Will More Small Firms Self Fund Their Healthcare Plans?

The Affordable Care Act (ACA) was intended to increase access to quality and reliable healthcare, partly through the employer mandate. However, the ACA may inadvertently push small firms toward riskier activities by financing their own healthcare plans.

In the past, most large firms took the risk of financing their own healthcare programs, rather than buying traditional insurance. By contrast, self funding has historically been limited to 8% to 16% of small firms – defined as 1 to 100 full-time employees (FTEs).

In the future, these statistics may change dramatically because the ACA creates new regulatory incentives for small firms to self fund their healthcare plans.If these incentives lead to a substantial increase in self funding by small firms, this would pose significant risks to these firms and the insurance market for small groups. 

By self funding healthcare plans, small firms can derive five main regulatory benefits:

• Self funded plans are not subject to the essential health benefit requirements of the ACA, which stipulate minimum coverage for healthcare plans sold by insurers to small firms with less than 50 FTEs in 2014, to be extended to small firms with 50 to 100 FTEs in 2016. Such minimum coverage includes maternity care, mental health and preventative services.
• Self funded plans are not subject to the community rating requirements that ACA applies now to small firms with less than 50 FTEs and in 2016 to Small Firms with 50 to 100 FTEs.  These requirements severely restrict how much insurers may vary premiums based on health factors like age and smoking status.
• Self funded plans are not subject to medical loss ratio requirements, which apply to traditional policies issued by healthcare insurers. These requirements mandate that at least 80% of premiums received by the insurer be spent on healthcare activities, as distinct from administrative functions.
• Self funded plans escape the health insurance tax mandated by the ACA on most healthcare premiums paid to traditional insurers. In 2014, this federal tax amounted to 2% of such premiums.
• Self funded plans also escape the state taxes on healthcare premiums paid to third party insurers.  In 2014, these state taxes amounted to roughly 1.75% of such premiums. 

Despite these regulatory benefits, self funding of healthcare plans is much riskier for small firms than large companies. Small firms do not have the diversified employee base or financial resources of large companies to absorb substantial overruns in healthcare expenses.  Therefore, most small firms hire brokers to find stop-loss insurance limiting their potential losses.

Small firms buy stop loss insurance from a handful of large reinsurers.  These large reinsurers assess the healthcare situation of a small firm before offering a stop loss policy with an annual premium and a deductible. However, these large reinsurers do not usually ask a small firm to adopt new measures to constrain healthcare costs. If a reinsurer believes that a small firm has an expensive healthcare plan, the reinsurer will charge a higher premium with a higher deductible.

Furthermore, stop loss insurance is not protected by the guarantee issue and renewal provisions of the ACA, which apply to traditional healthcare policies.  Since stop loss policies are issued on an annual basis without any guaranteed renewal, an unexpected rise in the healthcare costs at a small firm can lead to much higher premiums the next year or outright cancellation of the stop loss policy.

A shift to self funding may also lead to adverse selection in the broader insurance market for small groups. Firms with younger and healthier workers would likely self fund, while the traditional group market would cover mainly firms with older and less healthy employees.

A widespread increase in self funding would be particularly damaging to the Small Business Health Option (SHOP) exchanges, created by the ACA to provide lower cost policies to small businesses. SHOPs are now operating in most states for firms under 50 FTEs, and their reach may be extended by states in 2016 to firms with 50 to 100 FTEs.

However, without enough healthy employees in their risk pools, the cost of SHOP policies could rise sharply. Although firms with 25 or fewer FTEs are eligible for modest tax credits if they purchase healthcare policies through SHOPs, these credits will expire after 2015.

What can be done to address the risks of increased self funding to Small Firms and to the insurance market for small groups? It is not politically feasible for Congress to pass amendments to ACA that would limit self funding of healthcare plans by small firms.

Under ERISA, states are not permitted to regulate healthcare plans of employers. By contrast, under ERISA, states do retain the power to regulate stop loss insurers. Some states have prohibited stop loss insurers from offering policies to Small Firms; others have banned stop loss policies with very low deductibles.

Under state laws, all stop loss insurers should be required to send to all small firms with self funded healthcare plans a written notice at least 90 days before materially changing a stop loss policy – canceling, not renewing or substantially increasing premiums. These 90 days would allow small firms to find another stop loss insurer or purchase traditional insurance for their healthcare plan.

In theory, small firms could be steered away from self funded plans by SHOP exchanges with attractive group policies. In practice, the deck is stacked against SHOPs. At the very least, the current tax credits available to very small employers for using SHOPs should be made permanent.

In short, the potential for limited the risks of self funding by small firms is heavily constrained by legal and political realities.