Switching to self-insurance; small firms may cut costs by paying employees' health claims directly, but they should carefully weigh the risks of going it alone - includes related article on proposed healthcare legislation and a checklist to help business owners decide if they should self-fund - Cover Story

Nation's Business, March, 1996 by Laura Litvan

Small firms may cut costs by paying employees' health claims directly, but they should carefully weigh the risks of going it alone.

Arni Cohen, the owner of seven pizza and sandwich restaurants in West Lafayette, Ind., has been offering health-care coverage to his workers since he opened his first establishment in 1964. To him, the cost is well worth the benefits; medical coverage engenders employee stability in an industry plagued by high turnover.

While stability is the goal, however, risk-taking is his means of shouldering health costs. Years ago, Cohen dropped the safety net of health coverage offered by insurance companies. Instead, he started paying most of his employees' health-care claims out of company coffers--an approach called self-insuring, or self-funding.

Cohen, whose Arni's restaurants employ 220 workers, understood that he was gambling. If his employees' claims were low in a given year, his payouts would be less than the premiums he would have paid. But if several of his workers suffered major illnesses at the same time, he might face a cash-flow crunch.

Nevertheless, he knew he could never lose his shirt. He protected himself by buying special coverage called "stop-loss" insurance, which takes over the payment of claims that exceed a predetermined level.

For Cohen, self-insuring has paid off. While he doesn't have an exact figure, he says, in the 18 years since he began self-insuring, his company has saved tens of thousands of dollars--compared with the costs of buying a standard health plan.

At the same time, self-insuring has enabled Cohen to tailor his plan to the needs of the 65 full-time employees who participate. He has added dental and vision benefits, and he has also established a wellness program aimed at helping workers who smoke to kick the habit.

"We feel like basically we're in charge," Cohen says, referring to types of health coverage offered to his employees. "It's like being our own boss. Decisions are ours to make, not an insurance company's."

Self-insuring is not always a positive experience for companies, however. Some small firms that have made the switch have seen their costs increase. Even at Arni's, two "disastrous years" of high claims in the mid-1980s left managers wondering if it had been wise for the company to go it 'alone, says Nancy Conners, the firm's office manager. "But we've learned that if you want to try it, it has to be a long-term commitment," she says. "You're kind of playing the averages."

Among small companies, Arni's was something of a pioneer when it made the switch in 1978. At that time, it was generally believed that the approach could work only in large companies, where the risk of high claims could bedspread among hundreds--or even thousands--of employees.

Over the years since then, many other business owners have decided to self-insure. In fact, companies flocked to such plans during the past decade as health-care costs soared. Between 1985 and 1994, for example, employers' average cost of health and dental insurance per employee increased 85 percent, to $2,757, according to statistics compiled by the U.S. Chamber of Commerce. During the nearly identical period-1985 to 1995--employers who were self-funding their companies' health plans grew to 57 percent from 39 percent, according to broad-based surveys by Hay/Huggins, a Philadelphia-based benefits consulting firm. (See the bar graph on this page.)

While research focusing exclusively on small companies has been limited, it too shows a migration toward self-insurance. According to the U.S. Bureau of Labor Statistics, 28 percent of employees in 1990 who had medical benefits and worked at establishments with fewer than 100 workers were in self-funded plans. That share rose to 32 percent in 1992, the most recent year for which such figures are available.

"Employers, under the present scheme of health care in America, are the payers of most medical bits," says Carlton Harker, executive director of the Self-Funding Academy, a professional association based in Winston-Salem, N.C. "They realize that if they are going to pay the bills, they will want to have as much control over those bills as possible."

Although control is a powerful incentive, self-insurance could not have flourished without the protective shield of the Employee Retirement Income Security Act of 1974. ERISA regulates private pension plans and also provides a federal regulatory framework for self-funded health plans.

ERISA's health-insurance provisions were intended to enable large companies operating in more than one state to create plans that would be uniform in all locations and not subject to a crazy quilt of state regulations. In effect, the law blocks states from regulating all self-insured plans, whether the company employs 10 workers at one site or 10,000 workers in several states.

By insulating self-funded plans against state regulation, ERISA has made those plans potentially less costly than insurance companies' plans for two reasons:

First, self-insured companies do not have to pay state insurance-premium taxes, typically 2 percent, or other state taxes to help cover the costs of the uninsured. These taxes are routinely applied to health plans sold by insurers.