Risk Adjustment with an Outside Option

Much of the risk adjustment literature has focused on how persons should be classified and given weights. It has given less attention to the amount of funds in the risk adjustment pool. If, however, there is an outside option, as there is in the principal American risk adjustment systems, there can be favorable or adverse selection in the risk pool. To address any such selection requires that the risk adjustment system not be zero sum; the main American risk adjustment systems differ in this respect.