Competition leverage: How the demand side affects optimal risk adjustment

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 competition from the elastic low-risk market to the less elastic high-risk market. Third, mandatory pooling can increase consumer surplus further, at the cost of efficiency.