Health Care Self-Funding and Stop-Loss: Small Employers Balancing Risks and Rewards

By Christopher Brown, Sun Life Financial Sep 2, 2008

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Years ago, you would have been thought crazy to suggest self-funding a health care plan to a small employer. But these days, with the proper safeguards in place, self-funding an employee health plan is not just for big companies anymore. With health care taking an ever-larger chunk of the bottom line and state mandates increasing, small businesses are turning to self-funding as a way to control costs and simplify plan designs.

The statistics bear that out. In 2004, 10 percent of workers at small firms (three to 199 employees) were covered by a self-funded health plan; in 2007 that number grew to 12 percent, according to the Kaiser Family Foundation. It’s a small increase, but telling nonetheless. And many in the self-funding industry are seeing more new requests from smaller companies.

Smaller companies can and should consider self-funding as a cost-effective way to continue to offer comprehensive health benefits. When properly set up, it can help small employers save money and gain more control over their plan designs.

Self-Funding 101

For those not familiar with self-funding, it’s an alternative to traditional health insurance and health maintenance organizations (HMOs) that’s been around for nearly 30 years. Rather than buying a group medical policy to cover employees, the employer assumes financial responsibility for its group health plan and hires vendors to provide the services typically performed by the insurer.

What does self-funding look like? With traditional health insurance, premiums are paid in advance, at the beginning of the month, to the insurer. The insurer keeps the money, earning investment returns on it, until it is needed to pay out claims. Any funds left over at the end of the month are kept as the insurer’s profit. On top of the insurance premiums, employers must pay a state premium tax, similar to a sales tax, on the policy.

With self-funding, an employer takes the money it would otherwise pay to an insurer and establishes a special bank account to pay for claims. A broker or benefits consultant is hired to develop a customized medical plan for the group. A third-party administrator (TPA) is hired to receive and manage claims, and the employer authorizes the TPA to draw money from the bank account to pay claims. Typically, the TPA arranges to have preferred provider organization (PPO) networks, wellness programs and other managed care elements in place. The TPA issues employee ID cards, too, so from the outside it appears that the employees have traditional medical insurance.

Why Should Small Companies Self-Fund?

Self-funding offers many advantages over traditional health insurance and HMOs:

    • Fewer mandatory state benefits. Employers with workers in multiple states can offer one uniform plan design to all employees, free from the dizzying patchwork of state-mandated benefits.

    • Freedom to customize plan design to suit the group’s demographics. Rather than buying an “off-the-shelf” medical plan, employers can offer the benefits to meet the needs of the employee group and its unique demographics. And employers can profit directly from disease management and wellness programs.

    • Elimination of insurance company overhead and fees.With traditional insurance, a portion of the premiums go toward the insurer’s advertising and fixed overhead, rather than paying for medical claims.

    • Employer holds claim dollars and reserves until actually needed. Premiums are no longer paid to the insurer in advance at the beginning of each month. Instead, the employer holds the money, earning investment returns on it, until it’s needed to pay out claims.

    • Lower state premium tax. Employers will pay far less in taxes that are built into the health insurance premiums.

    • No sharing of claim losses of other groups covered by insurer. If another employer has a bad year, self-funded employers don’t pay more to cover their claims.

Stop-Loss Provides a Safety Net

Most medical claims are routine and predictable, so employers can set aside a predetermined amount each month to cover them. Of course, there are occasional catastrophic claims, so employers must have proper safeguards in place. Most employers buy a high-deductible policy, called stop-loss insurance, to protect against those unexpected claims.

Stop-loss insurance can reimburse employers for those unexpected large claims that could otherwise wipe out their funds. So for most employers, the phrase "self-funded" actually means "partially self-funded." Typically, employers don’t pay for all of their employees’ medical expenses. Instead, employers pay for the smaller, routine claims, and the stop-loss insurer reimburses for the larger, catastrophic claims.

There are two types of stop-loss insurance employers can buy:

    • Specific—Protects the employer if one person gets seriously ill. The employer picks a specific deductible and is responsible for all claims below the deductible. The stop-loss insurer is responsible for all eligible claims above the deductible.

    • Aggregate—Protects the employer if many people get sick, causing unusually high claim levels for the entire group. The expected claim level for the group for the upcoming year is determined and then the stop-loss insurer adds a buffer, or “corridor,” of 20 or 25 percent. If the group’s claims exceed the expected level plus the corridor, then the stop-loss insurance pays for any eligible claims above that level. If needed, other routine, low-dollar employee benefits, such as dental, vision or short-term disability can be covered by aggregate stop-loss insurance.

Most employers buy both types of stop-loss coverage. As employers expand, some choose to drop aggregate coverage or raise their deductibles, since they can assume more financial risk.

How To Buy Stop-Loss Insurance

If a small employer chooses to self-fund, a good stop-loss policy is a must. Because of limited budgets, small employers may be tempted to go with the lowest rate. But as with anything, you get what you pay for.

It’s important to go beyond the rate and consider what you’re actually buying. Here are a few factors to consider:

Factor #1.

Who’s providing the coverage?

    • Reputable carrier. Since stop-loss claims are large, and there are relatively few barriers to entry in the stop-loss market, it’s important to select a reputable carrier who will be around at claim time. Do your homework with rating agencies, financial information, history and references as part of your standard due diligence process.

    • TPA credentialing. Some stop-loss carriers evaluate TPAs and work only with those that meet their quality standards. Often, the choice of TPA can affect the stop-loss rate, positively or negatively.

    • Risk retention.Be sure to ask how much stop-loss risk the insurer actually keeps. Some insurers keep very little risk, laying off a good portion of the risk to reinsurers. If there is heavy reinsurance in place, the insurer may have to get the reinsurer’s approval before paying large claims or accepting unusual risks, which can slow down service times.

Factor #2.

What options are available to small employers?

    • Terminal liability. This option can be purchased to extend your stop-loss coverage at the end of the policy year if you decide to switch back to a fully insured plan.

    • Monthly aggregate accommodation. This option enables employers to request an advance on their aggregate benefit in the middle of the policy year rather than waiting until the end. If claim expenses are higher than expected, this can help employers avoid cash flow problems.

    • Clinical trials. Although most employers’ health plans don’t cover experimental treatments, this option can be purchased to cover certain types of clinical trial claims if the employer’s plan covers them.

Factor #3.

How will the insurer help control costs?

    • High quality contract. Contracts vary in their exclusions and limitations. Be sure to ask what is excluded and what benefits are limited. If there are certain expenses that you want covered—such as off-label drug use, state mandated surcharges, clinical trials or alternative care—be sure to ask the insurer how they are treated.

    • Cost-containment programs. Insurers vary in the degree to which they will partner with you. Some will team up with employers, helping to locate savings and lower their overall medical costs. It’s in the stop-loss insurer’s best interest to do so; when their costs are lower, there is less likelihood you will need stop-loss insurance. But these services also can help lower the total cost of the self-funded plan.

Factor #4.

What will happen when the policy is renewed?

Stop-loss insurance is purchased every year. Policies can be renewed after one year, although the insurer can offer different rates and terms.

    • No new lasers at renewal. At the end of your policy year, some insurers offer to renew your stop-loss policy, but may “laser” risky individuals (those expected to incur large medical bills in the immediate future) with a higher specific deductible, or exclude them from coverage altogether. Other insurers don’t do this, or they can guarantee in their contract that they won’t do this.

    • Gapless renewals. Each year, there is the chance that some medical claims will “fall through the cracks” between policy years and go uncovered by stop-loss. This is attributable to the nature of medical bills—they are often incurred but not paid until one to three months later. Some insurers offer an option to seal this gap or cover these claims that fall outside the normal pattern.

    • Renewal rate cap. Stop-loss rates increase every year, along with medical inflation. To make self-funding more predictable for employers, some insurers offer to place a “cap” or limit on the rate increase. Often, this is offered by insurers with larger blocks of business so they can pool claim risk together for all their customers.

Stop-loss policies do vary, so it’s important to know what you’re getting before a claim occurs.

With the proper safeguards in place, a self-funded health plan can offer significant financial and administrative benefits. Small employers, just like large employers, can control their costs in the face of rising medical inflation and increasingly complex government regulations and mandates.

Christopher C. Brown is vice president, stop-loss, in the employee benefits group division of Sun Life Financial U.S.

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