slightly lower average risk than the high-end type of product. Why shouldn’t this situation be allowed to persist, rather than effectively have one set of small employers (who have chosen to provide a less costly insurance product insurance out of necessity or priority) subsidize the richer insurance selection of another set of firms? This is a philosophical point as much as it is a point about the health of markets.

Allowing states to apply for a modification to the formula is a good step in the right direction, but any such changes approved by CMS under this option will not to take effect until 2020. While many new entrants and underdogs have become insolvent or left the individual and small group markets, many still remain, and this wait will ensure that they continue to subsidize their competitors in 2018 and 2019. Combined with the instability created by the loss of the individual mandate, more may leave.

Option 2: State Implementation of Supplemental Risk Adjustment

After I first wrote about this in 2016, New York became the only state to take matters into its own hands to stabilize its small group and individual community-rated health insurance markets. It created its own risk adjustment pool, designed in reference to the federal program. The purpose of the pool was to reduce the size of transfers by 30% for the small group market in 2017 and to reduce both small group and individual market transfers by 26% in 2018.  New York referenced some of the issues above in justifying these numbers, as well as the fact that up until 2016 administrative costs were fully baked into the average statewide premium that plugged into the risk adjustment model, meaning that large plans with high administrative costs and profit could skew the average premium upward and with it raise risk adjustment payments (because they are pegged to the average state premium). That particular feature of the federal model has largely disappeared, but the rest of the problems remain.

Neither New York nor any other state to my knowledge has announced its own adjustment to stabilize these ACA markets for 2019. In part the lack of follow-through by other states may be because the 2017 and 2018 New York State adjustments resulted in a lawsuit from the insurer with the biggest winnings under the old model. So the question is: can and should New York and other states act on their own to reduce the damage from risk adjustment, at least until the new Federal process take effect?

Encouragingly, the most recent federal guidance appears to confirm that they can. When asked whether New York’s emergency stabilization action was in conflict with the federal risk adjustment program, HHS responded:

States are the primary regulators of their insurance markets, and as such, we encourage States to examine whether any local approaches under State legal authority are warranted to help ease the transition for new participants to the health insurance markets. States that take such actions and make adjustments do not generally need HHS approval as these States are acting under their own State authority and using State resources. However, the flexibility finalized in this rule involves a reduction to the risk adjustment transfers calculated by HHS and will require HHS review as outlined above.

Given a direct invitation to wag its finger and declare that New York should have received HHS approval, instead HHS provided a general statement about state authority to regulate insurance markets. Specifically, states have the authority to set up their own risk adjustment and stabilization measures using their own resources, which is what New York did. The reference to easing the transition for “new participants” is a bit confusing, since state regulatory authority in insurance extends far wider than this. Even if the focus is on new entrants, a state must consider the possibility that yet more companies may seek to enter a market and the State may issue regulations conducive to such entry to improve competition. New York, and other states where risk adjustment continues to be a problem, should take this opportunity to create a bridge fix for another year until the federal process can be improved.

New York is actively considering the use of this authority for 2019. On April 19^th its Department of Financial Services posted instructions to insurers that they “should not include an assumption for a New York market stabilization pool in [developing their] 2019 rates” but did so “solely to assist insurers in using consistent assumptions for upcoming rate submissions for 2019” and retained full discretion to implement market stabilization measures after reviewing the impact of the federal risk adjustment program.

New York’s past corrective actions have contributed to greater market stability in 2018. The scale of payouts to the largest plans was reduced. In the individual market, the state reported modest increases in QHP enrollment during the annual election period despite the turmoil and uncertainty around the ACA. In the small group market one new insurer, Oscar, began offering plans. But without further action the same pattern of the smaller players subsidizing the bigger ones is likely to continue and that does not bode well. Based on all the evidence, New York should take the steps within its authority to correct for the adverse effects of federal risk adjustment in 2019 for the sake of the health and continued viability of their ACA markets.

Other states should take heart from the CMS comments and New York’s experience, and seriously consider whether circumstances in their individual or small group markets warrant similar temporary actions in 2019 before the formal remediation option begins in 2020.

Jonathan Halvorson is with the Sachs Policy Group and was formerly a New York State health plan regulator