How Obamacare inadvertently threatens the financial health of small businesses, and what states should do about it

Editor’s Note: This blog post originally appeared on Forbes.

Starting in 2016, push comes to shove for small businesses under the Affordable Care Act, better known as Obamacare. As of January 1, small businesses, broadly defined as firms with 50 to 100 full-time employees, must comply with the ACA’s employer mandate and provide qualified health insurance to their workers or face stiff penalties. But this requirement poses a big threat to the financial stability of small employers—and not for the reasons you might think.

Obamacare includes a myriad of regulatory incentives and exemptions that define the parameters of the employer mandate. However, these have inadvertent consequences. Most important, exemptions in the ACA encourage small firms to self-finance their health care plans—that is, pay their workers’ health care bills directly, rather than covering them through a traditional insurance policy. Most large companies in America (above 3,000 employees) engage in self-funding, but that is done now by only about 16% of small companies of between 50 and 100 employees. According to my research, that number is set to rise.

It’s understandable that small companies see self-funding as the superior option. By financing their own health care plans, they stay exempt from the community rating requirements that restrict how much insurers may vary premiums based on factors like age and smoking status; they also stay exempt from the federal and state taxes on most health care premiums that are paid to traditional insurers.

But these benefits pose significant risks for small businesses. While a big company usually has a diversified employee base and financial resources that can help absorb substantial overruns in health care expenses, a small company has neither. One big claim can wipe out a small company.

To limit their risk, small companies usually purchase stop-loss insurance, which kicks in when an employee incurs unusually high medical expenses. But here’s where things get dangerous: The handful of large reinsurers that sell stop-loss insurance do not typically require small businesses to constrain their health care costs. In other words, if a reinsurer believes a small firm has an expensive health care plan, it will simply charge a higher premium with a higher deductible. Since stop-loss policies are issued on an annual basis without guaranteed renewal, an unexpected rise in the health care costs at a small firm can lead to much higher premiums the following year or an abrupt cancellation of the policy.

A doomsday scenario is not far-fetched. Say an employee at a small company is diagnosed with some obscure but deadly type of cancer. He needs intensive therapy for two or three years at a cost of millions of dollars. The stop-loss insurer may pay for his care for one year but then get out of the contract as soon as possible. No other reinsurer will take on the policy, so the employer gets stuck with the bill. And for many small companies, a bill like that would be financially devastating.

With Congress gridlocked, it’s not politically feasible to pass amendments to the ACA to limit self-funding, so a solution must come from the states. Although states are not permitted to regulate the health care plans of employers, they are able to regulate stop-loss insurers. Some states have prohibited stop-loss insurers from providing policies to small companies; others have banned stop-loss policies with very low deductibles.

These measures are a good start, but we need more. One possible improvement would be for state regulators to require that every stop-loss reinsurer under its jurisdiction provide small firms with advance notice of three months before canceling a stop-loss policy or materially raising its premiums. The notice would give the employer a bit of leeway to figure out an alternative.

Another idea would be to expand and enhance the role of the brokers that small companies hire to handle their reinsurance needs. Today brokers get paid a commission on each reinsurance policy they sell to a small firm. But perhaps brokers could be paid differently, and then they could play a consultant role by helping small businesses institute cost controls to get better deals from reinsurers.

A final possibility would be to extend the reach of the new health insurance exchanges operating under the Small Business Health Options Program, or SHOP. SHOPs are already operating in most states for firms with under 50 full-time employees, and they will be expanding soon to firms with fewer than 100 employees. States should actively encourage small businesses to consider using the exchanges rather than self-funding. And the federal agencies should try to extend more financial subsidies to small firms and their employees who utilize the SHOPs.

The dream of the ACA, to extend affordable, quality health care coverage to nearly all uninsured Americans, is laudable. But unless reforms of self-funding are instituted soon, the dream could turn into a nightmare for many small businesses.