Why Do Employers Do What They Do?

Would employers risk rate employees on their employer health insurance plans if they could? Why don’t they impose a mandate on employees? These questions are asked by Austin Frakt. (See here and here.) In asking them, he is inviting us to compare employer insurance pools with markets such as those envisioned in the ObamaCare health insurance exchanges.

Let’s take the second question first. It goes to the question of why employer pooling works.

We are told that ObamaCare needs a mandate in order to prevent people from gaming the system. Without the mandate, people who are healthy would remain uninsured until they had a health problem. Then they would enroll and get their medical bills paid. But if that were possible, only the sick would insure ― making premiums inordinately high and possibly leading to a “death spiral.”

Yet employers don’t require employees to enroll in their health insurance plans. So why don’t they experience death spirals?

Potentially, they could face something similar. The reason: employers have exactly the same problems that the individual market has. Here is how they solve it.

Commercial insurers generally won’t sell insurance to an employer unless the employer agrees to:

  1. Pay a substantial portion of the premium (usually 50% is required, but the average is around 75%).
  2. Restrict enrollment to a certain date or to a qualifying event, such as a marriage or the birth of a child.

The first restriction means that employees can buy insurance for 25 cents on the dollar. This makes insurance attractive, even to people who don’t plan on any medical expenses in the near future. The second restriction means that even if people try to game the system, they have to wait up to a year before they can enroll after they experience a serious medical problem. This is the employer’s version of an open enrollment period.

Alert readers may wonder why employers aren’t paying even more of the premium. Answer below the fold.

If employers can pay premiums with pretax dollars while employees generally pay their share after-tax doesn’t it make sense for the employer to pay the entire amount? The problem is that employers have no way of knowing how valuable this benefit is to each employee.

Suppose an employee pays 25% of the premium after tax. Given a 40% marginal tax rate (combined federal and state income taxes and payroll taxes), the insurance would have been 10% cheaper if the employer had made the full payment instead. If the employee pays 50% of the premium, a 20% discount is left on the table.

On the other hand, about 20% of employees turn down their employer’s offer and among young employees it’s 30%. That means the insurance is not worth what it costs, even though the employee is paying half or less of the real cost. In competing for labor, employers follow a better strategy (especially for younger workers) if they pay less of the premium and pay higher wages instead.

[Aside: In saying this I am ignoring the fact that most employers mis-price the employee's share of the premium. Although small employers may age rate, large employers typically charge employees the same premium regardless of age. If employees are charged 25% of the premium, this means that a young worker's share is closer to 50% of the real cost and an older worker's share is closer to 10%.  And if we remember that young healthy workers could undergo medical underwriting and get a substantial discount in the individual market, the premium their employer asks them to pay may be substantially more than half of the real cost.]

Why don’t employers risk rate? Medical underwriting is illegal for employers under HIPPA. But employers weren’t doing it even when it was legal. Right? Not quite.

Let’s do this in two stages.

First, why don’t employers re-rate employees once a year, based on their health status, the way small groups are re-rated? The answer is that the alternative to employer provision is individually purchased insurance. And in the individual market, no re-rating and guaranteed renewability has always been the norm. If employers are going to complete for labor based partly on their ability to purchase insurance pre-tax, it needs to be the kind of insurance (with the same protections) that workers can purchase on their own.

Second, why don’t employers risk rate new employees? I suspect part of the explanation is the economics of signaling. The employer is trying to attract labor that is often coming from some other place where the insurance does not involve further risk rating (another employer or an individually purchased policy). If the employer is going to do it once, how does the prospective employee know the employer won’t do it again? For that matter, if the employer risk rates new hirers, how do the current employees know they won’t be risk rated at some point in the future?

That said, employers have placed pre-existing condition waiting periods on new hires in the past. The current law (HIPAA) allows pre-existing condition exclusions of 12 months or 18 for late hires.

There are two more things employers are doing that I wrote about in Priceless:

  1. The health insurance they offer employees is designed to appeal to the healthy at the expense of the sick.
  2. Companies are developing cultures of “healthy living,” which tend to appeal to prospective employees who already lead healthy lifestyles and repel those who don’t.

Almost all the insurance products being sold to employers these days have first dollar coverage (or small co-payments) for doctor visits and preventive care ― and this was true even before ObamaCare required some of this. At the same time, these plans can cost an employee $10,000 or more in case of a hospital visit. (The new law restricts the total.)

The first item is perverse. But it duplicates what is happening in the health insurance exchanges. As for the second item, I suspect we are going to see more of that in the exchanges as well.

This reflects the fact that the employer health insurance functions in a way like one big exchange. Think of employers as health insurers and think of your premium as the work you have to do for the employer in order to get the insurance. All the employers are required to guarantee issue and community rate (at least modified). So like the health plans in the (ObamaCare) exchanges, employers have strong incentives to attract the healthy and avoid the sick. After enrollment, they have strong incentives to over-provide to the healthy and under-provide to the sick. (See our previous analysis here.)

This blog is one of the very few places on the Internet ― maybe the only place ― where you can find out about these perverse incentives and the reasons why they arise.

Comments (21)

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  1. Patrick Pine says:

    Agree with your assessment generally – but would add other factors that many employers consider as well. Many employers consider the costs of workers’ comp coverage in deciding whether or not to offer employee coverage. In general, workers comp costs will be higher when no coverage is offered and workers comp can be more expensive relative to offering an employee plan. In some cases, employers choose to offer benefits to reduce possibility of being unionized – this is not as common as it once was – but is definitely a factor in some industries and locations.

  2. Jack Towarnicky says:

    I’ve worked in corporate employee benefits for almost 35 years. The two main reasons employers do not age rate or risk rate their employee contributions (unlike many group term life insurance programs) is:
    (1) Inertia, and
    (2) Concern over potential legal challenges (ADEA, HIPAA)

    It is easy for me to confirm inertia. Simply, there is an employee expectation of large employers developed over the past three, four, five decades. For example, I never had to argue in favor of offering health coverage at any of the five Fortune 500 firms I worked for – my predecessors made that happen. So, any proposed change would likely rock the boat and disrupt worker expectations – where the disruption may be disproportionate to the potential expense reduction.

    In terms of legal challenges, age rating employee contributions may prompt unecessary litigation, while risk rating employee contributions would violate HIPAA. Even allowable actions, such as moving to a high deductible health plan, adding a peri-employment physical for all new hires, adding a wellness program with financial incentives, depolying pre-ex (to the extent allowed, soon to end due to PPACA), are all items that have triggered employee relations, engagement and/or legal challenges.

    • Patrick Pine says:

      Agree with Jack. Would note that in my experience the internal pressure to provide medical benefits was greatest at the executive and managerial levels. The lowest paid folks did not exert as much influence on the decision as the highest paid.

  3. Sabal says:

    Great analysis. The left will keep pushing systems full of perverse incentives. Gimmicks don’t work!

  4. Rick says:

    There have and always will be perverse incentives associated with health care, so long as insurance is a money-making industry. Obamacare hardly addresses these perverse incentives. It doesn’t seem to matter how or why employers community rate; the high risk Americans still will not receive the care they need, as employers and insurance companies alike will find ways to skirt around the law and avoid insuring or providing care for the sick.

    • robertnelsonmd says:

      How can you finance an insurance product if it doesn’t make money? Even mutual companies make a profit; the money may belong to the policy holders but they still have to make money to pay salaries,unexpected claims, etc…

      If you are talking about publicly traded companies, then I would agree in part.

      What Dr. Goodman is talking about are perverse economic incentives due in part to regulation and tax laws; and they don’t necessarily apply in all industries or economic models. There are ways to insure risk without perverse incentives but we must permit individual underwriting in order to accomplish this.

  5. A Benefits Professional says:

    “Why don’t employers risk-rate employees on their health insurance?” The answer is: to preserve the illusion that all employees are treated equally, no matter their circumstances. This has many benefits for the employer, from a legal as well as a practical standpoint.

  6. Jimbino says:

    You ignore one very important factor that serves as a safety-valve for employers: contract labor

    Both I and Edward Snowden have worked mostly on contract. As contract IT workers, we earn TWICE the hourly rate of the “captive” employee doing the same job by forgoing benefits that include vacation, pension, and health care, not to mention things like access to the gym or tennis court. And Snowden doesn’t even have a high-school diploma, much less a law degree!

    Employer-paid health care is for the risk-averse, women, breeders and the older employee. What kind of high-tech go-go company, especially a startup, would want to attract persons who are risk-averse? No, risk-averse folks who favor insurance and pensions are for petrified companies like GM or IBM, utilities, or the gummint. That’s why you find so many breeding, married women working for the gummint at all levels and well represented at petrified companies, and very few in high-tech STEM or economics.

    • Marguerite BarnettMD says:

      i’m sorry to disagree with your thoughtful comments but i went to MIT and got my advanced degree there and am a woman and have worked for the government (military) and prefer to have health insurance. Since i work in a high-risk profession and enjoy doing dangerous sports in my off-hours, i would guess that i am not risk-adverse. However, i do think health insurance is a smart idea as is a pension but i prefer to think that it’s because i’m smarter than you, not because i’m risk adverse!

      • Jimbino says:

        It’s “averse” not “adverse.” Yeah, I remember trying to drum baby physics and baby math into the heads of pre-meds and pre-laws who couldn’t afford to take real science and math.

        MIT appears to have lowered its standards by raising its acceptance of women.

        The best thing I can say about a risk-averse person who has joined the military is that you have a safe job far from the front lines, or have an indolent hubby and lots of kids to feed at the military-benefit trough, or are schizophrenic. Did you ever study econ?

  7. A Benefits Professional says:

    “Why don’t employers impose a mandate on employees to have health insurance?” The answer is, state payroll laws prohibit employers from withholding money from employees’ pay without their consent (although some employers may do this anyway because of ignorance of the law). By the way, the Affordable Care Act overrides these state payroll laws in a mild way, by requiring health insurance coverage as a default election; this ACA provision is not yet effective.

  8. Patrick skinner says:

    Correction – most EE’s pay their 25% potion of the premiums pre-tax thru a Sec 125 Cafeteria plan, all but self employed pay individual insurance premiums after tax – another big incentive to take ER group coverage.

  9. PJ says:

    Interesting post!

  10. Attila says:

    Base Insurance Premium rate + Deductible amount + co-insurance amount – Tax credit(if any) + un-compensated care (if any) + insurance company payment + expenses + agent commission + enroller fees + risk pool assessments – risk pool payments + picori fees + state premium taxes + federal taxes + federal exchange set up and computer charges cost overruns – refund of premium (mlr) + cost shifting + did I miss something = employer contribution (if any) + (medicaid subsidy if you qualify)+ any balance remaining is the individual’s portion …good luck with that, as there is no free lunch.

  11. John R. Graham says:

    Hmmm,

    I would aver that employers do not have to explicitly risk rate because it is achieved through adjustment in money wages.

    Ceteris paribus, employees who believe that they will incur few medical claims next year will demand higher salaries. Those who believe that they will incur expensive medical claims next year will seek employers with gold-plated benefits and settle for lower money wages.

    Of course, there is lots of friction and opacity, so the adjustment is not perfect. Bhattacharya & Bundorf demonstrated this citing evidence from obese workers. (See NBER WP 11303, May 2005.)

  12. Ron says:

    Keep in mind that employee provided coverage is provided to new employees who are “ACTIVELY at WORK.” Working employees are better risks in general and they want to get back to work once sick.

  13. civisisus says:

    Goodman’s post betrays his comprehensive ignorance of the market for employer-sponsored health benefits. Just one example: it practically ignores critical differences between the vast # of very small businesses that provide coverage for a fraction of all people covered by employer-sponsored health benefits.

    Regardless your ideological persuasion (though if you’re reading this it’s not terribly hard to anticipate what yours is), you’ll be doing yourself a service to ignore the Doctor’s ditzy notions regarding what really goes on among employers who provide health benefits for their employees.

    • Charles Johnsen says:

      Reason, experience, and wisdom are not ideology.
      The belief system that political power is omnipotent is an ideology.
      I do not understand your sentence beginning “Just one example:…” Could it be that you, like the United States Senate/House/Supreme Court/President, prefer big business over small business because of their paternalism? Please restate your example more clearly.
      Why does the Left use insults so often? Sarcasm and insults are not arguments or facts. It sounds arrogant, which, I am sure, is not one of your characteristics.
      Ops, now I am a Leftist.

  14. Patrick Pine says:

    Personally I am one of those dreaded “liberals” but also have an MBA and have worked in government, business, and not for profit and over a range of organization sizes. I differ with John in our general perspective – but at the same time he does offer an important perspective and does make some valid points – and must agree with many of his criticisms of the approach taken with the ACA. Many of my friends who are ardent proponents of the ACA and some who are directly involved in implementation have a very hard time accepting the valid criticisms that John and others offer.
    As to the reason many employers offer benefits – it is simply because it has become fairly customary for employers to do so. But those who comment that employer provided benefits are only to serve the risk averse – the reality is that even the most politically conservative, free market advocates often have spouses and children who have an expectation that the health care for the entire family will be provided via the employment relationship.
    Having served as a corporate benefits director I can confidently say that I have most often received calls regarding benefits from spouses and parents of younger employees more than from the employees themselves. My greatest pressure to provide very generous benefits most often came from the family of the highest ranking executives – and that was true across three different corporations and also in two not for profits. I left government a long time ago but I would suggest that was the case as well regardless of the political leanings of the legislators and governors and their staffs that I served.