Fitch ratings: rising health care costs taking a toll on local government finances.

The rising costs of employee health care and health insurance have created significant budgetary, financial, and management challenges for U.S. state and local governments over the past five years, according to a new Fitch Ratings survey. As governments seek to manage cost increases by shifting them to public employees, significant problems may arise pertaining to productivity, morale, and retention.

The cost to local governments of providing employee health care increased an average of 14.2 percent per year between 2000 and 2004, compared to overall annual expenditure growth of 5.5 percent. According to U.S. economic data, wages grew 3.2 percent and inflation averaged 2.4 percent over the same period. Most survey respondents expect future employee health care cost increases to be in the 7 to 10 percent range.

As the growth of health insurance costs has far outpaced other government expenditures, its relative importance to total operating costs has increased. Health insurance constituted an average of 5.4 percent of the responding governments' 2004 operating expenses, up from 3.4 percent in 2000. Health care cost increases have had an even greater effect on local governments than private sector employers because governments have historically provided more generous health insurance benefits to their workers.

Fitch expects employee health care costs will be an increasingly important credit consideration for government issuers. As part of the normal credit review process, Fitch analysts now seek information from municipalities on their current employee health care expenses, expected growth in these costs, flexibility to control the increases, and details on plans to do so. Fitch believes that the problem is most severe for issuers whose financial operations are already strained and those with limited revenue-raising capacity or other financial flexibility. However, given the likelihood for costs to continue to increase, even issuers that have historically had positive financial operations and maintained strong fund balances may be affected if health care costs are not proactively and cautiously managed.

To control costs, 61 percent of respondents have shifted a greater share of the cost to employees by lowering the employer contribution rates on insurance premiums and/or increasing copayments and deductibles. However, many respondents noted that their flexibility to take further steps that reduce benefits or shift costs to employees is balanced by labor demands, especially with unions. Additionally, further cost shifting may reduce productivity and performance levels, as well as make it more difficult to attract and retain employees.

Most governments (57 percent of respondents) have also reported shopping for other insurance providers and plan administrators. Other common actions taken or investigated were to switch to self-insurance on some services (35 percent) and to offer less expensive plans. Some governments (30 percent) have offered wellness programs for conditions that can be partly controlled through diet and exercise, such as blood pressure, diabetes, and heart disease.

To control the cost of prescription drugs, 26 percent of governments offer tiered coverage (higher copayment levels for brand name drugs than generic drugs) and have promoted the use of mail order instead of retail purchases. A few respondents reported savings by merging plans with neighboring entities (9 percent) and educating employees on how to be better health care consumers (4 percent). The latter was considered particularly effective, since higher deductibles and copayment rates increase the incentive to voluntarily avoid unnecessary or costly services.

Of the governments that provide retiree health care benefits, most acknowledge that the financial impact of GASB 43 and GASB 45 is likely to be significant. These accounting regulations, which for the largest governments start going into effect in December 2005, will require accruing liabilities and expenses for other postemployment benefits on an actuarial basis, similar to defined benefit pension plans. Fitch believes some municipalities may consider the possibility of issuing bonds to fund accrued OPEB liabilities. If so, Fitch will review the credit implications for entities taking such action.

"Local Governments Pressured By Rising Employee Health Care Costs" is available on the Fitch Ratings Web site at www.fitchratings.com under the public finance header.