01:00 AM EST on Wednesday, November 17, 2004

BLUE CROSS has problems. This time the problems are with its Direct-Pay customers. Customers who actually pay. They actually write checks. Blue Cross wants to charge these self-sufficient individuals a whopping 17-percent increase in their health-care premiums. This program obviously does not work, which should surprise no one. It was not meant to. It is predictable.

It is also an example of what is wrong with Blue Cross and what is wrong with the Rhode Island business climate in general.

The purpose of insurance is to shift the risk of an uncertain future event to a large pool of risks, to reduce it. The larger the group, the lower the premiums, because the higher-risk populations will be mixed with lower-risk populations. This spreads that risk over a broader group and lessens the average risk.

The Direct-Pay customers have been carved out as a higher-risk group. Obviously, business owners and retirees are generally older than the general population; since they are older, there is a higher probability of illness and claims compared with other group policies, which are assessed with a younger and healthier pool. The Direct-Pay customers are also more vulnerable because they are not organized with sufficient economic power to bargain with the provider.

So are we at all surprised that this program loses money and needs higher premiums?

Next is the problem with Blue Cross itself. The managers of Blue Cross are agents. The common laws of agency and game theory agree that agents act in their own interests, rather than the interests of their employers or shareholders. (See Enron.) But exactly who are the owners of Blue Cross?

Both the law and the market provide six methods to stop agents from taking anything that is not nailed down. They are: 1) business failure, 2) the market for corporate control, 3) managerial duties required by law, 4) direct managerial financial incentives, 5) corporate-governance oversight, and 6) shareholder empowerment. None of these applies to Blue Cross.

Blue Cross is a not-for-profit corporation. It can't go bankrupt. If it is even close, it gets bailed out by the state. It cannot be bought out. There are no publicly traded shares. If its management is inefficient, inept or corrupt, who cares? Its managers are supposed to have a fiduciary duty to shareholders, but there are no shareholders and therefore no shareholder lawsuits. A manager in a public corporation is sometimes given stock, which in theory is supposed to align his interest with the shareholders'. Who wants Blue Cross stock?

In the absence of shareholders, the state and the board of directors are supposed to regulate things. Not very promising. I am sure that Genevieve Martin, Elizabeth Dwyer, and their boss at the Rhode Island Department of Business Regulation, Marilyn McConaghy, are very competent lawyers, but that is the problem. They are lawyers, not experts in health-care administration or economics.

Do they have the expertise to ensure that Blue Cross is bench-marking its practices to the most efficient companies? Why isn't there a pharmacy-benefit manager, as in a corporate setting, for the Direct-Pay customers? Is there any move to institute economic incentives to encourage staying healthy and using cheaper drugs? Besides, what is their economic incentive? If they lose, do their health-care premiums go up? Are they out of a job?

The Journal has already described the competence of the Blue Cross board and its managers. Suffice it to say that it is appalling. If Blue Cross were a public company, its carcass would now be covered with lawyers.

So if Blue Cross is never going to work, what should we do? Try selling it. It must be worth something. Why does Rhode Island, a small state with a small insurance pool, need a separate Blue Cross? Why not merge it with Massachusetts Blue Cross? Why not a New England Blue Cross -- a company large enough to negotiate with all providers?

Finally, this is a perfect example of why the Rhode Island economy has problems. We have created a system designed to transfer money from small-business owners -- the source of most of our growth, jobs and taxes -- to people who retard growth and consume taxes. If it is economically inefficient to have a separate entity in this state, don't bother. If it is broke, which Blue Cross obviously is, don't fix it -- get rid of it. Or, in the alternative, put the Direct-Pay customers into the state-employee pool, so that we, too, can buy from UnitedHealthcare.

William Gamble is a Providence-based lawyer who does risk analysis of emerging foreign markets.