The health insurance system that prevailed from the 1940s through the 1970s contained the seeds of its own destruction. To point, any system that allows patients to spend other people's money at the point of purchase and reimburses providers based on their costs and not on set fees describes a system that will allow health care costs to invariably rise.

Consequently, rising health care costs will lead to higher health insurance premiums, thus incentivizing the people who are being overcharged through the system to find cheaper alternatives. New entrants into the health insurance market will supply those alternatives. And with increasing pressure to hold premiums down, third-party providers have increasing incentives to find cheaper alternatives to the cost-plus hospital system.

The system began to unravel in the 1970s and 1980s. Large employers took over managing their own health care plans, began paying hospitals based on fixed charges rather than costs, and negotiated cost discounts. The federal government, through the Medicare program, began paying hospitals fixed amounts for surgical procedures, i.e., the Prospective Payment System). Other prepaid programs, such as health maintenance organizations (HMOs), under which total charges are fixed in advance, emerged to compete with traditional fee-for-services medicine. The community rating system collapsed as insurance companies lowered their premium prices for lower-risk individuals and groups. The market for every medical service became more competitive.

The federal government began to encourage competition in the health care. For example, it eliminated federal funding for health planning agencies. It also eliminated "certificate of need controls" that required hospitals to have the government's permission to expand capacity or to buy expensive equipment. These changes increased the private sector's ability to solve many issues. Yet, the removal of the most overt barriers to competition -- while leaving more invisible barriers in place -- has caused three problems.

One is the lack of health insurance. About 34 million Americans do not have health insurance, and this number has been rising. At least two government policies have contributed to this problem and made it much worse.

The first policy is the tax law. Many people who work for large companies get health insurance as a benefit. Because health insurance premiums are deductible expenses for employers, workers effectively avoid a 28 percent income tax, a 15.3 percent tax for Social Security (half of which is paid by employers), and a 2-9 percent state and local income tax. As a consequence, as much as 50 cents of every dollar spent on health insurance through employers is effectively paid by the government. And we get what we subsidize. About 90 percent of the people who have private health insurance get it through an employer.

In contrast, the unemployed, the self-employed, and most employees of small businesses get little or no tax subsidy. If they have health insurance, they must first pay taxes and then purchase insurance with what is left. On the other hand, most of the 34 million people who do not have health insurance pay higher tax rates to cover the $60 billion annual tax break for those who have employer-provided insurance.

A second source of the problem is state government regulations -- specifically, laws that cover what is covered under health insurance plans. Examples of mandated coverages include drug abuse, alcoholism, AIDS, acupuncture, mental illness, and in vitro fertilization.

In 1970 there were only thirty mandated health insurance benefit laws in the United States. Today there are at least one thousand. Coverage for heart transplants is mandated in Georgia, and for liver transplants in Illinois. Minnesota mandates coverage for hairpieces for bald people. Mandates cover marriage counseling in California, deposits to sperm banks in Massachusetts, and pastoral counseling in Vermont.

There are more than 240 different health-related professions in the United States, ranging from chiropractors and naturopaths to athletic trainers. Every year, these special interest groups demand more and more regulations -- and more and more mandated coverage. These regulations drive up the cost of health insurance. For example, the National Center for Policy Analysis estimates that as many as one out of every four people without health insurance have been priced out of the market by costly regulations.

Not everyone is directly affected by state regulations. For example, federal law exempts government employees, Medicare participants, and employees of companies that manage their own health care plans. The last group employs more than half of all workers. State governments often exempt Medicaid patients and state employees. Therefore, the burden of the mandates falls on employees of small businesses, the self-employed, and the unemployed. Yet these are the very groups that increasingly do without health insurance.

Rising health care costs is the second major problem. This is a problem that also is exacerbated by federal tax law.

The primary reason health care costs are rising is that most spending on health care is accomplished with someone else's money rather than the patient's. As a result, patients avoid making tough choices concerning health care. The most wasteful kind of health insurance is that for small medical bills. These are expenses patients elect to make and create opportunities for waste and abuse. Moreover, by the time an insurance company gets through processing a twenty-five-dollar doctor bill, the cost will be fifty dollars which doubles the cost of the medical care.

An alternative to third-party insurance is self insurance. An alternative to having third parties pay every medical bill is having people pay most medical bills with their own money. An alternative to large bureaucracies limiting spending decisions with arbitrary rules and regulations is letting people make their own decisions.

Many economists who have studied the health insurance market believe a more prudent approach is to choose a high deductible and put the savings from lower premiums in individual medical savings accounts. In a short period of time, a majority of people would have accumulated savings far in excess of the annual deductible. If not spent, these funds could be used for post-retirement medical expenses or as a supplement to retirement pensions. Singapore, for example, has built its entire health care system around self insurance. Singapore workers are required to put 6 percent of their income into medical saving accounts every year.

In the United States, we have moved in exactly the opposite direction. Every dollar employers spend in premiums for third-party health insurance receives a generous tax subsidy. Every dollar employees put into a savings account is taxed.

The third problem is the lack of actuarially priced insurance. In other words, there is not a real market for health insurance in which health risks are accurately priced. During the 1980s, many large companies realized that premiums did not buy insurance. Instead, they were established to cover the employees' actual health costs each year. This is the reason why most chose to self insure, cut out the middleman (i.e., the insurance company), and pay health care bills directly. Today, about 80 percent of large companies use third-party insurers primarily to process health care claims rather than to provide actual insurance services.

Ironically, however, many large companies continue to price health insurance internally using the old Blue Cross method. Consequently, if the average cost per employee is $3,300, employees are asked to pay half that amount; thus, all pay $1,650, regardless of their individual health risks. Because a 60-year-old employee will generate about $5,280 in costs, on the average, older employees find health insurance underpriced and tend to bargain for more coverage for more items. For younger employees with expected costs of only $1,320, even one half of the premiums they would pay is often a bad buy, and their impulse is to forgo coverage.

For small group and individual policies, the problem is even worse. Under the pay-as-you-go approach, insurers typically increase premiums each year to offset the continuing costs of people who contracted lengthy illnesses in previous years. As a result, healthier people who are better risks find they can switch insurers and pay lower premiums or do without coverage altogether. Remaining are the people who continue to buy coverage and pay higher and higher premiums each year.

Today, many large insurers propose dealing with this problem via state or federal laws that would reimpose to least some extent the old system of community rating. This would, in effect, outlaw price cutting and force insurers to share in the losses of others. The alternative is to adopt policies that encourage a market for real health insurance, in which risk is accurately priced. This course requires laws and regulations designed to prevent the market from working as it normally would. The alternative requires a legal environment that will allow the market to work as it should.