[An updated version of this article can be found at Health Insurance in the 2nd edition.]
The Birth of the "Blues"
In the thirties and forties a competitive market for health insurance developed in many places in the United States. Typically, premiums tended to reflect risks, and insurers aggressively monitored claims to keep costs down and prevent abuses.
Following World War II, however, the market changed radically. Hospitals had created Blue Cross in 1939 and doctors started Blue Shield later. Under pressure from hospital and physician organizations, the "Blues" won competitive advantages from state governments and special discounts from medical providers. Once the Blues had used these advantages to gain a monopolistic position, the medical community was in a position to refuse to deal with commercial insurers unless they adopted many of the same practices followed by the Blues. Some of these practices were also later adopted by the federal government through the Medicare (for the elderly) and Medicaid (for the poor) programs.
Four characteristics of Blue Cross/Blue Shield health insurance fundamentally shaped the way Americans paid for health care in the postwar period.
First, hospitals were reimbursed on a cost-plus basis. If Blue Cross patients accounted for 40 percent of a hospital's total patient days, Blue Cross was expected to pay for 40 percent of the hospital's total costs. If Medicare patients accounted for one-third of patient days, Medicare paid one-third of the total costs. Other insurers reimbursed hospitals in much the same way. For the most part, physicians and hospital managers were free to incur costs as they saw fit. The role of insurers was to pay the bills, with few questions asked.
Second, the philosophy of the Blues was that health insurance should cover all medical costs—even routine checkups and diagnostic procedures. The early Blue plans had no deductibles and no copayments; insurers paid the total bill and patients and physicians made choices with little interference from insurers. Therefore, health insurance was not really "insurance." Instead, it was prepayment for the consumption of medical care.
Third, the Blues priced their policies based on what is called "community rating." In the early days this meant that everyone in a given geographical area was charged the same price for health insurance regardless of age, sex, occupation, or any other factor related to differences in real health risks. Even though a sixty-year-old can be expected to incur four times the health care costs of a twenty-five-year-old, for example, both paid the same premium. In this way higher-risk people were under-charged and lower-risk people were over-charged.
Fourth, instead of pricing their policies to generate reserves that would pay bills that weren't presented until future years (as life insurers and property and casualty insurers do), the Blues adopted a pay-as-you-go approach to insurance. This meant that each year's premium income paid that year's health care costs. If a policyholder developed an illness that required treatment over several years, in each successive year insurers had to collect additional premiums from all policyholders to pay those additional costs.
Even though most health care and most health insurance were provided privately, the U.S. health care system developed into a regulated, institutionalized market, dominated by nonprofit bureaucracies. Such a market is very different from a truly competitive market. Indeed, the primary reason that the medical community created the Blues was to avoid the consequences of a competitive market—including vigorous price competition and careful oversight of provider behavior by third-party payers.
One area where consumers become immediately aware that the medical marketplace is different is in the area of hospital prices. Even today, most patients cannot find out in advance what even routine surgical procedures will cost them. When discharged, they receive lengthy itemized bills that are difficult for even physicians to understand. Thus, the buyers (i.e., the patients) of hospital services cannot discover the price prior to buying and cannot understand the charge after the purchase has been made.
Under some reimbursement formulas in the cost-plus system, a hospital's reimbursement was partly determined by its charges. Hospitals discovered that by manipulating the charges, they could increase their total reimbursement. And because less than 10 percent of hospital bills were paid out of pocket by patients, artificial changes in the charges did little to affect the overall demand for hospital services. Even though the cost-plus system has been substantially dismantled, hospital charges still do not function as market prices that affect people's decisions and allocate resources. Instead, they are artifacts, arbitrarily manipulated to increase reimbursements from third-party payers.
One way to appreciate how much third-party payment has influenced the hospital marketplace is to contrast cosmetic surgery with other types of surgery. Because neither public nor private insurance any longer covers cosmetic surgery, patients pay with their own funds. And even though many parties are involved in supplying the service (physician, nurse, anesthetist, and the hospital), patients are quoted a single package price in advance. In other words, ordinary people, spending their own money, have been able to get advance price information that large employers, large insurance companies, and even federal and state governments generally have been unable to obtain for any other type of surgery.
Changes in the Eighties
The system of health insurance that prevailed from the forties through the seventies contained the seeds of its own destruction. Any system in which patients spend other people's money at the point of purchase and in which providers are reimbursed based on their costs and not on set fees, is a system in which health care costs will invariably rise.
Rising health care costs lead to higher health insurance premiums, giving the people who are being overcharged through the system of community rating greater incentives to find cheaper alternatives. New entrants into the health insurance market have incentives to supply those alternatives. And with increasing pressure to hold premiums down, diverse third-party payers have increasing incentives to find cheaper alternatives to the cost-plus system of hospital finance.
Thus, the system began to unravel in the seventies and eighties. Large employers began to manage their own health care plans, started paying hospitals based on set charges rather than costs, and negotiated price discounts. Through the Medicare program, the federal government began paying hospitals fixed prices for surgical procedures (the Prospective Payment System). Alternative prepaid programs, such as health maintenance organizations (HMOs) (under which total charges are fixed in advance) emerged as competitors to traditional fee-for-services medicine (under which charges rise with usage by people in the covered group). The system of community rating collapsed as individual insurers lowered their premium prices for lower-risk individuals and groups. The market for every medical service became more competitive.
The federal government also began to encourage competition in the health care sector. For example, it eliminated federal funding for, and encouragement of, health planning agencies. It also eliminated "certificate of need controls," under which hospitals had to have the government's permission to expand capacity or to buy expensive equipment. These changes strengthened the private sector's ability to solve many problems. Yet, the removal of the most obvious barriers to competition—while leaving more subtle barriers in place—has exacerbated three problems.
Lack of health insurance. One problem is that about 34 million Americans do not have health insurance, and their number has been rising. At least two government policies have contributed to this problem and made it much worse than it needs to be.
The first is the tax law. Most people who work for large companies receive health insurance as a fringe benefit. Because the health insurance premiums are deductible expenses for employers, many workers effectively avoid a 28 percent income tax, a 15.3 percent tax for Social Security (half of which is paid by employers), and a 2 to 9 percent state and local income tax. Thus, as much as fifty cents of every dollar spent on health insurance through employers is effectively paid by government. And we get what we subsidize. About 90 percent of the people who have private health insurance obtain it through an employer.
In contrast, the unemployed, the self-employed, and most employees of small businesses get little or no tax subsidy. If they have health insurance at all, they must first pay taxes and then purchase the insurance with what is left over. At the same time most of the 34 million people who have no health insurance pay higher tax rates to fund the $60 billion annual tax break for those who have employer-provided insurance.
A second source of the problem is state government regulations—specifically, laws that mandate what is covered under health insurance plans. Examples of mandated coverages include alcoholism, drug abuse, AIDS, mental illness, acupuncture, and in vitro fertilization.
In 1970 there were only thirty mandated health insurance benefit laws in the United States. Today there are at least one thousand. Coverage for heart transplants is mandated in Georgia, and for liver transplants in Illinois. Minnesota mandates coverage for hairpieces for bald people. Mandates cover marriage counseling in California, pastoral counseling in Vermont, and deposits to a sperm bank in Massachusetts.
There are more than 240 different health-related professions in the United States, ranging from chiropractors and naturopaths to athletic trainers. Every year, these special interest groups descend upon state legislatures demanding more and more regulations—and more and more mandated coverage. These regulations are driving up the cost of health insurance. The National Center for Policy Analysis estimates that as many as one out of every four people who lack health insurance has been priced out of the market by these costly regulations.
Not everyone is directly affected by state regulations. Federal law exempts federal government employees, Medicare enrollees, and employees of companies that manage their own health care plans. The last group employs more than half of all workers. State governments often exempt their own Medicaid patients and their own state employees. That means most of the burden of the mandates falls on employees of small businesses, the self-employed, and the unemployed. Yet these are the very groups that increasingly do without health insurance.
Rising health care costs. The second major problem is rising health care costs, a problem that also is exacerbated by federal tax law.
The primary reason health care costs are rising is that most spending on health care is done with someone else's money rather than the patient's. As a result patients avoid making tough choices between health care and other goods and services. The most wasteful kind of health insurance is insurance for small medical bills. These are the expenses over which patients exercise the most discretion and for which opportunities for waste and abuse are greatest. Moreover, by the time an insurance company gets through processing a twenty-five-dollar physician fee, the cost will be fifty dollars—thus doubling the cost of medical care.
The alternative to third-party insurance is individual self-insurance. The alternative to having third parties pay every medical bill is to have people pay most medical bills with their own money. The alternative to having large bureaucracies limit spending decisions with arbitrary rules and regulations is to let people make their own decisions.
Many economists who have studied the health insurance market believe that a more prudent approach would be to choose a high deductible and put the savings (from lower premiums) in individual medical savings accounts. In a short period of time, the vast majority of people would have accumulated savings far in excess of the annual deductible. If not spent, these funds could be used for postretirement medical expenses or as a supplement to retirement pensions. Singapore, for example, has built its entire health care system around individual self-insurance. Singapore workers are required to put 6 percent of their income into medical savings accounts every year.
In the United States we have moved in the opposite direction. Every dollar in premiums spent by employers for third-party health insurance receives a generous tax subsidy. Every dollar employees try to save is taxed.
Lack of actuarially priced insurance. The final problem is a lack of a real market for health insurance in which health risks are accurately priced. During the eighties most large companies realized that their premiums did not buy insurance. Instead, they were set to cover the employees' actual health costs each year. That is why most chose to self-insure, cut out the middleman (the insurance company), and pay health care bills directly. Today, about 80 percent of large companies use third-party insurers simply to process health care claims rather than to provide insurance services.
Ironically, however, most large companies continue to price health insurance internally (i.e., to employees) using the old Blue Cross method. Thus, if the average cost per employee is $3,300, and employees are asked to pay half that amount, all pay $1,650, regardless of their individual health risks. Because a sixty-year-old employee will generate about $5,280 in costs, on the average, older employees find health insurance underpriced and tend to bargain for more coverage for more items. To younger employees with expected costs of only $1,320, even one-half of the artificial premiums they face is often a bad buy, and their incentive is to forgo coverage.
In the market for small group and individual policies, the problem is even worse. Under the pay-as-you-go approach to premium pricing, insurers typically increase premiums each year to cover the continuing costs of people who contracted lengthy illnesses in past years. As a result healthier people and better risks find they can switch insurers and pay lower premiums for coverage or do without coverage altogether. That leaves the people who continue to buy coverage paying higher and higher premiums.
Today, most large insurers propose to deal with this problem by state or federal laws that would reimpose (to one degree or another) the old system of community rating. These proposals would, in effect, outlaw price cutting and force some insurers to share in the losses of others. The alternative is to adopt policies which encourage a market for real health insurance, in which risk is accurately priced. The first course requires laws and regulations designed to prevent the market from working. The alternative requires a legal environment that will allow the market to work.
John C. Goodman is the president of the National Center for Policy Analysis, a Dallas-based think tank. In 1988 he won the Duncan Black Award for the best article in public choice economics.
Goodman, John C. Regulation of Medical Care: Is the Price Too High? 1980.
Goodman, John C., and Gerald L. Musgrave. Patient Power: Solving America's Health Care Crisis. 1992.
Herzlinger, Regina. Creating New Health Care Ventures. 1991.
Kessel, Reuben. "Price Discrimination in Medicine." Journal of Law and Economics 1 (October 1958): 20-53.
Starr, Paul. The Social Transformation of American Medicine. 1982.