Where do the sick go? Health insurance and employment in small and large firms.

1. Introduction

The difficulties that small firms face in obtaining and maintaining health insurance for their employees have been widely documented (Brown, Hamilton, and Medoff 1990; McLaughlin 1992; Fronstin and Helman 2000). Only 45% of firms with fewer than 50 employees offer health insurance, compared to 97% of firms with 50 or more employees (Agency for Healthcare Research and Quality 2002). This low proportion has been attributed, in part, to the high administrative cost of health insurance for small firms, the low demand for insurance among workers in these firms, and the unwillingness of insurers to take on small firm risks (McLaughlin 1992; Monheit and Vistnes 1999; Fronstin and Helman 2000).

In recent decades, small firms that provide health insurance to their employees were in a precarious position. Their premiums were calculated yearly, based on the expected value of their health care utilization. Hence, a single high-cost employee could lead to a substantial surcharge on the premiums for the firm (Zellers, McLaughlin, and Frick 1992). In a survey of small employers that did not offer health insurance, 75% claimed that an important reason for not offering insurance was high premium variability (Morrisey, Jensen, and Morlock 1994). Concerns about these problems fueled the passage of numerous state small group health insurance reforms in the 1990s that implemented premium rating reforms and restrictions on pre-existing condition exclusions. While a few states have implemented premium rating reforms that have severely restricted small group insurers' ability to use health status to set premiums, in most states, these reforms have been moderate.

Assuming that firms are unable to perfectly tailor individual wages to individual health insurance costs, unexpectedly high premiums may impose a large burden on small firms. Paying high premiums, possibly financed by borrowing at high interest rates, may increase the risk of bankruptcy. If small firms choose not to pay high premiums, and instead drop insurance coverage, they renege on the implicit compensation contract with workers. Employers may opt to raise employee contributions to cover higher costs, but large increases may lead to healthier employees dropping coverage. Faced with this predicament, small firms may choose to prevent expensive premium variability by maintaining a workforce that has a low-expected utilization of health care services. Thus, the link between employment and health insurance in small firms may result in a welfare loss if it prevents individuals with high-expected health costs from being employed in small firm jobs in which they may have high match-specific productivity.

Employers may obtain information about employees' medical conditions in several ways. Before the passage of the 1990 Americans with Disabilities Act (ADA), half of all employers conducted pre-employment medical examinations (U.S. Congress 1988). Most small group employers required the completion of a family health questionnaire for insurance coverage (Zellers, McLaughlin, and Frick 1992; Cutler 1994). While the ADA now restricts employer inquiries on employee health, it does not apply to firms with under 15 employees. In addition, employer compliance with the ADA may be hindered because its stipulations about pre-employment health inquiries are vague. Medical inquires are allowed if they pertain to the applicant's ability to perform the job. In addition, medical information is explicitly allowed in the use of medical underwriting for insurance (Epstein 1996). The media continues to report cases in which employers easily obtained employee medical records (Rubin 1998) or in which employees have been laid off because of high health costs (O'Connor 1996) or in which employee premiums have been adjusted to reflect the employee's claims experience (Kolata 1992).

The Health Insurance Portability and Accountability Act of 1996 (HIPAA) includes a nondiscrimination provision that bars a group health plan or issuer from discriminating in eligibility or contributions on the basis of a health status-related factor. However, HIPAA allows medical underwriting and allows insurers to rate groups of employees based on health status as long as the premium rate for all employees is blended. This stipulation prevents employers from requiring higher cost employees to contribute a higher premium share, but it does not shield employers from bearing the costs for a sick worker.

Economists have typically believed that health insurance is an attribute of "good jobs" and that workers do not choose jobs based on whether or not the job provides health insurance. In fact, this precept is behind the notion that employment is a mechanism for minimizing adverse selection in the market for health insurance (see, for example, Gruber and Levitt 2000). However, a number of recent studies have suggested that worker demand for health insurance may play an important role in employment decisions. Workers with high-expected family costs may prefer jobs that offer health insurance, and, conversely, workers with low preferences for health insurance may sort into jobs that lack health insurance (Monheit and Vistnes 1999, 2006; Bundorf and Pauly 2004; Royalty and Abraham 2006).

In this paper, we use the Medical Expenditure Panel Survey (MEPS) from 1996 to 2001 to examine the magnitude of employment distortions for workers with high-expected health costs. Since health insurance and employment are linked, health insurance may be an important determinant of employment outcomes. High-expected health costs may reduce the probability that workers are employed in firms in which they have the highest match-specific productivity. We estimate the magnitude of distortions in hiring, employment, and separations. Furthermore, we examine the effect of state small group health insurance reforms that restrict insurers' ability to deny coverage and restrict premium variability on employment distortions in small firms relative to large firms. Estimating the magnitude of employment distortions in insured small firms and understanding the effect of small group regulation on these distortions is essential in deciding optimal public policy toward the small group health insurance market.

2. Literature Review

The first literature that is relevant to this paper relates to small firms and health insurance. Cutler (1994) finds evidence that small firms are subject to a higher degree of premium variability than are large firms. Moreover, small firms with young workers, high turnover, or low wages tend to have the highest premium variability. The possibility of employment screening as a result of the incentives created by the small group health insurance market has been previously noted in the literature (Aaron and Bosworth 1994; Madrian 1994). Monheit and Vistnes (1994) find that the risk selection practices of insurers segment the small-group market so that only persons who are favorable health risks obtain employment-related insurance. They find that the employees and dependents with coverage from small firm policies are in better health than those with non-group policies (when firm coverage was not available) or those who had no coverage. While these results may indicate the presence of employment distortions due to health insurance, it is also possible that we may see these results if individuals in good jobs that offer health insurance are in better health than those who are not offered health insurance. Olson (1993) finds that individuals who say that they are in bad health are far less likely to have health insurance in industries that have a high proportion of small firms than in industries that have a high proportion of large firms. Using the 1987 National Medical Expenditure Survey (NMES) data, Kapur (2004) finds evidence of employment distortions in small firms that is consistent with underwriting rules in the small group health insurance market. Extension of this analysis to the 1996 MEPS is limited by the relatively small sample sizes of insured workers with adverse health conditions. Although not focused on small firms, Buchmueller (1995) finds that men in worse health are less likely to be insured.

Another relevant literature examines the impact of health insurance costs on wages and employment. There is evidence to indicate that rising health insurance costs have led firms to increase hours worked by employees rather than employing more workers (Cutler and Madrian 1998). Other work shows that for certain groups, the wages and the probability of being hired are sensitive to health insurance costs (Gruber 1995; Scott, Berger, and Garen 1995; Sheiner 1995). However, several recent papers fail to find robust evidence of the expected relationship between wages and health insurance (Jensen and Morrisey 2001; Levy and Feldman 2001; Simon 2001).

Using the 1987 NMES data and the 2000 MEPS data, Monheit and Vistnes (1999, 2006) provide evidence that worker preferences play a role in employer-provided health insurance, showing that workers with low preferences for health insurance sort into firms that do not offer health insurance. Royalty and Abraham (2006) demonstrate that workers with access to spouse health insurance sort into jobs that do not offer health insurance, again indicating that worker demand for health insurance may play an important role in job choice. Bundorf and Pauly (2004) also find evidence that individuals who have high-expected health costs are more likely to obtain health insurance in the group market and in the individual health insurance market.