In competitive markets for individual health insurance, risk-rated premiums are observed to differ across subgroups of insured people, which are defined by rating factors such as: age, gender, family size, geographic area, occupation, length of contract period, the level of deductible, health status at time of enrollment, health habits (smoking, drinking, exercising) and — via differentiated bonuses for multi-year no-claim — to prior costs (Van de Ven et al. 2000). Financial transfers are needed in order to prohibit any problems of financial access to coverage for those at high risk. The first and best solution to increase financial access to coverage for those at high risk is to find a sponsor who organizes a regulatory system of risk-adjusted premium subsidies (Van de Ven et al. 2000). The financial transfers are then channeled via a so-called Subsidy Fund. In European countries such as The Netherlands, Belgium, Germany and Switzerland the Subsidy Fund is run by a government agency which assesses risks for individual policy holders. In all countries that apply risk-adjusted premium subsidies in their health insurance market, the sponsor organizes it in the form of risk equalization among health insurers, i.e., the risk-adjusted premium subsidies for the insured are channelled to the insurers. In this case, the Subsidy Fund is called Risk Equalization Fund (REF). An insurer receives a relatively large sum of subsidies via the REF if the risk profile of their members is relatively unhealthy, and vice versa.
Although premiums can be rated across many subgroups of insured people, a sponsor may not want to subsidize all observed premium rate variation in practice. The total set of risk factors that insurers use to rate their premiums can be divided in two subsets: the subset of risk factors that cause premium rate variation which the sponsor decides to subsidize, the S(ubsidy)-type risk factors; and the subset that causes premium rate variations which the sponsor does not want to subsidize, the N(on-subsidy)-type risk factors (Van de Ven and Ellis 2000, p. 768-769). In most countries, gender, health status and (to a certain extent) age will probably be considered S-type risk factors. Examples of potential N-type risk factors are: a high propensity for medical consumption, living in a region with high prices and/or overcapacity resulting in supply-induced demand, or using providers with an inefficient practice-style (Van de Ven et al. 2000). The sponsor determines the specific categorization of S-type and N-type risk factors. In case the government takes up the role of the sponsor, this categorization is ultimately determined by value judgments in society. Note that, because the premium subsidies are risk-based, price competition will not be distorted by these subsidies and therefore incentives for efficiency are not reduced.
This system operates in countries such as Australia, Germany, the Netherlands, Belgium, Switzerland, Ireland and the USA (Medicare).
For a theoretical introduction to risk equalization, see the video at http://www.youtube.com/watch?v=3HeqJEbUptA. In practice, the sponsor often encounters difficulties to find adequate measures of the S-type risk factors (e.g. health status) to include in the risk equalization model. This is explained in a follow-up video at http://www.youtube.com/watch?v=0wWNP_deiiY. Furthermore, research results are presented on the effectiveness of the 2004 Dutch risk equalization model (Stam 2007). For a video on the new Dutch health care system see the video at http://www.minvws.nl/en/themes/health-insurance-system/the-new-health-care-system-in-the-Netherlands-video/. (Warning: The video has a soundtrack in both English and Dutch. It is necessary to click the T symbol in video window early on during video playback to see subtitles in English). The system of risk equalization plays a crucial role in order to reduce the incentives for risk selection in this new Dutch market of regulated competition. Note that Dutch insurers are not allowed to risk-rate their premiums.