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Small Business Employee Benefits and HR Blog

Part 5: The Shift to Defined Contribution Healthcare

June 11, 2014

This post is part of a blog series on the history of the U.S. health insurance industry. This series has been adapted from the Zane Benefits white paper, The Inevitable End of Small Business Health Insurance. To access Part 4 of this blog series, please click here.

In the last several articles in the series, we outlined the inherent pitfalls of employer-provided health insurance and the many attempts to reform it. We also discussed how the Affordable Care Act (ACA) boosts the Individual Health Insurance Market. As a result of these factors, we predict that 60% of small businesses will eliminate employer-sponsored health insurance by 2017 in favor of individual health plans and Defined Contribution Healthcare arrangements.

This article examines why the shift is happening, how Defined Contribution Healthcare arrangements work, and why small businesses are rapidly shifting to Defined Contribution Healthcare.

4 Reasons for the Shift to Defined Contribution Healthcare

There are four reasons for the shift to Defined Contribution Healthcare:

  1. Small business health insurance costs are on an unsustainable trajectory

  2. Individual health insurance policies provide greater value to employees

  3. Individual health insurance costs are 20 to 60 percent lower

  4. Defined Contribution Healthcare arrangements allow employers to reimburse employees for individual health insurance costs

Reason #1: Small Business Health Insurance Costs are on an Unsustainable Trajectory

The ACA does not address the “death spiral” of small business group health insurance. As previously discussed, one of the major drivers of cost increases in the employer-based health insurance market is the spreading of risk and costs in a small pool of participants which leads to drastic cost increases and participants dropping out. On the other hand, the Individual Health Insurance Market has been made more robust by the ACA due to the increased ease of finding insurance, guaranteed issue policies, and the premium tax credits.

As the small employer group health insurance death spiral continues to run its course, small businesses that currently offer health insurance coverage will either: (1) be forced to cancel the plan; or (2) become unable to meet the minimum contribution requirements or minimum participation requirements set by the insurer, and have the plan canceled by the insurer.

Reason #2: Individual Health Insurance Policies Provide Greater Value to Employees

Once educated, employees prefer individual health policies to employer-provided plans due to two key advantages:

  • Choice – With individual health insurance, employees choose the coverage and doctors that best fit their family’s needs and budget.
  • Portability – Employees keep their health insurance when they leave the company because individual health plans are independent of employment.

Reason #3: Individual Health Insurance Costs are 20 to 60 Percent Lower

The following U.S. maps show a state-by-state cost-comparison of individual health insurance premiums offered through the federal Individual Health Insurance Marketplace in 2014 compared to group health insurance premiums.

In all states using the federal Marketplace, individual health insurance policies are less expensive than group health insurance even before one takes into account premium tax credits.

As the maps show, this holds true across Bronze, Silver, and Gold plans.

Bronze Premium Cost Comparison Map

Silver Premium Cost Comparison Map

Gold Premium Cost Comparison Map

 Source of Maps and Data: The Inevitable End of Small Business Health Insurance Whitepaper.

Reason #4: Defined Contribution Healthcare Arrangements Allow Employers to Reimburse Employees for Individual Health Insurance Costs

Defined Contribution Health Plans enable small businesses to offer employee health benefits for recruiting and retention purposes without absorbing the premium and administrative costs of sponsoring a traditional group health insurance plan.

Under these types of arrangements, employees purchase their own individual health insurance policies and the employer reimburses the employees for their out-of-pocket premium cost, often up to a specified monthly healthcare allowance.

There are two core Defined Contribution Healthcare arrangements a small business will consider:

  1. A Taxable Healthcare Allowance, or

  2. A Tax-free Health Reimbursement Plan (HRP)

1. Taxable Healthcare Allowance

Under this Defined Contribution Healthcare approach, the employer reimburses employees for their substantiated individual health insurance costs on a post-tax basis up to a healthcare allowance specified by the company.

When offering a taxable healthcare allowance, the employer ensures employees use the dollars on health insurance, and employees associate the arrangement as a health benefit. However, one major limitation of this approach is the lack of tax advantage – requiring employees to pay taxes on the reimbursements they receive. As a result, most employees prefer their employers to establish a Section 105 health reimbursement plan providing tax-free reimbursement of individual health insurance costs.

Under Section 105 of the Internal Revenue Code (IRC), employers are able to establish a formal self-insured medical reimbursement plan to reimburse employees for individual health insurance premiums on a tax-free basis.

2. Tax-free Health Reimbursement Plan (HRP)

Under this Defined Contribution Healthcare approach, an employer utilizes Section 105 of the Internal Revenue Code to establish a formal self-insured medical reimbursement plan to reimburse employees for their substantiated individual health insurance costs on a pre-tax basis. Proponents of this arrangement refer to this approach as a Health Reimbursement Plan (HRP).

Note: An HRP should not be confused with an Employer Payment Plan allowed under Section 106.

When providing tax-free reimbursement of individual health insurance premiums through an HRP, the employer must ensure compliance with federal regulations, including but not limited to legal plan documents, summary plan descriptions, and new “Market Reforms” required by the Affordable Care Act.

For example, in order to comply with the rules outlined in IRS Notice 2013-54, the HRP must be structured to reimburse employees for only: (a) health insurance premiums up to a specified monthly healthcare allowance; and (b) unlimited basic preventive health services as required by Public Health Services (“PHS”) Act Section 2713.

Failing to comply with the applicable regulations could result in fines of up to $100 per day per employee (or 10% of the value of the benefit) if a failure is not corrected within 30 days once it is identified. Therefore, it is expected that small businesses will seek assistance in administering HRPs to ensure compliance.


To summarize, due to the high cost of group health insurance and the better value of individual health insurance, small businesses have begun shifting employees to the Individual Market and are replacing existing employer-sponsored health insurance premium contributions with a Defined Contribution toward employees’ individual health insurance premiums.

Click here to read The Inevitable End of Small Business Health Insurance.

Find all articles in this series here.

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