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 costsâ€"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 marketâ€"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.