Incentives for Small Firms to Self Fund Their Healthcare Plans

Robert C. Pozen and Anant Vinjamoori

When firms offer healthcare plans to their employees, they have two main choices. They can buy insurance from traditional health insurers like Aetna or Blue Cross Blue Shield, or they can self-fund their own healthcare plan.

In self funding, the employer usually hires a third party administrator ( TPA ) to help run the healthcare plan – establishing a network of doctors and hospitals; and then collecting premiums from employees (which would otherwise be paid to insurers) and making payments for claims that are incurred.  Most importantly, in self-funding, the employer bears the risk that the costs of providing healthcare to its employees will exceed the premiums collected.

Most large firms self fund their healthcare programs, rather than buy insurance. By contrast, just 8%-16% of small firms (between 1 and 100 full-time employees) choose to self-fund.

However, the Affordable Care Act ( 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 small firms and the insurance market for small groups.  

This article will first explain the ACA’s regulatory incentives for small firms to self fund their healthcare plans. Second, it will review the potential risks involved with self funding by small firms even with stop-loss reinsurance.  Third, it will discuss various proposals to reduce these risks within current political and legal constraints.  

I. New Regulatory Incentives for Self Funding

Many provisions of the ACA apply to all types of health insurance. For example, the ban on pre-existing condition denials as well as the ban on annual caps apply to both self-funded and traditional health insurance. Yet, by self-funding healthcare plans, small firms can avoid significant ACA and state requirements applicable to traditional health insurance.

Below are the five main regulatory benefits that small firms derive from self-funding their healthcare insurance.

  1. Self-funded plans are not subject to the Essential Health Benefit (EHB) 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.
  2. 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 to100 FTEs.  These requirements restrict how much insurers may use health factors like age and smoking status within a firm’s population to vary the total premiums charged to the firm.
  3. Self-funded plans are not subject to medical loss ratio requirements, which apply to policies issued by traditional 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.
  4. Self-funded plans escape the health insurance tax mandated by the ACA on most healthcare premiums paid to traditional health insurers. In 2014, this federal tax amounted to 2% of such premiums.
  5. Self-funded plans also escape the state taxes on healthcare premiums paid to traditional health insurers.  In 2014, these state taxes amounted to roughly 1.75% of such premiums.  

II. Other Benefits and Significant Risks of Self-Funding

Beside these regulatory benefits outlined above, self-funding by small firms has two other benefits.  In general, total costs for self-funding are lower than traditional health insurance because self-funding does not absorb the marketing costs and profit margins of traditional health insurance. These relative costs savings have been estimated at 10 to 25 percent in non-claims expenses, according to the Self Insurance Educational Foundation.

In general, self-funded plans allow greater flexibility than traditional insurance policies in the design of benefit packages. A small firm can customize benefits to reflect the special circumstances of its workforce. For example, if its workforce included a high number of smokers, the small firm could include more rigorous incentives to stop smoking than a traditional health insurance policy – which would otherwise be limited by community rating requirements.

Given these regulatory exemptions and other benefits, some observers predict that there will be a dramatic increase in self-funding of healthcare plans by small firms.  If this occurs, there will be substantial risks to small firms and specialized exchanges for the small group market.

A. Risks of Self-Funding for Small Firms

Small firms engaged in self-funding 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 – from either the healthcare costs in aggregate of their workforce and/or from healthcare costs of a specific employee needing very expensive treatment.

Small Firms buy stop-loss insurance from a handful of large reinsurers such as General Re and Reinsurance Group of America.  These large reinsurers will assess the healthcare situation of a small firm before offering a stop loss policy with an annual premium and a deductible (called the attachment point).  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 unhealthy population, the reinsurer will simply charge a higher premium with a higher deductible.

Furthermore, stop-loss insurance is not protected by the guaranteed issue and renewal provisions of the ACA, which apply to traditional health insurance 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 policy.  In either case, a small firm could risk becoming insolvent – unless it could purchase a stop-loss policy from another reinsurer or buy traditional health insurance.

B. Risks of Self Funding for Specialized Exchanges

At a broader level, a shift to self-funding may lead to adverse selection in the third party insurance market for small groups. Such adverse selection, if it were widespread, would weaken the entire traditional health insurance market for small groups because it would come to cover mainly firms with older and less healthy employees.

A widespread increase in self-funding would be particularly damaging to the specialized healthcare exchanges, which have been created under the ACA to provide lower cost policies to small businesses. Each state is supposed to have a Small Business Health Options ( SHOP ) exchange, as well as a health insurance exchange for individuals. 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.

Very small firms with 25 or fewer FTEs are eligible for modest tax credits if they purchase healthcare policies through SHOPs. But these credits will expire after 2015. At the same time, no federal premium subsidies are available for employees if their policies are purchased by their employer through a SHOP. Employees can obtain subsidies only by foregoing their employer’s insurance policy and obtaining their coverage on separate state exchanges for individuals.

III. Proposals to Address Risks of Self Funding

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. Such amendments would be strongly opposed by supporters of small business.

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, or policies with low attachment points. While such prohibitions may discourage some small firms from self funding, they will substantially increase the risk of insolvency for any small firm continuing to self-fund its healthcare plan.

In any event, state regulators should require all stop-loss insurers to provide small firms running self funded healthcare plans with 90 days’ advance notice 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 health insurance. No such regulations exist presently.

In theory, small firms could be steered away from self-funded plans by SHOP exchanges with attractive group policies. In practice, the deck is currently stacked against SHOPs. At the very least, the current tax credits available to very small employers for using SHOPs should be extended beyond 2015 and made permanent. Similarly, if politically feasible, federal premium subsidies should be available to employees even if their healthcare policies are obtained through SHOPs.

At the same time, we recommend that health insurance brokers assume a more consultative role, providing small firms not only with assistance in finding stop-loss policies for self-funding but also in evaluating the full set of options for their healthcare plans. As part of this role, we believe brokers should accept fee-based compensation instead of commissions. We further recommend that brokers form alliances with TPAs, which are in the best position to suggest plan designs and procedures that should attract better offers from stop-loss insurers. We envision a broker and TPA developing an array of cost-efficient healthcare plans for a small firm and actively shopping them among stop-loss insurers to obtain the best policy.