Employer-Sponsored Health Insurance and Health Reform

Employer-sponsored insurance (ESI) plays a central role in the financing of health care in the U.S. Currently, 162 million Americans have ESI, representing over 60 percent of the non-elderly population. ESI dominates the private insurance market, accounting for 90 percent of the market. ESI not only is an important source of insurance coverage for workers and their families, but also affects individuals' employment decisions, including the choice of whether to work, how many hours to work, and what type of job to hold.

In light of the current focus on health reform in the U.S., it is worth examining the "goodness of fit" of ESI in the current economic and health insurance environments and how that might change under various health reforms. This is the subject of a new working paper by researchers Thomas Buchmueller and Alan Monheit, Employer-Sponsored Health Insurance and the Promise of Health Insurance Reform (NBER Working Paper 14839).

The authors begin by discussing the history of ESI. While its origins can be traced back to 1929, when a group of Dallas teachers contracted with a hospital to cover inpatient services for a fixed annual premium, the link between employment and private health insurance was strengthened by three key government decisions in the 1940s and 1950s. First, during World War II the War Labor Board ruled that wage and price controls did not apply to fringe benefits such as health insurance, leading many employers to institute ESI. Second, in the late 1940s the National Labor Relations Board ruled that health insurance and other employee benefit plans were subject to collective bargaining. Third, in 1954 the Internal Revenue Service decreed that health insurance premiums paid by employers were exempt from income taxation.

The authors next discuss salient facts and trends in ESI coverage. ESI coverage is strongly correlated with firm size, with 97 percent of firms with over 100 employees offering coverage vs. 40 percent of firms with fewer than 25 employees. Offer rates have remained fairly steady over the past ten years, increasing in small firms in the late 1990s during a period of robust economic growth before slipping back to 1996 levels. The share of premiums paid by employers has remained constant over time, averaging 85 percent for individual coverage and 75 percent for family coverage. However, due to the rising cost of health care, employee premiums more than doubled in dollar terms over the past decade, from $1,300 to $2,900 for family coverage.

The likelihood of being a full-year policyholder of ESI is strongly correlated with demographic characteristics. In 2005, the likelihood of holding ESI coverage was 47 percent for individuals age 44 to 54, vs. 39 percent for individuals age 25 to 34. Individuals with low income or education and Hispanics are much less likely to hold ESI. Thus while there is little evidence that ESI is disappearing, rising health costs are a concern, as are disparities in ESI offer and coverage rates by firm size, age, race and ethnicity, and socioeconomic status.

Next, the authors review the advantages and disadvantages of ESI. Since economists typically assume that workers pay for health benefits through reductions in wages, why do workers choose to purchase insurance through their employers rather than on the individual market? The answer is that there are significant savings associated with ESI. First, there are substantial economies of scale when purchasing insurance through a group. Second, the problem of adverse selection (sicker individuals being more likely to sign up for coverage) is reduced in an employer-sponsored group, since a large group is likely to have something approaching the population average level of risk. Third, the fact that health insurance premiums are not subject to income taxation effectively reduces the price of insurance purchased through the employer.

The authors note that these advantages are bigger at large firms, who experience greater economies of scale, more efficient risk pooling, and tend to have higher-paid employees. These factors may help to explain the higher ESI offer rates at large firms. Large firms also are able to self-insure rather than purchase insurance coverage directly, giving them the opportunity to shape the benefit package to suit their employees' needs and to actively manage costs.

There are also notable disadvantages of ESI. The exemption of insurance premiums from taxation may lead to higher health spending. The benefits from the tax exemption flow disproportionately to high-income workers, who have higher marginal tax rates and more generous plans. The link between employment and insurance coverage may distort employment decisions, such as whether to switch jobs or retire, and does not work well for people who have high rates of job turnover.

The authors focus their discussion of health reform on strategies in which private insurance remains the dominant mechanism for financing health care.

Approaches that include mandates generally do not aim to reduce the role of ESI. Indeed, ESI may play a bigger role under reforms that involve either an employer mandate, such as in Hawaii, or a "pay or play" requirement for employers, such as in the recent Massachusetts reform. As the authors note, the Massachusetts reform "can be seen as a pragmatic response to the strengths and weaknesses of the ESI system," in that it does not alter the incentives leading to the dominance of an ESI system that works fairly well for many families, but includes an individual mandate, which may be more effective at increasing coverage and less likely to create labor market distortions.

Voluntary approaches to health reform often focus on reducing the cost of health insurance directly or indirectly. For example, one recent proposal would replace the tax subsidy currently given to ESI with a refundable tax credit that could be used when purchasing insurance on the individual market. This reform would ensure that the benefits of the tax subsidy are the same regardless of an individual's income or whether his employer offers ESI (unlike in the current system), but might also lead to an unraveling of the ESI market, creating other inequities such as higher premiums for sicker workers due to adverse selection. Voluntary approaches that promote ESI would not be subject to this concern.

The authors suggest that it is unlikely that health reform will lead to the end of ESI. However, there are four longstanding areas of concern with ESI that warrant further consideration, including its lack of portability, tendency to promote over-consumption of health care, lesser appeal for small firms, and lack of ability to control cost growth. As the authors conclude, "achieving workable solutions to these problems is the key challenge that will confront the ESI system as is strives to maintain its relevance during the likely contentious debate over the nature of health insurance reform."

The authors acknowledge funding from the Robert Wood Johnson Foundation's Economic Research Initiative on the Uninsured.