Many countries are turning to competition among managed care plans to make the tradeoff between cost and quality in health care. In the U.S., major public programs and many private health insurance plans offer enrollees a choice of managed care plans paid by capitation.1 Recent estimates are that 40% of the poor and disabled in Medicaid and 14% of the elderly are enrolled in managed care plans paid by capitation (Medicare Payment Advisory Commission, 1998).

Both figures are bound to increase rapidly. In private health insurance, about three-quarters of the covered population is in some form of managed care, though in many cases, employers continue to bear some or all of the health care cost risk (Jensen, 1997). Health policy in the Netherlands, England, and other countries shares similar essential features. Israel, for example, recently reformed its health care system so that residents may choose among several managed care plans which all must offer a comprehensive basket of health care services set by regulation. A common feature of such reforms is for plans to receive a risk-adjusted capitation payment from the government or private payers for each enrollee.

The capitation/managed care strategy relies on the idea that costs are controlled by the capitation payment and the “quality” of services is enforced by the market. The basic rationale for this health policy is the following: the capitation payment plans receive gives them an incentive to reduce cost (and quality), while the opportunity to attract enrollees gives plans an incentive to increase quality (and cost). Ideally, these countervailing incentives lead plans to make efficient choices about service quality.

Competition in the health insurance market has well-known drawbacks, the most troubling one being adverse selection. As competition among managed care plans becomes the predominant form of market interaction in health care, adverse selection takes a new form which may actually be much harder to address in policy, relative to the case of conventional health insurance. With old-fashioned fee-for-service insurance arrangements, a health plan might provide good coverage for, say, child care, to attract young healthy families, and provide poor coverage for hospital care for mental illness.

If it appeared that refusing to cover hospital care for mental illness was motivated by selection concerns, public policy could force private insurers to offer the coverage through mandated benefit legislation. As health insurance moves away from conventional fee-for-service plans, where enrollees have free choice of providers, and becomes “managed care,” the mechanisms a health insurance plan uses to effectuate selection change from readily regulated coinsurance, deductibles, limits and exclusions, to more difficult-to-regulate internal management processes which ration care in a managed care plan.