A Regulatory Paradox: How a Governmental Attempt to Stabilize Hospital
Finances Led to More Uninsured, Restricted Health Benefits, Reduced
Hospitalizations, and Weakened Hospitals
John W. Rodat
President, Signalhealth
373 Wellington Road
Delmar, New Y ork 12054
jwr@ signalhealth.com
Background: Key Patterns
In the US, private health insurance emerged out of the Great Depression. Coverage
grew rapidly during World War II and through the 1950s. It then began to stabilize until
the enactment of the Medicare program to provide coverage for the elderly and the
Medicaid program to (partially) provide coverage for the poor (See Graph 1.) generated a
further increase. However, sometime in the late 1970s or early 1980s, the growth of
health insurance ended, then reversed, and the number and proportion of people
uninsured began to rise. During the same period health maintenance organizations
(HMOs) and other types of managed care plans emerged and began to grow, substituting
for traditional service and indemnity plans. (See Graph 2.)
Graph 1: Health Insurance Status, NYS, 1930-1996, With Trends
18.0
160 = —
14.0
no ®
Mill
Meso Zz
Nw
so
a0
20 et
=
Oa Cs Cs CC Cs CC CC Co Co CC)
30 35 40 45 50 55 60 65 70 75 80 8 90 95
[22s Trnsrred Sais Tested —S Poy NYS Unnsured) —Poly NYS Insured) |]
Graph 2
HMO Enrollment, NYS, 1979-96
5,000,000
4,500,000
4,000,000
3,500,000
3,000,000
2,500,000
2,000,000
1,500,000
1,000,000
500,000
0
1979 1982 1985 1988 =:1991 1994
Hospital inpatient use grew along with health insurance and peaked in 1983. It has
been declining fairly steadily since. (See Graph 3.)
Graph 3: Total Hospital Admissions, NYS, 1980-96
2,900,000
2,850,000
2,800,000
2,750,000
2,700,000
2,650,000
2,600,000
2,550,000
2,500,000
2,450,000
2,400,000
1980 1982 1984 1986 1988 1990 1992 1994 1996
New Y ork State is a particularly useful jurisdiction in which to study the
interactions between parts of the healthcare system. It was the first state to create special
legal status for Blue Cross and Blue Shield Plans.! The first two large Blue Cross plans
were established there by hospitals, seeking to stabilize their cash flow during the
Depression. Although New Y ork was also the home of one of the first health maintenance
organizations, generally they started later and initially grew more slowly than in many
other states. It is also the home of an extraordinarily large and complex medical system,
including the nations largest concentration of academic medical centers and teaching
hospitals.. New Y ork has the nation’s largest and most expensive Medicaid program.
Especially important to this analysis, from the late 1960s onward, New Y ork had one of
the most comprehensive, detailed, and aggressive health regulatory systems.
Background: New York's Regulatory “ Solution”
In the late 1960s, in response to rising healthcare costs, New Y ork embarked on an
extended and increasingly detailed regulatory approach to controlling institutional
healthcare costs. It began with the State’s regulating hospital prices for Medicaid and
Blue Cross and with establishment of a “certificate of need” program which required the
State Health Department to determine whether there was a “public need” for a service and
whether it would be “financially feasible” before granting a license for establishment or
expansion of institutional health care services. These requirements did not apply to
private physicians or their practices.
The method of regulating prices was based on comparing a hospital’ s per patient
costs per day to those of other hospitals for a past year, screening out costs too far above
the average, and then inflating the result to be used as the price in a future year. In 1983,
State regulation was extended to all payers, including commercial insurers and Medicare.
In 1986, regulation of Medicare prices reverted to the federal government. In 1988,
following the federal lead, New Y ork switched the unit of price regulation from a per
diem to a per case basis. That is, the State set a separate price for each of over 200
hospitals for each of nearly 500 Diagnosis Related Groups (DRGs), for each of several
classes of payers. The method for calculating the prices was quite complex. The law and
regulation comprised hundreds of pages and there were only a handful of technical
experts who fully understood all of its complexities and nuances.2
A seemingly technical, but profoundly important part of the price-setting method
was the determination of the “trend factor,” the rate used to inflate costs from a past to
future year to determine regulated prices. From the late 1970’s onward, the statute
required a panel of economists to determine this factor based on a market basket of
hospital input costs. No consideration was to be given to the financial abilities of insurers,
government, employers, or the public to absorb price increases. As a practical matter,
when combined with the regulatory behaviors described below, what this mechanism did
was ensure that prices always rose. Since a percentage inflator was used, by law hospital
prices were guaranteed to grow exponentially.
By the late 1970s, finances of New Y ork hospitals were among the weakest in the
country and during the 1980s and early 1990s hospital financial concerns were regularly
among the most significant State policy issues. Within the context of the regulatory
infrastructure, repeated attempts were made to remedy this.
At the same time, as early as 1986, state policy makers were aware of the rise in the
number and proportion of the uninsured.? They had previously been aware of the
immediate effects of the uninsured on hospital finances and had created a “Bad
Debt/Charity Care Pool,” subsidized through increased hospital prices.
However, it was only in the mid 1990s that policy makers also became aware that,
despite weak hospital finances, hospital and total healthcare costs in New Y ork were
relatively high. By 1990, hospital costs per New Y ork resident were higher than those in
every other state except Massachusetts.4 Moreover, while their margins were relatively
low, New Y ork’s hospital costs were among the highest in the nation and they were just
as inefficient as hospitals outside of New Y ork, leading to questions regarding the
effectiveness of the regulatory system.®
Effective January 1, 1997, New Y ork abandoned hospital price regulation for
private sector payers. However, it maintained: price regulation for Medicaid, the
certificate of need laws, and cross-subsidization of bad debt and charity care and certain
other costs.
Analysis: Dynamics of Health Insurance and Health Care Cost Growth
By its very nature, health insurance reduces the effective price paid by a patient for
medical services and therefore increases the quantity of services demanded. Since the
patient does not pay the full price of the service (and, in some cases, does not pay at all),
the patient consumes more service than would otherwise be the case. Moreover, the
service provider is able to charge a higher price than would otherwise be the case.*
Both the patient and the medical service provider are able to influence the degree of
service use and the provider is able to influence the price. In the insurance realm, “moral
hazard,” the ability of the insured to influence the risk, is generally grounds for not
insuring against the possibility of an event. Because of their fear of moral hazard, insurers
did not consider need for medical care an insurable risk until well into this century. In the
US, it was not the decision of an insurer to take this risk that started the first health
insurance plan, it was the decision of hospitals to create a plan to stabilize cash flow
during the Great Depression.
A static view of insurance financing of healthcare suggests higher consumption and
prices, but does not go far enough. A dynamic view presents us with a self-reinforcing
system of continually increasing prices and use. By its very nature, health insurance leads
to healthcare cost growth and the seeds of its own decline. Diagram 1 depicts two
reinforcing loops which convey this. Loop R1 shows
the reinforcing effects on service price and R2 shows the reinforcing effects on service
use. There is also some anecdotal evidence that insurers not only did not resist these
cycles, they embraced them. Until their customers began to resist, it was in their interest
for these cycles to continue because it meant that the health insurance industry also grew.
This was particularly true of plans that were paid a percentage of claims. The greater the
healthcare spending, the more they made. This loop is not depicted in the diagram.
The insurance cycles described above were reinforced by other factors, most
notably the “medical arms race.” 7 But at the time, what enabled the arms race was the
relative insensitivity of payers to these rising costs. However, as healthcare costs and the
associated insurance premiums rose, payers became more sensitive.
Diagram 1 depicts three balancing loops. Loop B1 shows the effects of premiums
on service use controls. For many years, attempts to control service use were minimal or
perfunctory. However, as premiums rose, the need to control costs also grew and this led
to the implementation of utilization control systems and ultimately to the emergence of
managed care plans and programs. For the sake of simplicity, Graph 4 does not
distinguish between utilization controls implemented by traditional plans and managed
care plans.
Balancing Loop B2 shows the effect of premiums (as a percent of economic
capacity) on the ability to buy coverage. It impairs the inflow into covered status and
accelerates the outflow. There has been much discussion of the changing nature of the
economy as the explanation for the loss of health insurance coverage. For example,
service workers are less likely to have coverage than manufacturing workers; the service
sector is growing and manufacturing is declining. In fact, those explanations tend to be
correlational rather than causal and this loop alone is sufficient to explain loss of
coverage. ®
Balancing Loop B3 shows the effects of premiums on service prices. As premiums
increase, the pressure to restrict price growth also increases and prices are reduced.
However, as will be discussed below, this did not work effectively in New Y ork’s
regulatory system. Over the long term, the regulatory system neutralized this loop.
Diagram 1
+ Service Use
. >S.
Service Price Service Use Controls
- +
+ Bl
Covered Population Cost of Care
+ R1 +
+ B3 Premiums
Desire for Coverage
Perceived Risk
pn. 18
Ability to Buy Coverage B2 +
Wee Pctof Capacity
Economic Capacity
Although the relationships are hidden in the complexity of the system, there were
(and are) delayed but substantial effects:
* Increased payments to hospitals, whether from price or service use
increases, increase cost to payers.
* In return for premiums (or taxes for govemment sponsored coverage),
insurers provide health insurance coverage. Thus, increased costs to
payers means increased premiums paid by employers, individuals, and
families to insurers and increased taxes for public programs.
* Once the balancing loops overpowered the reinforcing loops, the greater
the increase in health care costs compared to growth in economic
capacity, the more people lost coverage, particularly traditional
coverage. Increased premiums lead employers to purchase more
restricted health insurance, to purchase for fewer of their employees and
dependents, government restricting Medicaid eligibility standards and
fewer families purchasing insurance directly. Thus, more people moved
and were moved into managed care.
* The more coverage is restricted or dropped, the fewer hospital
admissions are paid for. People who are uninsured are much less likely
to be hospitalized.® Since uninsured people are less likely to be
hospitalized, increasing numbers of uninsured
contribute to an overall decline in the number of
hospital admissions. In those cases where uninsured people are
hospitalized, they are much less likely to pay or pay the full amount
than they were when insured. In turn, this increases bad debt and the
need for charity care which leads to further price and premium
increases.
* For those covered, the greater the increase in health care costs, the more
that coverage is restricted and the fewer health services are paid for. As
a practical matter, this results in increased efforts to reduce utilization
through higher co-payments and deductibles, more rigorous utilization
review, benefit reduction, higher employee premium shares and
accelerated movement into managed care, the essence of which is to
control the use of services.
* It is noteworthy that the peak number of hospital admissions in New
Y ork was the first year of comprehensive price regulation. The
subsequent decline was largely concentrated among those with
traditional coverage.
* As utilization falls, hospital revenues fall and hospital financial status
weakens. During the past 15-20 years weakened financial status led to
increased lobbying and increased prices.
The three scenarios shown in Graphs 4-6 show the effects of this system on
enrollment in traditional (service and indemnity) coverage plans, managed care plans, and
those with no coverage, the uninsured. The scenarios differ in the relative growth rates in
prices paid for health services by traditional and managed care plans and in the relation of
their premium growth to economic capacity. The traditional plan, after a long period of
dominance is moving from decline to collapse. It is being replaced with managed care,
which after a period of emergence has gone through a period of explosive growth.
However, managed care is not growing as quickly as the traditional plans are dying and
thus the number of uninsured is growing.
Graph 4: Three Scenarios for Indemnity (Traditional) Insurance Plans
L:Sve Indem Pop 2:Sve Indem Pop 2:5ve nem Pop
200807
1.908407
/
9.09 {930.00 195125 197250 1993.75 2015.00
vers
Graph 5: Three Scenarios for the Uninsured Population
1: Uninsured Pop 2: Uninsured Po 2: Uninsured Pop
20007
1000107
St
909 1930.00 195125 197250 1993.75, 2015.00
vers
Graph 6: Three Scenarios for Managed Care Plans
Lig Care Pop 2: mgd care Pop
2000007
100007
—_ —
iss000 Tests ie7hs0 9885 701500
vers
Analysis: “Regulatory Loops”
Numerous studies have been conducted comparing hospital cost growth in highly
regulated states to those in non-regulated states. The results were mixed or ambiguous,
but today, only one state, Maryland, continues to regulate hospital prices and there is
increasing dissatisfaction with that system. The economic literature is replete with
discussions of “regulatory capture,” the eventual control of the regulatory process by the
regulated entities. In this case, regulatory capture produced a “fix that failed.” Because
the primary regulatory tool was price control, and because the insurance relationship
masked and delayed the effect of price increases, the more that hospitals experienced
financial distress, the more they lobbied for price increases. The more that prices were
increased, the more insurance premiums rose. The more that premiums rose, the more
that insurers attempted to control utilization and the more than people lost coverage. The
net effect was to neutralize Balancing Loop, B3 (showing the relationship between
premiums and service prices) in Diagram 1 and replace it with the reinforcing effects
depicted in Diagram 2.
Diagram 2
+
pon ilscal Distress
Uncompensated Care Kan.
R2
Compensated Care Lobbying Activity
R1
Number ae a
corte
There were also other, more subtle, effects of the regulatory system. In all
economic sectors, management tends to behave differently when regulated.!° In regulated
industries, management tends to:
* Focus on the regulator as customer rather than the ultimate customer, in
this case the patient and the community.
* Often perceive a lack of accountability since final authority for many
decisions is vested in the regulatory agency.
+ Allow and even encourage cross subsidization of products and show a
lack of cost sensitivity since they become part of the rate base.
* Emphasize the process of decision making rather than the outcome.
* Compete with other organizations by attempting to limit their access to
the market rather than by selling a superior or less expensive product.
This is an important effect of the certificate of need system.
These effects are presented in Diagram 3. This structure is not explicitly part of the
model. However, its effects of the price setting behavior are captured implicitly in the
price inflator rates which are built into the model.!! Loop B1/R4 is described as such in
this diagram because some services are subsidized and others subsidize.
Diagram 3
+
Regulatory Activity
ro}
Management ‘) ‘on Regulator
Service Cost
4 R2
Perceived Mgt de
Cost Sensitivity +
- : +
/R4 \compete by Limit Competitors Market Access
Cross Subsidization of Services
Observations and Conclusions
The most important conclusion was that continued increases in healthcare costs
generally, and hospital prices specifically at rates greater than rates of economic growth
could not be sustained indefinitely. This seems self-evident after the fact (and probably
before hand to a System Dynamicist), but it was far from obvious in the policy making
environment. Continued growth in hospital prices at rates greater than growth in
economic capacity forced accelerated movement into managed care and accelerated loss
of health insurance. As premiums absorbed an increasing share of carrying capacity,
those responsible for paying premiums created backpressure (balancing loops), by forcing
changes that reduced utilization, by forcing reductions in spending elsewhere in
healthcare, and ultimately, when no other options were available, by dropping coverage
entirely.
Over the long term, rather than controlling medical cost growth, New Y ork’s price
regulatory system made the problem worse. Because the combination of the regulatory
infrastructure and the surrounding politics prevented price stabilization, much less
reduction, the only outlets for the backpressure were elsewhere, more utilization control,
more loss of coverage, and more restrictions on non-hospital services. Attempting to
remedy weak hospital finances through a price regulatory system that increased prices
was a Classic “fix that failed.” Subsequent to de-regulation, the same will be true for
hospitals that attempt to improve their financial status with voluntary price increases.
In the aggregate, price controls could theoretically hold price increases to rates less
than growth in the economic capacity of those paying for the system. However, price
control systems are subject to “regulatory capture” by the regulated industry. Ironically,
because of its structure, New Y ork’s system required prices to grow exponentially with
its effects on coverage. As the State regulated private payments only for hospital services,
payers looking for price reductions focused their attention on other services, most notably
physician services. Although it was not part of the model, this analysis suggests that
greater price increases under the regulatory system created pressures for tighter fee
controls on physician services. This may partially explain why per capita expenditures on
physician services in New Y ork were less than the national average.'? Ultimately
policymakers in New Y ork concluded that politically they could not sustain rates of price
increases at or below rates of growth in economic capacity and therefore could not
prevent the downstream effects described above. This was the fundamental reason for de-
regulation.
The dynamic interactions between healthcare service use, pricing and health
insurance described above is generalizable to what is happening in medical cost growth
throughout the US. It explains the simultaneous growth of efforts to control service use
through utilization control, the growth of managed care and the growth in the uninsured
population, along with the demise of traditional health insurance plans. However, if
managed care plans are unable to control cost growth, then their aggregate enrollment
will not reach the same peak that traditional insurance once attained. This suggests that
after they have completely replaced traditional health insurers, managed care plans will
begin to lose enrollment, and will become even more price competitive than they are
today and they will be forced to take additional, and probably even more controversial,
steps to control costs. The traditional health insurance plan, one which lacks control of
service use and prices is likely doomed. The only scenario in which it might have
survived is one in which healthcare cost growth is consistently less than growth in the rest
of the economy. However, it is probably too late even in that case.
A corollary to these observations is that were the medical system to hold price
increases to relatively low levels, it would reduce other pressures on itself. However, each
part of the system must do this and must also restrain growth in service use, a much more
difficult proposition. Health insurance itself creates open (or at least semi-open) access
resources, and a classic “dilemma of the common.” There are indications that the
dynamics of open access resources (the dilemma of the common) are subject to repeated
boom and bust economic cycles.' If health insurance is correctly characterized as an
open access resource, then we may expect similar system behavior. A bsent healthcare
cost stabilization, the number of uninsured will continue to rise. Given the nature of
health insurance, spontaneous self-control by the healthcare system is unlikely. If health
insurance is correctly characterized as an open access resource, then we may expect
similar system behavior. These will be explored in future work.
1 James R. Tallon, Jr. and John W. Rodat, Health Insurance, Public Policy in New Y ork, a Report of
the Subcommittee on Health Insurance, Council on Health Care Financing, December 31, 1984
The law itself ran about 200 pages and even included mathematical formulae in equation form.
3 Tallon and Rodat, and John W. Rodat, New Y orkers Are Losing Their Health Insurance, March 19,
1986.
4 John W. Rodat, “Hospital Reimbursement Revisited,” Empire State Report, March, 1994.
5 Donald F. Vitaliano and Mark Toren, “Hospital Cost and Efficiency in a Regime of Stringent
Regulation,” Eastern Economic Journal, Vol. 22, No. 2, Spring 1996.
5 Paul J. Feldstein, PhD, Health Care Economics, Third Edition, John Wiley & Sons, New Y ork, 1988;
Sherman Folland, Allen C. Goodman, and Miron Stano, The Economics of Health and Health Care,
Second Edition, Prentice-Hall, Upper Saddle River, NJ, 1997.
7 “The Medical Arms Race,” The Systems Thinker, Pegasus Communications, Cambridge, MA,
November, 1991.
8 John F. Sheils, Paul Hogan, and Nikolay Manolov, Ph.D., Exploring the Determinants of Employer
Health Insurance Coverage, A Report for the AFL-CIO, The Lewin Group, January 20, 1998.
5 John W. Rodat, and Barbara Caress, Risking the Future, Low Income People in New Y ork Without
Health Insurance: Problems and Proposed Solutions, August, 17, 1987, Hospital Trustees of New Y ork
State
1° Thomas S. Robertson, Scott Ward, and William M. Caldwell, IV, “Deregulation: Surviving the
Transition,” The Harvard Business Review, (July-A ugust, 1982), p.20.
1! Experience suggests that the a similar pattern applies to regulatory oversight of the quality of care.
2 Tt certainly helps to explain why physician fees under Medicaid in New Y ork are so low. For the
past 20 years, New Y ork’s Medicaid physician fees have been among the country’s lowest. Not
surprisingly, few private physicians in New Y ork participate in its Medicaid program.
13 Matthias Ruth and Bruce Hannon, Modeling Dynamic Economic Systems, Springer-Verlag, New
York, 1997, pp. 233-245.
