Why Do Employers Provide Health Insurance?

Once the concept of compensating differentials is understood, we can immediately see the conditions necessary for employers to offer health insurance to their workers. First, employees must value the health insurance. If employees do not value the coverage, they will not consider it a form of workers compensation and will only see that their wages are lower. Theoretically, these workers would quit and take a similar job offered by employers that provided higher wages and no health insurance.

The second condition necessary for employers to offer health insurance to their workers is that it must be less expensive for an employee to buy health insurance through an employer than to buy it independently. Health insurance may be less expensive through an employer for three reasons. The first is favorable selection. A worker’s ability to hold a job is a very low-cost signal to the insurer that the worker is likely to have low claims experience. Experience rating results in lower premiums for low- risk individuals. Members of an employed group are likely to have lower claims experience than would a random draw of the population, and certainly lower than a random draw of unemployed people. Moreover, an employer’s health insurance plan may have a healthier draw of the population over time as well, if sick employees tend to drop out of the workforce and new healthy employees join.

Employer-sponsored health insurance tax is the second reason for lower insurance costs through an employer. Compensation provided in the form of health insurance is not subject to federal income tax, Social Security or Medicare payroll taxes, and state income tax. Suppose you are in the 27 percent federal income tax bracket, your state imposes a 5 per- cent state income tax, and Social Security and Medicare have a combined tax rate of 7.65 percent.1 For every $100 of compensation paid to you by your employer, you take home $60.35. If instead you received that $100 of compensation in the form of health insurance, you would have the full $100 of coverage. In this example, the U.S. tax system effectively reduces the price of health insurance purchased through your employer by almost 40 percent! If you bought the coverage on your own, under most circumstances you would pay with after-tax dollars, so you would not receive this tax subsidy.

The third reason why health insurance is likely to be cheaper if purchased through an employer has to do with administrative cost savings. This category includes a wide range of potential savings. Some are simply savings that occur because the employer’s human resources office performs tasks the insurer would otherwise have to do, such as keeping track of which employees are covered and what plan they have and dealing with open enrollment and employees changing health plans. Lower insurer marketing costs are another administrative cost savings. It is almost certainly cheaper to enroll people in groups of 25 or 50 or 1,000, rather than trying to sell to individuals and signing them up individually. Finally, and perhaps of most cost consequence, employers serving as agents for their employees can rationally search longer for a better health insurance value than would individuals. Individuals should search for a better health insurance value until the cost of the extra time spent in search just equals the expected extra savings from continuing to search. In contrast, an employer with 25 or 50 or 1,000 workers can usually afford to search longer because an improvement in the coverage or a reduction in the price will apply to 25 or 50 or 1,000 people.

To summarize: Employees buy health insurance through their employers because (1) they value health insurance, and (2) health insurance is less expensive through an employer than otherwise. If either of these conditions is not met, employers probably will not provide health insurance deductible coverage. If they consider themselves invulnerable to injury and disease, their demand for coverage is low. They do not value personal insurance coverage and are more likely to seek out jobs that offer higher wages and little or no health insurance. Others may find that family coverage is less expensive through a spouse than is individual health coverage through their own employer. They, too, are more likely to seek out jobs that provide higher wages and little or no health insurance. If a public program provides coverage for children for which employed households are eligible, demand for dependent coverage is likely to be more limited and people probably will seek jobs that provide higher wages and no dependent coverage. This last effect is known as “crowd-out” of private insurance.