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Why self funding is less expensive by Brad Vernon

For many employers, self funding employee health benefits is an opportunity to save substantially on the cost of those benefits.  There is a tradeoff to the expected saving in that the employer is giving up knowing exactly what the benefit costs will be.  Variability and volatility are the price one must pay to reap those expected savings.  So why is self funding cheaper on average than a fully insured plan?  As is the case with any investment or financial instrument, there is a tradeoff in risk and return.  This is as true in interest rates of debt and prices of equity as it is in the insurance industry.  So part of the reason self funding is cheaper on average is because less of the risk is being transferred, hence less of a risk charge is paid.  That is obvious perhaps, but there are some other reasons self funding is less expensive and I want to talk a little about some of these.

The first such reason is premium tax.  By paying a portion of claims directly, and not paying a carrier to pay those claims for them, employers avoid paying the premium taxes that carriers undoubtedly pass along to the consumer.  This is not an unsubstantial amount as premium taxes can be as high as 5% depending on the state you are in and the state your carrier is domiciled in.  Another large savings area is flexibility of plan design.  Increased flexibility is achieved because the employer is not dependent on an insurance carrier to offer the plan they want and because state mandated coverage is avoided through ERISA.  This increased flexibility allows employers to take on the cost of only the benefits they want to offer.

Another area where the cost of self funding can be much less than it is with fully insured plans is administrative costs.  This is partly because the administrative costs are known when purchased from a third party administrator (TPA) or on an administrative services only (ASO) contract with an insurer while they are mostly hidden in an insurer’s premium rates.  It is also partly the result of how insurers load for administrative costs.  Most, if not all, insurers load their administrative costs as a percentage of premium which doesn’t very well match up actual cost with priced charged.  Larger groups and those with richer benefits, even with sliding administrative loads, will most of the time subsidize the true administrative costs of smaller volume groups.

The last area of potential savings I’ll talk about only applies to some groups and that is capturing good experience that an insurance carrier does not give credit for.  One instance of this is when multiple years of consistent claims experience that demonstrate a group’s good experience is more credible than traditional credibility formulas would give it.  Most carriers, when experience rating, will look only at the most recent twelve months of experience and apply credibility based on just those twelve months of experience.  So a group with good experience in many past years will be getting the short end of the stick in experience rating.  Another example would be if a group’s experience warrants a reduction in rates, which will often lead to the carrier holding rates but not reducing them.  The last instance I’ll mention where a carrier won’t give credit for good experience is when they don’t know about it.  In other words, a company may know things about its usage of benefits that those outside of the company do not.  For example, decision makers may know that pregnancies are expected to drop off, or that a high cost employee is about to retire, and an insurance carrier obviously wouldn’t take that into consideration.  Often times having more information, means knowing costs will be lower than in the past and self funding presents a way to take advantage of that.


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