ACA & The New Normal

Mitigating Volatility and Cost of HealthCare

Self-Insurance is the true grassroots movement for healthcare reform

by Andrew Cavenagh

Mr. Cavenagh is Managing Director and Founder of Pareto Captive Services. Visit

Employer-based health insurance is the backbone of health insurance in the United States. Currently, employers provide more than 150 million Americans with health coverage – more than any other source of health insurance.

When a company offers health insurance, it makes an implicit promise to its employees and their dependents to cover a portion (often around 80 percent) of the costs of their future health claims, as long as the worker remains employed.
Let’s quickly define “health care” and “health insurance,” since these terms often are confused.

Health care is the provision of medical services – such as trips to the doctor for an ear infection, a knee replacement, the treatment of cancer, or a delivery of a baby.

Health insurance is the risk financing package that limits the cost of any one claim or the aggregation of numerous claims. Health insurance exists at both an employee and an employer level. An employee has deductibles and overall caps on spending that limit their financial exposure to the unexpected costs of health care. Likewise, an employer sponsoring a health insurance plan has a risk financing structure that limits its exposure to large claims or a terrible year of claims.

Whether by design, by accident, or by habit, the health insurance industry often distracts employers from what really impacts long-term costs.

A Typical Example

Let’s look at a typical health insurance renewal from the employer’s perspective. Assume that the employer is paying $1,000,000 for health insurance and that its renewal premium will be $1,100,000 (health insurance costs about $11,000 per employee, so this means that our sample employer has about 100 employees on its plan). The employer is therefore facing a $100,000, or 10 percent, increase in its costs.

The health insurance industry often tries to focus the employer’s attention on the $100,000 cost, noting that the $1,000,000 current premium is a sunk cost. As a result, the industry often argues that employers should only focus on the 10 percent cost increase.

But this is a highly flawed perspective. Instead, employers should focus on the $15,000,000 number. That’s right – we haven’t seen that number yet because the industry tries not to talk about it. But $15 million is the estimate of what this employer is going to spend over the next 10 years if it does not change its course.

Companies often try to negotiate the $100,000 down to $80,000 or $60,000. However, the employer should try to make decisions based off of the $15 million number, instead of just the costs for the next twelve months. The once a year question should not be: What will allow me to pay the lowest amount over the next twelve months? Instead, the company should ask: What can I do today and in the coming years to decrease the expected $15 million cost?

There are two forms of employer health insurance: fully-insured plans and self-insured plans. In a fully insured arrangement, an employer pays a fixed monthly premium to an insurance carrier, and in turn, the carrier pays all claims. Each year, the carrier adjusts the premiums. And the adjustment is almost always upward. In fact, 83 percent of medium sized employers use a fully insured risk-financing model.

The fully insured model has a few benefits:

  • The cost of large claims, particularly major, ongoing claims, is spread across a large pool of employers, and therefore has a minimal impact on an individual firm. This is by far the fully-insured model’s best attribute, which successfully protects employers from large claims. And the ability to pool these claims makes this protection possible.
  • The fully insured model is also very simple, making it easy for unsophisticated brokers to sell to employers.
  • But the fully insured model also has several significant flaws:
  • State and federal taxes, as well as carrier profits, consume approximately eight percent of premiums.
  • An employer has very little control over plan design.
  • The employer does not receive claims data in a format that enables it to formulate or adjust a strategy.

When a carrier adjusts rates each year, the first number in the calculation is typically the employer’s smaller claims from the prior year. The claims are adjusted for medical trend. A charge for large claims, often called the pooling charge, is added, and the administration costs are put on top. This formula determines the renewal premium.

Self-insurance offers more control and better data. With these tools, the employer can finally do what matters – impact the actual costs of healthcare and reduce its long-term expenses

There is a linear correlation between the claims incurred in year one and the premium charged in year two. Since each year’s premium calculation starts with last year’s claims, this means that even within a fully insured program, the employer is self-insured for its smaller claims. The carrier has simply provided a deferral mechanism and not insurance. This is what we refer to as “deferred, not insured.”

The Self-Insured Model

The other form of employer health insurance is the self-insured model. Under this system, a firm pays its own claims. In fact, 94 percent of large employers are self-insured, as they refuse to cede control of such an important part of their business. In this model, the employer chooses a company called a Third Party Administrator (TPA) to adjust its claims and fulfills the functions that an insurance company performs in a fully insured plan. The TPA:

  • Provides access to a Preferred Provider Network
  • Issues ID cards to employees
  • Helps with enrollment and claim questions
  • Determines eligibility, and
  • Adjusts and pays claims

The employees of a self-insured company will not typically notice a change. They will receive an ID card, see a doctor, and pay any co-pay.

In addition, Human Resources will not typically experience a significant increase in workload, as the TPA will perform many of the tasks associated with the model.

A self-insured model “fixes” many of the disadvantages to an insured model:

  • The employer pays the claims when they occur and does not pre-fund them, thereby improving cash flow
  • It eliminates most of the taxes and carrier profits, which reduces costs
  • An employer has nearly complete control over plan design and receives actionable data, enabling strategic and impactful decisions to be made

While the self-insurance model has many benefits, it can be bumpy or volatile. This is the major downside associated with a self-insured model.

In order to mitigate some of the volatility, an employer can purchase an excess policy called “stop loss.” There are two types of stop loss. “Specific stop loss” provides protection against large claims from one individual, while “aggregate stop loss” provides protection against a large number of smaller claims. In short, these two forms of insurance work together to protect the employer from both large individual claims and a bad overall year.

In addition, employers can participate in a captive insurance arrangement to further reduce year-to-year volatility. Captives have made self-insurance accessible and practical for employers with as few as 50 employees and are one of the fastest growing segments within self-insurance.

Both the fully-insured and self-insured risk financing models protect the employer from a major health claim or a costly year. And in both models, the future costs are still linearly correlated to the employer’s healthcare expenses.

Companies have already made an implicit promise to pay for a portion of the healthcare costs for their employees and their dependents. But while the employer’s health insurance might renew once a year, their employees will be there much longer. If an employer wants to reduce its health insurance premiums over the next 10 years, it needs to reduce its healthcare costs over that same time period. In some cases, this will mean spending more money today in order to spend less over the next ten years.

Employers, including small and medium sized businesses (SMBs), are increasingly turning to self-insurance to manage the costs of healthcare. Self-insurance offers more control and better data. With these tools, the employer can finally do what matters – impact the actual costs of healthcare and reduce its long-term expenses.

A self-insured employer has many cost containment levers available to it that a fully-insured employer does not. Companies are increasingly taking control of primary care through onsite or shared clinics. They are banding together to purchase prescription drugs more efficiently. And they are making modifications to plan design to eliminate abusive pricing practices for things like air ambulances, specialty drugs, and substance abuse treatment.

Healthcare reform isn’t coming from Washington. As more employers move to self-insurance, these firms are innovating and finding ways to reduce the cost of health insurance and healthcare. Employers – not politicians – will lead to true, grass roots healthcare reform. And they will do it largely through self-insurance. ◊