Hospital Insurance

"Well, I get darn sick of trying to pick up after a gang of fast-talking salesmen dumb enough to sell life insurance to a guy who sleeps in the same bed with four rattlesnakes."
--Barton Keyes (Double Indemnity)

Interesting article highlighting key developments in medicine and health insurance in the US. One development was hospital insurance. Early hospitals were designed for the very poor, particularly for those suffering from blindness, mental illness, or contagious diseases. Those who could afford better were treated at home or in privately run nursing facilities. Until antiseptic procedures were adopted, hospitals were key sources in spreading rather than curing diseases.

Because hospitals were perceived as places for the poor and desperate to die, demand and supply were low. In 1873, there were only 149 hospitals in the US. Things obviously changed over the next one hundred years. By the 1970s, the number of US hospitals had reached about 7,000.

From their beginning, hospitals had a financial problem. They are labor intensive and expensive to operate, with the majority of costs being fixed and independent of number of patients served. To help solve this problem, the idea of hospital insurance was born in the 1920s. The first hospital insurance plan was introduced at Baylor University Hospital in 1929. Some 1,500 teachers paid six dollars in annual premiums. In turn, the hospital agreed to provide up to 21 days of care to subscribers who needed it.

In exchange for the modest fee, subscribers were protected from unexpected health care costs while the hospital improved its cash flow. Before long, groups of hospitals were offering similar plans which gave subscribers choice of which hospitals to use. This became the model for Blue Cross which first operated in Sacramento, California in 1932.

These hospital plans differed from conventional notions of 'insurance.' Traditionally, insurance policies protected policyholders from large, unforeseeable losses and came with a deductible. In contrast, early hospital plans paid all costs up to a limit. The primary reason of course, was that the policies were being underwritten not by third party insurers but by operating hospitals themselves that were trying to generate steady demand for their services and regular cash flows.

The tradition of early hospital 'insurance' to cover health maintenance costs rather than catastrophic medical costs was one of three defects associated with these plans that would ultimately drive US healthcare costs through the roof. A second defect was that the early plans paid only those medical expenses incurred in hospitals. Consequently, those cases that could be treated on an outpatient basis were instead kept in house--a more expensive form of care.

The third defect was that hospital insurance did not provide indemnity coverage. Indemnification is when the insurer pays for the loss and then the policyholder decides how to best deal with it. Instead, the insurer (hospital) was providing service benefits, and paying the bill whatever the cost was. Consequently, consumers of medical services had little incentive to shop around. This raises the classic moral hazard problem--which someone else is paying the bill, healthcare consumers become indifferent to the cost of care.

Predictably, the medical profession lobbied in favor of retaining the Blue Cross system. The American Hospital Association and American Medical Association worked hard to exempt Blue Cross from regulation that would have forced it to adhere to standards required of more conventional insurance plans. Meanwhile, the IRS ruled that hospital insurance companies were charitable organizations and free from paying federal taxes. Free from regulation and tax burdens, Blue Cross and Blue Shield (a physician plan similar the Blue Cross hospital plan) came to dominate the market, holding about half of all policies outstanding by 1940. To compete, private insurers began modelling their policies similar to the Blue Cross and Blue Shield designs.

Hospitals thus came to be paid on a cost-plus basis, receiving the cost of services provided plus a percentage to cover costs of invested capital. Incentive for hospitals to be efficient vanished. Incentive to add capacity, on the other hand, escalated.

This led to an odd economic situation where price of health care rose despite many years of increasing medical supply. We'll pick it up from here in an upcoming post.