We study optimal risk adjustment in imperfectly competitive health insurance markets when
high‐risk consumers are less likely to switch insurer than low‐risk consumers. Insurers then
have an incentive to select even if risk adjustment perfectly corrects for cost differences. To
achieve first best, risk adjustment should overcompensate insurers for serving high‐risk
agents. Second, we identify a trade‐off between efficiency and consumer welfare. Reducing
the difference in risk adjustment subsidies increases consumer welfare by leveraging …

We study optimal risk adjustment in imperfectly competitive health insurance markets when
high-risk consumers are less likely to switch insurer than low-risk consumers. First, we find
that insurers still have an incentive to select even if risk adjustment perfectly corrects for cost
differences among consumers. Consequently, the outcome is not efficient even if cost
differences are fully compensated. To achieve first best, risk adjustment should
overcompensate for serving high-risk agents to take into account the difference in mark-ups …