Why Do Firms Use Insurance to Fund Worker Health Benefits? The Role of Corporate Finance

• DOI: http://doi.org/10.1111/jori.12207
• Author: Christina M. Dalton,Sara B. Holland
• Published date: 01 March 2019
• Date: 01 March 2019

©2017 The Journal of Risk and Insurance. Vol.86, No. 1, 183–212 (2019).

DOI: 10.1111/jori.12207

Why Do Firms Use Insurance to Fund Worker

Health Benefits? The Role of Corporate Finance

Christina M. Dalton

Sara B. Holland

Abstract

When a firm offers health benefits to workers, it exposes the firm to the risk

of making payments when workers get sick. A firm can either pay health ex-

penses out of its general assets, keeping the risk inside the firm, or it can pur-

chase insurance, shifting the risk outside the firm. Using data on insurance

decisions, we find that smaller firms, firms with more investment opportu-

nities, and firms that face a convex tax schedule are more likely to hedge the

risk of health benefit payments. Weshow how firms trade off the benefits that

come from financing and investment characteristics with the costs of regu-

lation when choosing insurance. We provide understanding of how firms’

policy and financial characteristics affect firm outcomes as the Affordable

Care Act provisions impacting plan funding continue to evolve.

Introduction

When a firm offers health benefits to workers, it exposes the firm to the risk of making

payouts when workers get sick. A firm can either pay health expenses out of its general

assets, keeping the risk inside the firm, or it can transfer the task to an insurer such

as Blue Cross Blue Shield, shifting the risk outside of the firm. Although nearly all

large firms offer health insurance to their employees, firm responses to this risk vary

significantly. In this article, we analyze the firm’s decision to manage this risk and

demonstrate how financing and investment affect this decision.

Large firms can spread the risk of health payouts across a large number of employ-

ees, which makes paying out of general assets, or “self-funding,” more attractive.

Christina M. Dalton is at Wake Forest University, 204B Kirby Hall, Winston-Salem, NC 27109.

Dalton can be contacted via e-mail: tina.marsh.dalton@gmail.com. Sara B. Holland is at the Terry

College of Business, University of Georgia, 439 BrooksHall, 310 Herty Drive, Athens, GA 30602.

Holland can be contacted via e-mail: sbh@uga.edu. We thank David Bradford,Mike Morrisey,

Jeff Netter, Christine Parlour, Brad Paye, Annette Poulsen, and participants at the American

Society of Health Economists 5th Biennial Conference, IUPUI, the University of Georgia Health

Policy Consortium brown bag, the University of Georgia Finance Department brown bag, and

the University of Pennsylvania Wharton Finance Department brown bag seminars for valuable

comments. Any errors are our own.

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184 The Journal of Risk and Insurance

Moreover, and of particular importance to policymakers, firms that self-fund health

plans are exempt from state laws mandating that insurance offer coverage of specific

benefits such as contraception, access to certain providers like physical therapists,

and coverage of designated persons such as dependents.1If self-funding is largely a

tactic to avoid insurance mandates, policymakers worry this will reduce the impact

of new mandates or cause adverse selection in group health insurance markets. This

worry was particularly acute prior to the implementation of the Affordable Care Act

(ACA). Federal regulations now require self-insured plans to cover certain benefits,

but application of these federal standards depends on each state’s current mandate

environment (Giovannelli et al., 2015). Focusing on the role of corporate finance in the

funding decision during the period before ACA enactment provides a useful setting

for analyzing the firm’s choice, particularly as the regulatory environment continues

to evolve.2

In 2005, approximately 67 percent of firms purchased health insurance fromproviders

such as Blue Cross Blue Shield rather than self-fund their health plans. Even 20 percent

of very large firms with 500 or more employees still chose to contract with an insurer.

This variation extends across industries as well; almost 40 percent of large firms in

agriculture hedge fully compared to only 11 percent in financial services (Agency

for Healthcare Research and Quality, 2005). Moreover, the magnitude of expected

self-funding expenditures is economically important. Insurance expenditures are on

average 1 percent of assets and 3 percent of cash flows in IRS benefit filings data. These

amounts vary by industry and account for up to 10 percent of cash flows for service

industries.

Why do so many firms continue to manage health benefit risk with insurance? Fo-

cusing solely on the benefits of risk pooling and avoiding potentially costly mandates

ignores important corporate finance effects. In particular, labor is an important input

in firm production. When workers make claims on health benefits, the cost of labor to

the firm fluctuates, changing the cash flows available for investment opportunities.

To generate predictions about which firms purchase insurance and which firms self-

fund their health benefit plans, we adapt the Froot, Scharfstein, and Stein (1993) model

of corporate hedging for labor risk. Firms have an investment opportunity that uses

both physical capital and labor in production. Any required funding beyond internal

general assets comes from costly external financing. Labor is either present and pro-

ductive or “sick,” in which case labor requires a health payout to return to the present

and productive state. If the firm does not hedge, then when labor is “sick” the firm

1In particular, firms that choose to self-insure and take on all risk from health insurance plans

are exempt from certain state insurance laws and taxes and are subject instead only to federal

Employee Retirement Income Security Act (ERISA) regulations.

2Recent changes to federal and state legislation stem from the concern that firms will choose

to self-insure and leave state exchanges, leading to adverse selection in the exchanges. Be-

ginning in 2016, the right to define “small” employer size was transferred to the states

(Corlette, Williams, and Lucia, 2016). Based on Labor Department recommendations, Cali-

fornia and Maryland have enacted legislation making self-funding arrangements more diffi-

cult (Ferguson, 2015). The “Cadillac tax,” contested since its inception and now postponed,

provides additional incentive for firms to self-insure (Armour and Rubin, 2015).