The big choice: fully insured or self-funded employee healthcare?

Small businesses have a lot of options when it comes to employee health insurance. GoCo alone provides access to plans from over half a dozen carriers that each offer a different combination of prices and coverage. But while plans can vary greatly in the benefits department, they all fall into just one of two basic financial categories.

The first is known as fully insured, which is the default choice for companies with fewer than 200 employees. It follows a straightforward model: you pay a pre-determined monthly premium to shift liabilities onto an insurance provider. The appeal is that the arrangement offers protection against the risk from any large claims that might come out of the blue, but the underlying financial calculus is starting to change. As Texas A&M professors Robert Bloink and William Byrnes have observed, rising healthcare costs are driving a growing number of companies to adopt a different kind of coverage that prioritizes lower premiums.

That means self-funded plans, the other major category in the insurance market. Businesses that adopt this model assume the responsibility of paying out claims along with the associated financial risk. Optimally, the medical costs and related administrative overhead end up being lower than what the company would have to pay for a fully insured plan. The value proposition is further sweetened by the fact that self-funded insurance is exempt from most state premium taxes, which the Health Care Administrators Association has noted shaves another 2–3 percent off the bill.

That's why research (PDF) from Aetna shows the self-funded route is by far the most popular among companies with a headcount of over 500. But the potential savings are much harder to achieve for a small business with limited risk tolerance.

In response, the insurance industry has come up with a more accessible variation of the model known as level funding that is available to firms with as few as 10 employees in some states. A business pays a fixed monthly rate just as it would under a traditional plan, but the money goes into a fund that is used to directly pay for employees' medical costs. The bill usually also includes two other items: the management fee of the Third Party Administrator running the plan (typically an insurer) and stop-loss insurance to protect against large losses. It kicks in when the value of claims exceeds a certain pre-determined dollar amount.

The end result is an up to 30 percent reduction in costs, according to health care executive Michael Levin. But there are certain drawbacks. For starters, the minimum expenditure past which companies can take advantage of their stop-loss policies is so high in some states (notably New York and California) that it's often unfeasible for a small business. Moreover, the price of protecting against unusually large claims increases every time the insurance is used, which means the savings provided by a level-funding plan can evaporate after a few bad years.

With that said, the potential upside is enough to justify giving self-funding consideration. Most small businesses take the well-trodden path and choose fully insured plans, but it can be worth moving in another direction if your specific employee welfare and financial requirements warrant doing so. Companies will likely have to revisit their insurance strategies either way given the major changes that are expected to take place in the healthcare sector over the next few years.