The nation's largest health insurance system is dominated by the physicians whose bills it was set up to pay, an arrangement that may reduce competition and raise prices artificially, the chairman of the Federal Trade Commission testified yesterday.

"It is difficult to see how the public interest can be served by such an apparent conflict of interest," FTC Chairman Michael Pertachuk said of the physician-dominated Blue Shield health insurance system, which covers doctor bills for roughly 40 per cent of the American population.

Testifying before the House subcommittee on oversight and investigations, Petshuk said that an ongoing FTC investigating has found that "most" of the 72 Blue Shield plans are controlled by local medical societies, other physicians' groups or "self-perpetuating physician boards" set up to run the plans.

Blue shield was established during the 1930s by physicians who were concerned about their patients' ability to pay their bills. Blue Cross a companion program, pays hospital bills.

"Whenever a supplier of a service controls how much the largest group of consumers is willing to pay, the cost of providing the service will go up and up and up." Rep. Albert Gore Jr. (D-Tenn) said. Gore said preliminary information gathered by the subcommittee indicates "that the medical professional retains effective control of Blue Shield policies. If this is true, it should surprise no one that medical bills have been rising much faster than the overall rate of inflation."

Since the FTC's investigation of Blue Shield is not yet completed, Pertschuk avoided drawing any firm conclusions about the effects of physician domination of the plans. Under questioning, however, he did agree that physician-controlled Blue Shield committees set the fees for physician services, that physicians on the committees receive fees paid by Blue Shield for services to patients and that these physicians are setting fees not only for other doctors but for themselves.

What the FTC staff has found, Pertischuk said, is the "appearance of an inherent conflict of interest in determining the method" of payment "and the apparent lack of incentives for utilizing innovative methods for keeping a lid on."

The subcommittee placed no estimate on the potential added cost to consumers that may result from physician domination of Blue Shield.

A study of New York state Blue Shield plans prepared by the New York state consumer protection board found, however, that the Blue Shield plan for the Rochester area had violated Medicare regulations by paying $700,000 in excessive fees over a three year period. The Rochester Blue Shield plan, like many around the country, administers medical care for the elderly under federal contractr, which accounts for $2.5 billion of the $6.5 billion that Blue Shield plans around the country pay annually to doctors.

The subcommittee also found that nominally "consumer" members of many Blue Shield boards actually are involved in the health care industry and that in at least one state - Indians - the president of a bank where Blue Shield deposited $107 million in funds was also Blue Shield's treasure.