How does Risk-selection Respond to Risk-adjustment? Evidence from the Medicare Advantage Program

Medicare administers a traditional public fee-for-service (FFS) plan while also allowing enrolles to join government-funded private Medicare Advantage (MA) plans.We model how selection and differential payments - the value of the capitation payments the firm receives to insure an individual minus the counterfactual cost of his coverage in FFS - change after the introduction of a comprehensive risk adjustment formula in 2004. Our model predicts that firm screening efforts along dimensions included in the model ("extensive-margin" selection) should fall, whereas screening efforts along dimensions excluded ("intensive-margin" selection) should increase. These endogenous responses to the risk-adjustment formula can in fact lead differential payments to increase. Using individual-level administrative data on Medicare enrollees from 1994 to 2006, we show that while MA enrollees are positively selected throughout the sample period, after risk adjustment extensive-margin selection decreases whereas intensive-margin selection increases. We find that differential payments actually rise after risk-adjustment, and estimate that they totaled $23 billion in 2006, or about six percent of total Medicare spending.