Defined Contribution Health Insurance

Policy Backgrounders | Health

No. 154
Thursday, October 26, 2000
by Greg Scandlen

Remaining Issues

Even if the group/nongroup issues are resolved and employers are allowed to contribute to a worker's individual premium, a number of market and regulatory issues will remain. We cannot anticipate the best resolution of these issues. To a large extent, the market will have to evolve through trial and error, and the regulatory environment will respond to market conditions. But addressing the issues requires a clear understanding of the dynamics of health insurance pricing and administration.

1. Should Employers Vary Their Contributions by Risk Factors?

"The issue of adjusting employer contributions to reflect the relative cost of the employee is complex."

It is often argued that employer plans are community-rated within the group. That is, the entire group may be experience-rated, but to the extent employees pay for some portion of their premium, they are all charged the same. But that is only partly true. Employers currently provide much greater nominal benefits to workers with families than they do to single employees, even though it may be less as a percentage of the cost of coverage. For example, an employer may pay 90 % of the cost of coverage for a worker, but only 75% of the cost of dependent coverage. If the per capita cost is $1,000 per year, Employee A with a spouse and two kids may get an employer contribution of $3,100, but Employee B, who is single, gets a contribution of only $900. Employee A is getting a much higher nominal benefit than Employee B, but the employer is paying 90% of Employee B's coverage and only 77.5% of Employee A's coverage.

Beyond the issue of family vs. single coverage, there is evidence that employers account for health differences between workers by adjusting wages. Federal Reserve economist Louise Sheiner has concluded that the extra cost of covering higher-risk workers is often reflected in lower wages for those workers.45

So the issue of adjusting employer contributions to reflect the relative cost of the employee is complex. Even defining the meaning of "equity" isn't easy. Is it "discriminatory" to adjust the contribution based on known actuarial risk factors, or is it discriminatory not to do so? One solution would be for employers to base the contribution on a percentage of the worker's cost, thereby accounting for the extra premium paid by higher-risk, older workers. But that would sacrifice one of the attractions of Defined Contribution: predictability. It would also encourage waste and inefficiency as the employer absorbs much of the excess cost of an inefficient plan.

"Carriers' risk-adjustment methods cannot be as complicated or intrusive as those in use today."

Another solution that will surely be discussed is requiring carriers to "community rate" premiums, thereby eliminating the need for employer adjustments. While this approach is appealing in its simplicity, its very simplicity makes it unworkable. As long as insurers are receiving the same premium from all customers, they will always have a strong incentive to attract healthy customers and to repel high-risk customers. There are an infinite number of ways to structure a program so that it is attractive to the young and healthy but less attractive to others. This is especially true in a multiple choice environment. The point of risk-based rating is to make high-risk individuals more attractive by giving them the resources to pay higher premiums.

The more likely solution is to use simplified rating adjustments, based on age, sex, geography and perhaps a short list of health conditions that both employers and insurers can use to synchronize contributions and premiums. Such adjustments will need to be transparent and easy to calculate to enable electronic enrollment and instantaneous premium quotes.

2. How will the insurance industry respond? Will it insist on applying individual-market underwriting standards? Will it continue using minimum participation rules?

As mentioned above, the kinds of extraordinary underwriting currently in use in the individual market would be inappropriate for this attractive new market. While carriers may want to use some form of simplified risk-assessment for setting premiums, it cannot be as complicated or intrusive as those in use today, and due to HIPAA it cannot be used to deny coverage.

On the group side, carriers often have minimum participation and contribution requirements to qualify employers for coverage. A carrier might require that 75% of a group's employees participate and that the employer contribute at least 50% of the premium. These participation rules would not make sense in an individual choice environment, though the minimum contribution rules might still be applied.

Employers or third party trusts might insist that concessions on underwriting and participation standards be a condition for health plans that want to access their business.

3. How can a Defined Contribution plan retain the marketing and administrative efficiencies of the current employer-based system?

Two oft-cited advantages of employer-based coverage are the administrative and marketing efficiencies of dealing with a large group and the ability to pool risks. These advantages are overstated. For example:

Risk Pooling. Most employers are not especially good risk pools, if risk pooling implies bringing together a large number of people of varying risks and backgrounds to share the cost of an occasional large claim. This is what an insurance company is designed to do, not what an employer is for. For one thing, workers all share one characteristic: they are able to work and so they are all in reasonably good health. For another, employees of a single employer are likely to be more like one another than the general population. Workers in a bicycle shop are more likely to be young bicycle riders, workers in a Chinese restaurant are more likely to be Chinese, workers in an auto repair shop are more likely to be male and teachers in an elementary school are more likely to be female - certainly more likely than would be true for the general population. Finally, a "risk pool" of 25 or 100 or even 1,000 workers is small compared to an insurance company that covers possibly a million or more people. A bout of influenza can easily sweep through a 100-person "pool" leaving very few unaffected people to pay the claims of the ill. It is better to have insurance companies pool risk than to rely on employers.

"It is better to have insurance companies pool risk than to rely on employers."

Administrative efficiencies. Larger employers are often thought to be more efficient than smaller ones, and certainly more efficient than the nongroup market. This idea is based on the notion that loss ratios (that is, the percentage of premium that is paid out in claims) are higher for larger groups. Very large groups may have loss-ratios of 93%-95%, mid-sized groups 85%-90%, small groups 75%-85% and individuals 60%-75%. Once again, there is some truth here, but it is often overstated. One of the reasons employer groups appear to be more efficient is that the employer performs many of the administrative functions an insurer must do for small groups and individuals. With the exception of marketing and underwriting, all of the same tasks (keeping enrollment records, distributing plan information, answering employees' questions, collecting premiums, processing claims, responding to appeals, etc.) need to be performed regardless of the size of the group. But larger employers are more likely to have human resource departments that absorb many of these responsibilities. The tasks are still performed and paid for, but they never become part of the insurer's administrative overhead. They are paid directly by the employer instead. Certainly it is more efficient to print 1,000 plan brochures than 50, but these kinds of bulk savings are trivial compared to the cost of answering worker questions, which a large employer does in-house and the insurer does for a smaller employer.

Marketing Efficiencies. Here there is a substantial difference. Engaging a broker to talk to one decision maker who can enroll 1,000 people is clearly more efficient than having the same broker talk to each of the 1,000 people. Commissions are much higher as a percentage of premium for smaller employers and nongroup insurance. There are two ways a Defined Contribution plan might solve this problem. One is through Internet marketing, combined with a strong customer service operation. The other is through long-term contracts which spread the cost of individual marketing over five, 10 or even 20 years.

It is doubtful Defined Contribution could succeed without the Internet. There is simply too much information to be successfully managed with paper, and the cost of moving all the paper back and forth would be prohibitive. The Internet is an ideal medium for this kind of decision making. Not only can it organize and present large amounts of information coherently, but it also can customize benefits and instantly calculate and compare the costs for each worker's unique situation. Internet enrollment is another major reason for keeping underwriting questions simple. But an effective service will never be able to answer all questions online, so it must be supplemented with a dial-in customer service operation staffed by knowledgeable, personable representatives.

4. How will employers communicate the change to their workers, especially in a tight labor market? What must employers do to ease the transition?

"Employers need to be sensitive to the fact that workers often view any change in benefits as a 'take away'."

Surveys repeatedly illustrate a high level of unhappiness with the current health benefits arrangement. A recent Watson Wyatt survey of very large (average size 16,000 workers) employers found that 88% of them believe their employees rate their health plans "average to poor," while only 10% consider them "excellent."46 So the potential to communicate these changes effectively should be very high. Still, it is a big change, and workers often view any change in benefits as a "take-away" rather than an improvement.

Employers need to be sensitive to that view, and avoid forcing workers into something they don't understand. That means there should be a transition period during which the conversion is voluntary, with a fallback plan available for those who are nervous about change or are unwilling or incapable of making effective choices.

Workers also may be anxious about being at the mercy of the market. Employers should make sure that the insurance companies are willing to accept all comers, or that a viable high-risk pool is available for those few workers who may be priced out of enrollment.

With these assurances, the process could be an exciting one, as workers take control of their own resources. The conversion can be upbeat, and can include a health fair or a benefits bazaar in which workers can comparison shop for plan options and think about how they might best spend their money. This should be a festive occasion that opens up a whole new world for empowered workers.

Admittedly, Defined Contribution plans introduce a host of new issues for employers. Different companies will try out different models, and some will work better than others. Over time, the questions will be answered and a new market will develop, one in which patients are empowered to choose their own health plans and to change plans if the first isn't satisfactory. Health plans will focus on pleasing the individual customer, rather than the employer. They will enter a new era of customer service and information or risk losing business. Employers will concentrate on what they do best and leave health care to those who are good at it.

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