MinnesotaCare: A Law That Lost Its Way

By Roger R. Conant, Bryan E. Dowd, and Robert E. Christenson

Executive Summary

The reform of America’s trillion-dollar health care system was a major campaign issue in President Clinton’s run for the presidency in 1992. His health reform plan received broad media coverage and provoked intense controversy until its demise in 1994.

Notwithstanding a major effort to create nationalized health care, a number of states independently have initiated their own health care reforms, most notably Hawaii, Massachusetts, New Jersey, Oregon, Vermont and Minnesota.

Minnesota is a long-time leader in health innovation. As far back as 1976, Minnesota developed quasi-public risk insurance pools. Minnesota was also a hotbed of HMO growth in the 1980s, which resulted in squeezing a large amount of excess capacity out of Twin Cities hospitals, contributing to a 50-percent drop in inpatient service utilization over 18 years.

In 1992, the Minnesota Legislature enacted “HealthRight” as a two-pronged initiative aimed at containing costs while simultaneously increasing access to health care. Minnesota’s experiment was widely debated and generated a great deal of commentary in the local and national press, as well as serious analysis by health researchers. Its metamorphosis in 1993 into MinnesotaCare made it even more controversial, frequently being showcased as one state’s alternative (good or bad) to national health reform legislation.

The Minnesota Legislature’s approach to health care reform — and its great mistake — was to place enormous power in the hands of the Department of Health and a newly created Health Care Commission. Rather than focusing on the original problem of uninsured individuals, these newly empowered bureaucracies, encouraged by the Legislature, set out to “fix” Minnesota’s entire health care delivery system. Though riddled with many flaws, one fatal flaw stands out in the legislation: Its premises are built on a foundation of poorly reasoned economic theory. Supposed solutions put forth totally ignore:

  • the basic economic importance of competitive pricing;
  • the inefficient nature of the oligopolies and ologopsonies that the act promotes;
  • the critical imperative of risk-rating to a coherent insurance market;
  • the futility of managing markets with outdated and imperfect information;
  • and the long history of failed attempts of top-down price controls.

This paper addresses a long list of initiatives in the act that encourage the creation of a highly integrated and regulated health care system in Minnesota. Though the intent of the designers of the legislation was to stimulate innovation and competition, it will be demonstrated that the exact opposite is occurring, especially when viewed from the perspective of consumers, smaller providers, and alternative medicine — the latter of which represents a very large segment of the health care market.

Because we believe the “wrongs” of MinnesotaCare can still be made “right,” the paper concludes by detailing the framework of a market-oriented health system that addresses tax changes, promotes medical savings accounts, and offers a whole new set of incentives. This approach will give Minnesotans an economically sound way to reduce health care costs, stimulate innovation, and empower consumers to achieve a higher level of satisfaction from the health delivery system.


Ought all Minnesotans, regardless of income, have access to good health care for themselves and their families? Of course, and not only is this a settled question, it never should have been conceived or understood otherwise.

But does that mean that the bureaucratic superstructure that the State of Minnesota has constructed over the last few years — MinnesotaCare — is the right method to that end? As this second question itself not-so-subtly suggests — and as this carefully argued essay makes clear on both theoretical and empirical grounds — the answer is no.

“Though the intent of the designers of the legislation was to stimulate innovation and competition,” Roger R. Conant, Bryan E. Dowd, and Robert E. Christenson write, “it will be demonstrated that the exact opposite is occurring . . . .”

This is not to say that the three authors indict all of MinnesotaCare (which is the composite product of several recent years of legislative activity). For example, they applaud its Minnesota Employers Insurance Program, which makes it possible for small firms to buy insurance for their employees under terms akin to those enjoyed by larger businesses. “Since the private sector had not been particularly successful,” they write, “in offering small businesses the high-quality policies offered by large businesses, it was reasonable to give the government a chance to try its hand.”

Still, their overall judgment is blunt:

The notion that the government does, or even can know enough to reorganize or allocate resources in an industry as large as health care is a prime example of what Friedrich Von Hayek termed “the fatal conceit” of socialism. The lesson of the 1970s health planning efforts, repeated in the 1993 [MinnesotaCare] act, is that even if it were technically possible for the government to know enough to reorganize the system efficiently, the government wouldn’t be capable of pulling it off. A government program with that much power is virtually certain to be commandeered by the health care industry and thus be driven by the desires of the industry, not consumers.

In addition to its critique, “MinnesotaCare: A Law That Lost Its Way” offers a full dose of improvements. These include repealing all sections of the legislation involving price controls and “global expenditure controls”; repealing the “community rating” insurance requirements; and rescinding the “standardized benefit” legislation and replacing it with a system of rating and ranking insurance policies. And so on.

Messrs. Conant, Dowd and Christenson conclude that if the Legislature, Department of Health, and the Minnesota Health Care Commission “had remained focused on the uninsured” rather than remaking Minnesota medicine, there still would have been some mistakes made, “but the benefits could have been great and the damage minimal.” Instead, they write, “results have been quite the opposite.”

Roger Conant is a founder and chairman of the board of the Lamat Corporation, a holistically based health care management organization in Minneapolis. He is also a managing director of Source Capital, Ltd. A practicing business economist for most of his career, he previously served as senior vice president and chief investment officer with the St. Paul Companies. He holds a Ph.D. in economics from Columbia University and an MBA from the Wharton School. He is also a Chartered Life Underwriter.

Bryan Dowd is an associate professor in the Institute for Health Services Research at the University of Minnesota, as well as director of graduate studies for the master’s of science program in Health Services Research and Policy (likewise at the U of M). His primary research interests are markets for health insurance and health care services, and evaluation of nonexperimental data. He received his Ph.D. in public policy analysis from the University of Pennsylvania.

Robert E. Christenson is founder and senior principal of The Center for Innovative Governance, which advises health care organizations on strategic issues and (as the name suggests) governance matters. Over a span of 30 years, he has served on the boards of numerous health care agencies, both locally and nationally. He is a past chairman of the board of Health Central Inc., a forerunner of the Allina Health System, and a past president of the Metro Hospital Trustees Council in Minneapolis.

This paper originated in a conversation late last year between Roger and American Experiment’s first chairman, Steve Young. One thing led to another, and the three eventual writers and I wound up meeting, debating and editing over breakfast every six weeks or so over the winter and spring. Frankly, I wasn’t confident that such a collective enterprise could work out so well — particularly since we had problems along the way with competing computer systems. But I’m most impressed with this solid piece of research and writing on what is an unusually complex topic. My great thanks to its three authors.

American Experiment members receive free copies of almost all Center publications, including “MinnesotaCare: A Law That Lost Its Way.” Additional copies are $4 for members and $5 for nonmembers. Bulk discounts are available for schools, civic groups and other organizations. Please note our phone and address on the first page of this Foreword for membership information.

Thanks very much, and as always, I welcome your comments.

Mitchell B. Pearlstein

June 1995

(I) Introduction

The 1990s have been a decade of sweeping health care reform in Minnesota. More than any other factor, Minnesota’s uninsured population has been the driving force behind the call for reform at the state level.

A 1990 survey, conducted by the University of Minnesota Institute for Health Services Research, found that at any given point, 6.5 percent of Minnesota’s 4.5 million residents were uninsured (Lurie, et al., 1990). Approximately 8.6 percent were uninsured for at least one month during the year, and 4.5 percent for the entire year.

Concern for the uninsured is a long-standing tradition in Minnesota. For evidence of this, one need only examine the generosity of the state’s Medicaid program and the establishment, in 1976, of the Minnesota Comprehensive Healthcare Association (MCHA). MCHA has become the country’s oldest, largest, and most expensive pool for medically high-risk consumers denied coverage by the insurance industry. The Children’s Health Plan, created in 1987, provided minimal coverage to low-income, children under age eight, as well as pregnant women who do not qualify for Medicaid. Its annual premium was only $25.

Commencing in 1989, Gov. Rudy Perpich appointed the Minnesota Health Care Access Commission to “develop and recommend to the Legislature a plan to provide access to health care for all state residents.”1

Major health care reform legislation was first passed by the Minnesota House and Senate in 1991 (House File 2), but was vetoed by Gov. Arne H. Carlson on the grounds that the bill lacked an adequate financing mechanism. A bipartisan commission representing the House, Senate and governor’s office then produced the so-called HealthRight bill (later renamed MinnesotaCare Act of 1992), which Governor Carlson signed into law in April 1992. The commission, health department, and Legislature continued to work on health care reform issues, and further legislation was passed during the 1993, 1994 and 1995 legislative sessions.

The main purpose of this paper is to provide a review and analysis of the 1992 and 1993 legislation. Our conclusions are mixed. Many of the goals and specific implementation strategies of the 1992 legislation were laudable and address real problems of equity and efficiency in health care markets. Other parts of the 1993 legislation, and virtually all of the subsequent legislation are conceptually flawed. Their implementation has already seriously harmed Minnesota consumers and the health care delivery system and created the potential for far more damage.

(II) A Brief Summary of Health Care Reform Legislation in Minnesota

The Minnesota Health Care Access Commission (1989-1990); the 1991 legislation (which was vetoed); and the 1992, 1993, 1994 and 1995 legislation were all developed in an environment that proclaimed a crisis in the American health care system. The following four factors contributed to the perception of a crisis:

  • relatively high insurance premiums and high premium growth rates;
  • special problems in the individual and small-group insurance market, including “blacklisting” (unwillingness on the part of insurers to write policies for certain types of businesses), and huge premium increases or termination of coverage following an illness or injury;
  • a significant number of Americans without health insurance; and
  • the impact of Medicare and Medicaid on other state and federal spending, as well as on the federal debt.

The original 1992 legislation addressed many issues beyond the immediate problem of the uninsured. The 10 main articles in the bill covered:

  • cost containment
  • reform of the small-employer health insurance market
  • reform of the individual health insurance market
  • expansion of the Children’s Health Plan
  • rural health initiatives
  • education of health professionals
  • data collection and research initiatives
  • medical malpractice
  • financing
  • appropriations

To address cost containment, the 1992 act established the Minnesota Health Care Commission (MHCC) with 25 members. The governor appointed 13 (including the chair); the Legislature appointed two consumer representatives; and trade associations and other organizations appointed the remaining 10.

MHCC was charged with submitting a plan to the governor and Legislature that would reduce the health care inflation rate in Minnesota by at least 10 percent over the following five years; make recommendations on any spending exceeding these limits; and “help Minnesota communities, providers, group purchasers, employers, employees and consumers improve the affordability, quality, and accessibility of health care” (House Research: Bill Summary H.F. 2800).

Other highlights of the 1992 legislation included:

  • the establishment of a health care analysis unit, data collection advisory committee, and practice-parameter advisory committee;
  • a provision allowing the Commissioner of Health to approve mergers in the health care industry;
  • a provision requiring the Commissioner of Health to review and approve capital expenditures greater than $500,000;
  • a timetable for moving the state’s health insurance industry toward community rating;2
  • establishment of the Minnesota Employees Insurance Program, an insurance pool designed primarily for small businesses; and
  • special health insurance policies for small businesses.

By design, MHCC consisted of 10 representatives of health plans and health care providers. The majority of members from the medical community either represented major health care provider organizations or were closely allied with them. It is, therefore, not surprising that the 1993 legislation relied on the HMO approach for the provision of health services. Nor is it surprising that the legislation encouraged the development of vertically integrated delivery systems that combine large health plans with large hospital and physician corporations.

The 1993 legislation was quite different from reform proposals in other states or those presented at the national level. Michael Scandrett, executive director of MHCC, put it succinctly in his comparison of Minnesota’s approach to that of President Clinton’s health care reform proposal: “A major difference between the [Clinton proposal and Minnesota’s plan as embodied in the 1993 legislation] is that Minnesota’s plan targets the health care delivery system, while the Clinton plan emphasizes purchasing reform” (Institute for Health Services Research, 1993). This focus on the supply side of the market rather than the demand side meant that the original problem of providing access to insurance for the uninsured had now become a problem of redesigning Minnesota’s health care delivery system.

Redesign of the health care delivery system in the 1993 legislation took the form of a cost-containment strategy that would divide Minnesota’s health care system into two sectors.3 One sector would consist of competing HMO-like organizations, termed integrated service networks, or ISNs. The other sector would include health care providers (e.g., physicians and hospitals) who chose not to join an ISN. This sector would be reimbursed under a regulated all-payer (RAPO) system. Fees under the RAPO system would be set by the state and, like ISN premiums, would be regulated with reference to expenditure “targets” established under the 1992 legislation.

The 1993 legislation also called for development of a standardized benefit package that would have to be offered by all ISNs. The effective date for the most significant provisions of the MinnesotaCare Act of 1993 has been deferred repeatedly. As of the most recent 1995 legislation, the effective dates vary from item to item, but center around July 1, 1997. A fixed date is no longer proposed for the attainment of universal coverage.

A. What’s good about Minnesota’s health care reform legislation?

The 1992 act made a number of positive contributions to the health care market in Minnesota. The Minnesota Employers Insurance Program (MEIP), for example, makes it possible for small businesses to purchase insurance under terms similar to those enjoyed by larger firms. Specifically, the MEIP pool offers employees of small firms a choice of health plans, with unrestricted choice of plans during annual open-enrollment periods. Pool membership also protects small businesses from experiencing dramatic premium increases should an employee become severely ill.

Since the private sector had not been particularly successful in offering small businesses the high-quality policies offered to large businesses, it was reasonable to give the government a chance to try its hand. The public’s subsidy of the MEIP pool was limited to a low-interest loan to cover start-up costs. This loan will be repaid through the premiums charged to pool members.

Another admirable feature of the 1992 act concerned insurance policies sold to small businesses. The 1992 act allowed the sale of reduced-coverage policies to small businesses that circumvented, to a degree, the state’s mandated benefit requirements. Jensen and Gabel (1992) estimated that 43 percent of smaller firms that do not offer health insurance are influenced by the high cost of state-mandated benefits.

The MinnesotaCare insurance pool, which offers basic coverage at subsidized premiums to low-income families, also was a desirable feature of the 1992 legislation. The coverage is not generous; it is limited to $10,000 of hospital expenses. However, expenditures above that level in a single year would qualify many MinnesotaCare enrollees for Medicaid coverage.

Providing some assistance to the working poor seems quite reasonable. This is particularly true because premiums paid for business health insurance plans are deductible. Employers who provide health insurance are allowed to deduct the employer-paid premium. If their employees also pay part of the premium, as most do under co-payment schemes, the employees can deduct the co-payments premiums (under Section 125 of the Internal Revenue Code) from their income prior to computing state and federal personal income and FICA taxes.

B. What’s bad about Minnesota’s health care reform legislation?

Unfortunately, the list of problems created by Minnesota’s health care reform legislation is considerably longer than the list of attractive features. The problems began with the 1992 legislation.

First it mandated implementation of community rating for all health insurers, requiring one premium for all customers. Community rating may seem fair at first glance. But its effects can be just the opposite. Under community rating, lower-income individuals who are healthy will provide premium subsidies to wealthy persons who are unhealthy. That transfer can occur either within or across generations. Good health, youth, and low income typically go hand-in-hand, and community rating requires the young — most of whom have yet to accumulate significant assets — to transfer their income, in effect, to the old, who typically have substantially greater income and assets.

However, young people have an escape clause under forced community-rating. They merely drop their health insurance. The Minnesota Department of Commerce predicted that 64,000 Minnesotans would drop their insurance coverage if the community rating provisions of the 1992 act were implemented.4 The community rating provisions of the law have not been extensively implemented, as yet. Thankfully, the governor and MHCC currently are recommending no further movement towards community rating in the individual and small group market, but the legislation remains in place.

The second problem was that the 1992 legislation proposed that the state track all health expenditures and take steps to prevent total expenditures from rising above a specified rate of increase. While there may be great value in making estimates of health spending in the state, the proposal that state government should limit health expenditures was hopelessly naive for these reasons:

  • It is not technically possible to keep track of every dollar spent on health care in the state. And when data are missing, they may be systematically, rather than randomly, missing.
  • The state does not have information that would permit it to know the “correct” rate of increase in health care spending, particularly for spending that is privately financed.
  • Controlling total health care spending would require the state to declare private transactions between citizens and health plans or providers to be illegal, a power the state does not possess nor is likely to be granted.

The third mistake in the 1992 act was granting the Commissioner of Health the power to override the state Attorney General in antitrust cases in the health care industry. Following the 1980s — which saw the number of competing Twin Cities hospitals reduced from 30 to three major systems plus a few independents, and the number of competing Twin Cities health plans reduced from seven to three — critics from both the political left and right agree: The primary antitrust problem in the health care industry has been inadequate, rather than overly aggressive, enforcement of existing law.

The 1992 act’s fourth flaw was inadequate financing for the premium subsidies required for the MinnesotaCare insurance pool. The two-percent tax on providers and the cigarette tax will leave the pool several hundred million dollars short of the amount necessary to subsidize the program.

Whereas the 1992 act was a mixture of good and bad legislation, the 1993 act was all bad. Perhaps the worst idea in the 1993 legislation was the RAPO system of state-imposed price controls. The original purpose of this legislation was to force providers into ISNs. This strategy assumes that the state is in a position to know the optimal design for the health care delivery system (i.e., ISNs), and that price controls are an effective way to force providers to accept the state’s superior wisdom. Neither premise is true.

The 1995 legislation eliminates the RAPO system. The threat posed by RAPO over three years unquestionably induced many physicians to sell their practices to HMOs. It will be interesting to see if the removal of this threat will reduce the pace at which providers have been joining HMOs.

The 1993 act also required the state to design a standardized benefit package. The argument in favor of standardized benefits, like the argument for the earlier mandated benefits legislation, is based on three highly suspect assumptions:

  • all citizens want or need roughly the same package of health insurance coverage;
  • the state is capable of discovering the contents of that package; and
  • the state is politically able to require the package that consumers want, rather than the package that health care providers want.

The state’s experience with mandated benefits suggests that rather than serving consumers’ interests, MinnesotaCare’s standardized benefits legislation is far more likely to serve the interests of providers, whose services many consumers would not voluntarily include in an insurance contract. It also more likely serves the interests of elected officials who find it more rewarding to cater to providers than consumers. Minnesota’s experience reflects the national experience with mandated-benefits legislation (Jensen and Gabel, 1992).

Why the errors?

The regrettable parts of the 1992 and 1993 acts arose for different reasons. The problems with the 1992 act result from lack of a clear understanding of the problems that plague the health insurance and health care services markets and failure to develop a clear perspective on what should be done to resolve those problems. In that respect, the 1992 legislation shares many of the same problems as the Clintons’ health care plan.

The regrettable parts of the 1993 legislation have a much simpler explanation. The 1993 act is the product of an over-empowered Department of Health and an over-empowered MHCC that sought not only to perform their legislatively mandated tasks, but also to expand the scope of their responsibilities, and in the process managed to construct new sources of market failure rather than remedy existing ones.

The 1993 legislation was produced by the same process that doomed the health planning efforts of the 1970s. During the 1970s, Americans undertook a vast experiment in health planning that featured mandated benefits, certificate of need (CON) laws, hospital rate regulation and regional health planning agencies. That experiment was abandoned for a simple reason: It was ineffective at best, and frequently harmful. Paul Feldstein, one of the country’s leading health economists, offers a succinct summary of health planning in his popular health economics text:

The evidence on health planning in this country does not support the traditional or public interest view of regulation, namely that regulators will lower the price of goods and services produced by the regulated industry. Instead, the evidence on performance of regulatory agencies in non-health fields appears to predict the outcome of regulation in the health field; when the regulated industry is the major group with a concentrated interest, regulatory agencies are strongly influenced by the industry they are meant to regulate. (Feldstein, 1993)

Salkever and Bice (1976) and Sloan and Steinwald (1980) found that certificate of need laws increased the cost of hospital care, and Sloan (1983) found that the effectiveness of CON legislation decreased over time.5

Minnesota’s health care reform legislation of the 1990s literally brought health planning, CON laws (approval of capital expenditures), price and expenditure controls, and mandated (standardized) benefits back from the dead. The most troublesome aspect of Minnesota’s health care reform legislation is not the regrettable parts, per se, but the strong indication that our policy makers find it necessary to keep repeating their mistakes.

The notion that the government does, or even can, know enough to reorganize or allocate resources in an industry as large as health care is a prime example of what Friedrich Von Hayek termed “the fatal conceit” of socialism (Hayek, 1988). The lesson of the 1970s health planning efforts, repeated in the 1993 act, is that even it if were technically possible for the government to know enough to reorganize the system efficiently, the government wouldn’t be capable of pulling it off. A government program with that much power is virtually certain to be commandeered by the health care industry and thus be driven by the desires of the industry, not consumers.

Unfortunately, the fatal conceit is alive and well both nationally and in Minnesota, particularly in health policy. In the next section we discuss the real problems with Minnesota’s health care system. Finally, we offer a set of recommendations that will expedite the state’s progress towards true consumer-driven reform of the health care system.

(III) The Real Problems in Health Care Markets

There are, of course, serious problems with markets for health care services and health insurance. Healthy markets require reasonably good information on the price and quality of goods and services, reasonably free entry to the market by new firms if the profits of existing firms get too high, and prices that reflect the marginal cost of commodities produced in the most efficient manner. None of these conditions is met in health care markets, but only one of the downfalls — poor information — is a natural problem. Restricted entry and price distortions are “manufactured” problems, and most often, these problems are the direct result of government policy.

A. Distorted prices

Insurance itself is a source of price distortions in the market for health care services. Widespread employment-based health insurance is largely a post-World War II phenomenon. Before that time, health care was delivered in a generally competitive environment characterized by many consumers, many suppliers, and competitively set prices. Physicians viewed the patient as the customer, and they attempted to maximize consumer satisfaction. The picture in our minds of the friendly family doctor making house calls is our reaction to physicians’ attempts to make us feel good about the services they provided.

Before World War II, health insurance was very rare. Hospital bills were routinely paid out-of-pocket by individuals. The result was that the daily cost of a hospital stay was not much more expensive than that of a medium-priced hotel. All of this began to change with the introduction of health care insurance. Slowly, the focus began to shift away from the medical care consumer to other parties.

During World War II, wages and prices were controlled, and controls were not removed immediately at the end of the war. The economy was quite strong, and employers needed to attract and retain labor. Since they were prohibited to bid for labor by raising wages, they hit upon the idea of offering health benefits as a way of competing for workers while avoiding the caps on wages.

Initially, corporations offered insurance similar to today’s auto insurance: indemnity with high deductibles. While the initial impact on the health care system was not great, the symbolism was important. Health care consumers had begun to be separated from their medical costs. Today, there is a movement to restore consumer sensitivity to price differences among medical providers, which includes preferred provider organizations, point-of-service HMOs, and medical savings accounts, which typically feature significant deductibles.

Another important price distortion occurs in the market for health insurance. Health insurance premiums, when purchased by employers, are exempt from state and federal personal income taxes and FICA taxes. This exemption is inefficient and easily could be considered unfair, as well. The tax exemption of insurance premiums creates an artificial reduction in the price of insurance (though not a real reduction), as consumers purchase, through their employers, more insurance than they would in the absence of the tax exemption. As a result, they have less disposable income and face higher prices of both insurance and health care services. Those losses outweigh the gains of additional insurance by an amount that Feldman and Dowd (1991) estimated to be as high as $100 billion per year (in 1984 dollars). Thus, the net effect of the tax exemption probably is to harm, rather than help, consumers. The tax exemption is thus “apparently” regressive, providing greater apparent benefit to those in higher tax brackets.

There is no intrinsic reason to favor health insurance over wages in the provision of compensation to employees. The primary beneficiaries of the tax exemption are health care providers and insurance companies who benefit from reduced price competition in markets for their services. Removal of the tax exemption would bring greater efficiency to the private health insurance market and also provide funds that are needed to help the working poor afford some level of coverage. In their rush to reorganize Minnesota’s health care delivery system, the 1992 and 1993 acts left this crucial source of distorted prices untouched.

Another distortion in the price of insurance introduced by the 1992 act is community rating. To understand how community rating distorts prices, it is important to understand the meaning and purpose of true insurance.

Insurance eliminates “risk” by pooling a large number of individuals together. The type of risk that is eliminated by insurance is random risk. To the extent that differences in expected health expenditures are predictable (i.e., two people have different probabilities of experiencing an unfortunate medical event), requiring them to pay the same insurance premium transfers income from the low-risk individual to the high-risk individual. The income transfer itself is not insurance; it is a “gift” from low-risk individuals to high-risk individuals. Thus, it is misleading to say that the purpose of an insurance policy is to transfer income from the healthy to the sick. That statement is true only if those who are currently healthy and currently sick were in the same state of health at the time the insurance contract was written.

Community rating is inefficient because it leaves both high- and low-risk individuals facing the wrong price of insurance (Pauly, 1970). As a result, low-risk individuals demand too little insurance, while high-risk individuals demand too much insurance. Furthermore, as discussed earlier, community rating could easily be considered unfair for three reasons.

First, it results in a transfer of income from low-risk individuals, who typically are young and have low income and few assets, to older individuals, who typically have greater income and assets.

Second, as noted by Pauly (1984), forcing insurers to charge one premium for all consumers guarantees that insurers will discriminate against high-risk individuals. When insurers are not allowed to charge premiums that reflect the true cost of insuring individuals, insurers have little choice but to try to discriminate against high-risk individuals in ways undetectable to watchdog bureaucracies.

Third, as noted by Minnesota’s Department of Commerce, community rating will drive healthy low-income consumers into the ranks of the uninsured. In short, by adopting community rating, the Legislature has formulated a policy that guarantees discrimination against both the sick and the poor.

B. Problems in the individual and small-group insurance market

The primary problems with the individual and small-group insurance market are high administrative costs and an apparent scarcity of policies that offer protection from having one’s risk redefined by the insurer in the event of a major illness or injury. The problem of high administrative cost can be solved instantaneously by offering individuals and small groups pooled insurance. As noted earlier, the MEIP pool, established under the 1992 act provides that opportunity to small businesses (as few as two employees), but individuals still face high administrative costs.

The problem of risk redefinition generally is laid at the feet of the insurance industry. But despite popular opinion to the contrary, the explanation of those problems is found primarily in consumer behavior rather than a villainous health insurance industry.

If an insurer markets a “community rated” policy, thereby charging the same premium to everyone who wishes to enroll, those who enroll are likely to be individuals who expect their health expenditures to exceed the premium. To keep from losing money, the insurer will have to raise the premium unless low-risk individuals generously offer to subsidize the costs of higher-risk individuals. In the past, that generosity has not been the norm. Insurers have responded by risk-rating applicants, so that individuals in the same risk class pay the same premium. The need for risk segmentation arose not from insurer greed, but from an unwillingness on the part of low-risk consumers to subsidize the premiums of high-risk consumers.

Mandatory universal insurance coverage won’t solve the problem of risk-rating. Even if a group of consumers who are in the same risk class are assembled in one time period and pay the same premium, their risk will change during that period because some individuals will experience illness or injury that will increase their expected expenditures in the next time period. When the insurer quotes premiums for the second time period, the insurer can continue to charge everyone the same premium only if the people who remained healthy during the first time period agree not to switch to another insurer who offers a lower rate due to their low-risk status. As noted, in the past, that sort of generosity has not been the norm. If the insurer does not redefine the consumer’s risk following an illness or injury, the good risks will be picked off by competitors offering lower rates. Insurers respond in the second period by dividing the high and low risks into separate groups with different premiums. Of course, that leaves the high-risk individuals paying a higher premium; in some case, much higher.

A far better approach is to offer consumers insurance contracts that extend over more than one time period, offered through insurance pools. But both Pauly (1978), and
Dowd and Feldman (1992), have noted the relative scarcity of multi-period health insurance contracts in the private sector. Since the private sector has not been particularly effective in producing pooling opportunities for consumers in the individual and small-group market, it is reasonable to give state and local governments a chance. That is why the MEIP pool began under the 1992 act is good public policy. In order to attract members, the MEIP pool must offer consumers a better deal than they currently are able to get in the traditional insurance market.

C. Poor information in health care markets

Of all the sources of market failure in the health care industry, the one natural problem is poor information. Insurance policies are often difficult for consumers to interpret and both consumers and physicians often have a limited understanding of the costs and benefits of particular treatments.

A popular but flawed approach to poor consumer information about insurance policies is to have the government mandate a minimum or standard set of benefits that must be included in all policies. Standardized benefits often are defended on efficiency grounds; i.e., once consumers are assured that their insurance contract contains a guaranteed package of benefits, they can focus their shopping efforts on price. This argument is flawed because many characteristics of health plans that are most important to consumers — such as the availability of specific physicians and hospitals, average waiting times for appointments, waiting time in the office, or courtesy of office staff — are never included in standard benefit requirements, so standardizing coverage in no way guarantees that consumers will focus on price.

Not only do standardized benefits fail to improve efficiency in insurance markets, they often have the opposite effect. Requiring all consumers to purchase the same set of benefits can dramatically reduce consumer welfare unless all consumers happen to want the same set of benefits, which is unlikely to be the case. Individuals in their 50s are likely to have low demand for coverage of infertility treatments, for example.

Another problem is that when governments set out to standardize health insurance benefits or to set a minimum level of mandated benefits, the results generally reflect confusion over efficiency versus fairness. In its attempt to be fair to low-income individuals, the government often sets a very generous level of mandated benefits. Frequently, the generosity of the mandated benefit package also reflects the degree to which the process has been captured by health care providers. In any event, the efficiency of health insurance policies with significant coinsurance and deductibles is abandoned in the pursuit of fairness.

The attractive aspect of health insurance is that it provides protection against the risk of unpredictable health expenditures. All risk-averse consumers should want to buy insurance that offers that protection, if it can be purchased at an actuarially fair premium. Consumers who are highly averse to risk should be willing to pay a substantial premium for that risk protection.

Many consumers also understand the downside of insurance — that it makes health care services appear artificially “cheap” at the time they are purchased, resulting in inflated demand for services and less careful shopping on the part of consumers. Both of these cause the price of services and insurance premiums to rise. For that reason, astute consumers choose policies with nominal coinsurance and deductibles.

Indeed, it can be shown that the optimal coinsurance will feature some degree of point-of-purchase cost sharing (Raviv, 1979). Unfortunately, however, this well-known result is forgotten when government goes about the task of designing standardized benefit packages as required by the Minnesota health care reform legislation.

The solution to the tension between fairness and efficiency is fairly simple, but infrequently implemented. If society wishes to ensure that low-income individuals have generous insurance policies with first-dollar coverage, then a separate entitlement to those policies should be constructed that is entirely separate from the policies that all individuals are required to buy. The standardized benefit package that will be produced by the State of Minnesota has yet to be determined, but by mandating a standardized package, the 1993 act sets the stage for the usual mistakes.

The problem of poor information about insurance policies can be addressed without requiring all consumers to buy the same insurance package. Insurance policies can be rated and ranked, thus simplifying consumers’ information requirements, while still maintaining a diverse range of insurance products in the market. A rating and ranking system currently is in place in the Medicare supplementary insurance market.

Evaluating the efficacy of treatements

A second area of poor information concerns the effectiveness of specific medical treatments. Both patients and physicians often have poor information on treatment effectiveness due to either ignorance of the options or a paucity of existing data on the effectiveness of the treatment. The lack of good information on the efficacy of medical treatments certainly is a problem that needs to be taken seriously.

The 1992 act attempted to address the poor information on medical treatments by establishing a health care analysis unit. The purpose of that unit was to conduct research on the efficacy of medical treatments, develop and disseminate the results of such research, and provide technical assistance to purchasers of health plans and health care services.

The act puts considerable weight on using outcomes research to determine the “best” medical procedures. But it is far from clear why a state government, with relatively limited resources, should expect to succeed where federal agencies with much larger budgets currently are struggling. The Agency for Health Care Policy and Research, the branch of the federal government charged specifically with doing outcomes research, has poured millions of dollar into that effort with very little to show for it (Kent, 1994). Whether the Minnesota Department of Health can outperform the federal government remains to be seen.

Why has medical outcomes research not produced more useful results? To be successful, it’s possible that outcomes research must focus on populations that are bigger than are available for most procedures. Also, the research may demand greater stability over time in the relevant technologies than is generally the case. For example, an outcomes study recently conducted in Canada concluded that mammography was not helpful for women under age 40 (Miller, et al., 1992). The research was justly criticized on the grounds that x-ray technology had improved during the course of the study to the point that, if the study were repeated, the results would be different. Thus changes in technology had invalidated the study. This problem is endemic to virtually all outcome studies.

An analogy drawn from the field of investment management may be useful. It has long been known that it is not possible to determine which investment house will produce the best future investment results by examining the firm’s past performance. The reason is that the researcher must gather data over a long period to obtain statistically valid information on past results. In the meantime, financial markets change their character and firms change their personnel and techniques. Before enough data have been collected upon which to base valid future projections, the markets, investment houses and managers all have changed so much that more data are needed. The process never stabilizes and no conclusions can be reached.

The 1992 act also required the Department of Health to develop a series of practice parameters that, if followed precisely, would provide physicians protection from medical malpractice suits. This means that physicians who choose to ignore government guidelines will face meaningful financial penalties in the form of increased malpractice insurance rates and increases in the time and energy that must be spent in malpractice defenses. Although the intent of the provision may have been benign, the result will be that government becomes the medical practitioner with the individual supplier acting as the government’s agent.

D. High health care costs

There is general agreement that the cost of health insurance and health care services is high for everyone. The most relevant indicator of high cost is the share of personal disposable income consumed by medical care, which rose from 8 percent in 1960 to nearly 14 percent in 1991. Over the same period, the share of income spent for food fell from 25 percent to 16 percent. The shares for housing, and gasoline and oil have remained relatively constant at about 14 percent and 3 percent, respectively (Council of Economic Advisors, 1993).

Is high health care spending a problem, per se? There are two schools of thought. Advocates of the first school answer “yes” and advocate the use of spending restraints, such as global budgets and regulation of premiums and provider fees to limit total health care spending.

The second school of thought contends that the current level of health care spending in the United States, per se, may not be a problem at all (Pauly, 1993). If the current level of spending is a problem, it is because prices for both health insurance and health care services are inflated due to market failure (Pauly, 1990). If prices were reduced to the competitive level, the level of expenditure by privately insured individuals would be neither inefficient nor a matter of public policy. However, expenditures by individuals in public insurance programs would continue to be a matter of public policy as long as those public insurance programs were funded by taxes.

Clearly, the 1992 and 1993 Minnesota acts, as well as the Clintons’ health care reform proposal are squarely in the first camp: High health care spending is a problem, per se. The problem with the proposed top-down price and expenditure controls in the 1992 and 1993 acts is that even if one thought that the current level of spending were the true problem (and we do not), it should be clear that the government has neither the knowledge, authority, nor technical capability to set appropriate spending levels, which would require restrictions on private transactions between patients and health care providers.

As for price controls, they have never worked in peacetime. The present health care delivery system evolved out of a successful attempt to avoid wage controls in the immediate post-World War II period. The price controls did mask inflation for a while, but as soon as the controls were removed, inflation returned to its natural pattern. Presidents Nixon and Ford also tried price controls, with a similar total lack of response.

To establish the efficient level of health care spending, the state would need to know each individual’s evaluation of the marginal benefits of additional health insurance or health care services. Having met that daunting requirement, the state would need to have the authority to prohibit private citizens from going to their physician or other health care provider, receiving services, and then paying for those services. It is difficult to imagine circumstances under which Minnesotans would willingly delegate that level of power to their state government.

E. Free entry into health care markets

The “free market entry” requirement ensures that new firms will enter the health insurance or health care market if the profits of existing firms get too high. Entry into these markets currently is far from “free.”

Both the health insurance and health care services markets are heavily regulated. Heavy regulation can impede new entry into markets. For example, licensing and reimbursement rules can make it difficult for nontraditional health care providers to enter the market. In 1994, Minnesota adopted “any willing provider” laws. These state that health plans must offer the services of any qualified provider who is willing to accept the published terms of the plan. It sounds like it should benefit the public, but in practice it results in a reduction of providers. Under the “any willing provider” laws, providers of cheap, low-quality medical service are able to demand that high-quality providers accept them as co-providers if the high-quality providers organize as HMOs. High- quality providers know this, of course, so they avoid the any willing provider laws by refusing to directly compete with established HMOs. This is why Weller (1984) has characterized any willing provider laws as a restraint of trade.

When industries are heavily regulated, markets can become concentrated; i.e., characterized by few sellers. But regulation is not the only factor that can lead to heavily concentrated markets. The evolution of the health insurance industry also has had an influence on the structure of health care markets. As employers became more involved in the provision of health insurance for their employers, they began to assert more control over health plans. After a slow start, HMOs began to grow rapidly in response to the needs of corporations and government incentives. As HMOs grew, they found that they could gain a competitive advantage over their traditional insurance rivals by controlling the utilization of services and demanding price discounts from hospitals and physicians.

Threatened with the loss of both income and control, physicians and hospitals began a process of consolidation, which accelerated dramatically during the 1980s. In the Twin Cities, increasing HMO market share came not from a single HMO (as in the case of Kaiser Permanente’s presence on the west coast) but from numerous aggressive HMOs. The pressure on utilization and prices was intense, and consolidation of both the health plan and hospital industry was a logical response. Currently, the Twin Cities health care market is dominated by three health plans and three hospital systems.

A little background may help explain what’s wrong with highly concentrated health care markets.

Monopolies, oligopolies, monosponies and oligopsonies

Monopolies are markets in which there is only one supplier. Monopolists control the market and, therefore, tend to supply less than would be the case in competitive conditions in order to hold prices, and thus profits, at high levels. For example, before the breakup of the long-distance telephone industry, AT&T kept long-distance rates high in order to maximize its own profits. Prices dropped as competition developed among newly created regional long-distance providers.

Oligopolies are markets in which there are only two or three suppliers, and in which restrictions inhibit new suppliers from entering the market. Although there are laws that outlaw active collusion among the suppliers, there is almost always implicit cooperation resulting in higher prices and lower supply than would exist under true competition.

The cellular telephone business is a case of oligopoly. By law, there currently are two, and only two, suppliers of cellular telephone services in each market. Consumers of cellular services find that there are only minor differences between the two suppliers, and that prospective costs of service between them are essentially the same. Within the next few years, however, there will be new entrants into the market. Without the slightest doubt, the presence of new suppliers will break the oligopoly, thereby leading to lower prices and better service than is currently offered.

Problems can arise when there is a dearth of purchasers, as well. Monopsony is a market in which there is only one purchaser, while oligopsony describes a market with only a few purchasers. A shortage of purchasers gives them market power to force a reduction in the price of the product they are buying. Although that may seem advantageous to the purchaser, problems arise when the purchaser uses the goods and services it buys in the production of other goods or services for consumers.

For example, if a few hospitals control the demand for nurses in a market area, the hospitals can extract a lower wage from them. But having driven down the wages of nurses below the competitive market level, the hospitals then are supplied with inefficiently low levels of nursing services (Varian, 1987).

Compared to the number of markets with restrictions on the number of suppliers, markets with a restricted number of purchasers are relatively rare, but they do exist. The effect of a shortage of purchasers is both market inefficiency and instability.

Sometimes markets are characterized by both a limited number of suppliers and limited number of purchasers. These “bilateral” oligopolies lead to unpredictable results characterized by both inefficiencies and instabilities. High profit levels can, however, induce new entrants into the market so that both the number of suppliers and health care products can increase. The resulting improvement in product quality and diversity, in turn, induces the number of purchasers to increase rapidly. This, of course, is how competition works.

How does this apply to Minnesota?

How does all of this apply to Minnesota’s health care industry? As noted earlier, the Twin Cities health care market is dominated by three large health plans and three large hospital systems: a bilateral oligopoly. In rural Minnesota it is not uncommon for a single large clinic to have complete control over the supply of physician and hospital services in a small town: a monopoly. Thus, the problems of inefficiency and instability that are endemic to highly concentrated markets are pervasive in Minnesota’s health care industry.

The designers of the 1993 act articulated the desire to stimulate more innovation and competition among ISNs than has been apparent among the existing HMOs. This was to happen naturally, due in part to specific provisions within the act. Those provisions of the act intended to stimulate competition have not been implemented. For example, the act provided that new ISNs could be established under special provisions with a capital base as low as $500,000. The act also stated that the state would lend part of the $500,000 to those interested in starting an ISN. In the two years since the act was passed, the special provisions have not been outlined, nor has the loan vehicle been created.

Concentration in health care markets facilitates collusion among sellers. Antitrust law normally prohibits collusion among market participants in setting prices and amounts of output. Long experience has shown that the public is ill-served by such collaboration and conspiracy. Rather than addressing the disturbing centralization of power in the private sector, Minnesota’s 1993 health care reform legislation encouraged it by giving the Commissioner of Health the authority to approve mergers among health care providers and insurers that otherwise would be in violation of antitrust law.

The natural competition that the acts’ designers had hoped to stimulate has not occurred. In the Twin Cities, where HMOs dominate the market, all ISNs have been created by existing HMOs. Smaller ISNs, called “Community Integrated Service Networks,” or CISNs, have formed in rural communities, but it is not yet clear whether these organizations, which are exempt from some of the requirements of larger ISNs, will enhance or preclude competition between local CISNs and larger Twin Cities-based ISNs.

Alternative providers

There is some good news on market entry, however. The traditional, highly regulated health care delivery system is being challenged by a system with many providers, many purchasers and competitively determined prices. Interestingly, an increasing number of consumers are supplementing — even abandoning — the highly regulated system in which they are not responsible for payments, in favor of this competitive system under which they must pay almost all expenses out of their own pockets.

The practitioners in this new system are identified as alternative, or complementary, or unconventional, or nontraditional care providers. Their legion includes chiropractors, naturopaths, acupuncturists, aromatherapists, herbalists, massage therapists, homeopathic practitioners, nutritionists, and any of dozens of other health-oriented disciplines. The alternative market system is almost entirely unregulated, and yet prices are kept low by the interaction of informed consumers and practitioners actively competing for customers. Practitioners advertise; they focus on client satisfaction. And despite the condemnations of alternative medicine by some medical doctors, malpractice suits are seldom experienced in this market.

The alternative health care market is immense and growing. At least 34 percent of the public uses this system.6 Many consumers find it an effective alternative to the traditional AMA system, and the result has been a higher number of visits to alternative health care providers than to conventional providers.7

Some of the alternative modalities are even achieving acceptance in physician clinics and hospitals, as well as health plans. Acupuncture has gravitated from the alternative to the traditional system. The mainstream medical journals now concede that chiropractors are effective for certain conditions, just as it is now recognized that a number of widely practiced traditional procedures are ineffective, if not dangerous.

(IV) Real Solutions for Minnesota’s Real Health Care Problems

MinnesotaCare should be replaced with a system that moves toward a market-oriented medical system. The provisions of this system would include the following:

To remedy distorted prices:

  • End the exemption of health insurance premiums from state personal income taxes.
  • Repeal all sections of MinnesotaCare legislation involving price controls and global expenditure controls.
  • Repeal the community rating requirements of the 1992 legislation.

To remedy restricted entry into health care markets:

  • Rescind the antitrust exemptions of the 1992 legislation.
  • Rescind the “any willing provider” provisions of the 1994 legislation.
  • Review all state licensure laws and insurer reimbursement practices to determine whether current practices primarily protect consumers or the incomes of traditional medical providers.
  • Remove the nonprofit requirement for HMOs in Minnesota.
  • Rescind the ISN legislation and then review current HMO regulations to determine the extent to which they discourage new entry into the market.
  • Provide additional funds for the state Attorney General’s office to monitor HMO pricing policies and the exchange of price information among HMOs.

To address the problem of poor information:

Rescind the standardized benefit legislation and replace it with a system of rating and ranking insurance policies.

Work with the private “information” industry to develop a data base on the efficacy of medical treatments that can be accessed easily by both health care providers and consumers.

Set a relatively short deadline (e.g., one year) for the Data Institute to produce useful consumer information on health plan and provider quality. If the Data Institute fails to provide useful information, withdraw public support from the Institute and contract directly with a public or private entity to produce the data and provide mandated access to “depersonalized” data from health plans and their participating providers.

To address problems in the individual and small-group market:

  • Offer lower-cost, reduced coverage policies through the Minnesota Employees Insurance Program (MEIP).
  • Use the MEIP administrative staff to open an unsubsidized pool for individuals, in addition to small businesses. The risk pool for individuals can be kept separate from the small business risk pool until the state is able to tell whether risks are substantially different in the two pools. Make small-business policies available to individuals through the “MEIP for individuals” pool.

These changes would clear out the harmful legislation that currently clutters Minnesota’s health care reform efforts, enhance the productive parts, and begin new initiatives that would increase the efficiency of our health care delivery system. As a result of that improved efficiency, health insurance would become more affordable for everyone, including those currently uninsured, and the cost of providing subsidies to those who truly need them would be dramatically reduced.

Thankfully, several of our recommendations have achieved the status of “talking points” in a number of policy-making circles. We understand that the department currently has no plans to develop or conduct outcome studies. Viewed across a very short time horizon, these proposed alterations to the MinnesotaCare legislation are encouraging. Viewed over a slightly longer time horizon, extending back to the 1970s and mid-1960s, the compelling question is why do our policy-makers keep making the same mistakes — health planning, certificates of need, price and expenditure controls, mandated benefits — over and over again?

V. Conclusion

Minnesota’s health care reform legislation began with a laudable goal: Providing assistance for Minnesotans without health insurance. The 1992 legislation contained several worthy provisions that addressed real problems of efficiency and fairness in our health care system. The legislation, however, suffered from lack of a sound conceptual basis, misunderstanding of health insurance markets, and a remarkably naive view of both the desirability and efficacy of “health planning” efforts such as caps on total health care spending, certificates of need, and price controls. The situation worsened as more and more powerful bureaucracies were created by the legislation, culminating in a misguided attempt to redesign Minnesota’s entire health care delivery system. As a result, Minnesota’s health care system now is more concentrated and potentially unstable than at any time in the past.

To see how far much of the MinnesotaCare legislation has digressed from its original goal, one need only examine the latest report on the uninsured (Minnesota Health Care Commission, 1995). The recommendations of this report include purchasing pools and subsidized coverage for low-income Minnesotans, both of which we support in some form. Interestingly, the report also contains a belated acknowledgment of the dangers of community rating and recommends a freeze on further movement toward pure community rating. What is most interesting about the report, however, is that virtually no reference is made to state-imposed expenditure caps, ISNs’ standardized benefits requirements, any-willing-provider laws, or antitrust exemptions. Why? Because these misguided initiatives have nothing whatever to do with the uninsured.

If the Legislature, Department of Health, and Minnesota Health Care Commission had remained focused on the uninsured, there still would have been a few mistakes in the area of insurance, such as community rating and standardized benefits, but the benefits could have been great and the damage minimal. Instead, results have been quite the opposite.


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1 Minnesota Health Care Access Commission Interim Report to the Legislature, 1990.

2 Insurance policies normally charge according to predetermined risk factors. For example, an individual with many automobile accidents will pay higher insurance premiums than somebody with a perfect driving record. “Community rating” means that all policy holders in a specified geographic area are charged the same insurance premiums, irrespective of their individual risk factors. Therefore, if there was community rating for automobile policies, all would pay the same premium regardless of driving record.

3 These are described in considerable detail in MHCC’s May 1993 report to the governor and state Legislature entitled “Containing Costs in Minnesota’s Health Care System.”

4 Department of Commerce study reported in the Star Tribune (Twin Cities), December 6, 1994.

5 See Phelps (1992) for a discussion of research on certificates of need.

6 The best hard data are based on the results of a 1990 survey in the February 1993 New England Journal of Medicine.

7 Ibid.