Grandfathering in the Small Group Market Under the Patient Protection and Affordable Care Act

The Patient Protection and Affordable Care Act (P.L. 111-148, or PPACA), signed into law by President Obama on March 23, 2010, will introduce new health insurance options for many Americans by creating state health insurance exchanges, incentivizing employers to offer coverage, requiring individuals to obtain health insurance, and providing subsidies for low-income Americans without qualifying employer offers. While these changes will alter the menu of health insurance options available to many people, one of the goals of the law is to enable Americans to keep the coverage they currently have if they choose to do so. In an effort to ensure that current coverage options do not change, PPACA exempts existing health insurance plans from certain regulations, a policy known as “grandfathering.”* Specifically, grandfathered plans are exempted from rate regulations limiting price variation across enrollees and from risk equalization policies designed to equalize the risk burden across insurers. Newly offered plans, including plans available through state health insurance exchanges, are not eligible for grandfathering and must abide by PPACA's rating regulations and risk equalization policies. Low-risk plans currently in the market may have a strong incentive to maintain grandfathered status, since grandfathered plans have the ability to offer lower rates than permitted with rate limits and no health status underwriting under PPACA. This effect is compounded by the fact that grandfathered plans avoid risk equalization, which tends to increase premiums for low-risk policyholders.

The rating regulations and risk equalization policies specified in PPACA limit variation in insurance premiums by effectively requiring lower-cost enrollees to cross-subsidize premiums for higher-cost enrollees. In general, such policies have the effect of raising prices for individuals and firms with lower health insurance expenditure, and reducing prices for individuals and firms with higher health insurance expenditure. One potential consequence of grandfathering is that healthier individuals and businesses will maintain coverage in grandfathered plans, while sicker individuals and businesses with less-healthy employees will shift into the exchanges. This type of risk segmentation could cause plans offered in the exchanges to have relatively high premiums, which could reduce the total number of people insured.

In this analysis, we used the COMPARE microsimulation model to analyze the effects of grandfathering in the small group market on outcomes including the percentage of small firms (with 100 or fewer workers) offering coverage, premium prices in the grandfathered market and in the exchanges, the total number of people enrolled in health insurance coverage, and the number of people enrolled in exchange-based health insurance plans. We modeled a single, national health insurance exchange designed to represent an exchange for a large state with a typical distribution of firms and workers. Because each state currently has different regulations regarding rating rules in the small group market, we ran several versions of the analysis with different assumptions about premium prices in grandfathered plans. We also considered alternative assumptions about the degree of inertia (bias toward remaining with a status quo choice) in firm decisionmaking and about risk pooling in the exchanges.

Scenarios Considered

We modeled the effects of PPACA on key outcomes, accounting for the individual mandate, employer penalties associated with not offering coverage, subsidies for low-income individuals, and a Medicaid expansion. We then considered how grandfathering in the traditional employer-sponsored insurance (ESI) market would affect coverage decisions among firms with 100 or fewer workers after health insurance exchanges are opened to these businesses. We also considered how the impact of grandfathering would vary depending on the degree of community rating in the current nongroup market. With full community rating, premiums cannot vary based on worker characteristics or past expenditure patterns among firms. Under modified community rating, premiums can vary with worker characteristics, but only within certain limits. With full experience rating, premiums are based entirely on the past claims experience of a firm. Since PPACA requires that all nongrandfathered plans be subject to risk equalization and adhere to 3:1 rate bands on age, it moves the nongrandfathered market to a situation similar to modified community rating. As a result, we expect that the effects of grandfathering will be stronger in states where there are less-restrictive rating regulations. That is, when there are less-restrictive rating regulations in the current market, firms with lower-cost enrollees have a greater incentive to stay in grandfathered plans.

We considered three scenarios regarding the degree of community rating in the pre-reform market: full community rating, full experience rating, and credibility rating. With credibility rating, premiums are a weighted average of the full community-rated and full experience-rated premiums. Full experience rating rarely occurs in the small to midsized group markets, since the year-to-year variance in expenditure within a firm is too high for insurers to rely on past experience as an accurate predictor of future claims. Nevertheless, we estimated a scenario that allows for full experience rating so that we could see the maximum potential effect of grandfathering on outcomes such as premium prices in the exchange. We did not consider a scenario with modified community rating in the pre-reform period, however; in practice, the effects of modified community rating will be similar to the effects of credibility rating.

It is likely that the first-year effects of the PPACA law will be different from the long-term or equilibrium effects. If firms are fully or partially experience-rated in the status quo, then firms that have unusually low expenditure in the period leading up to the reform might be offered unusually low premium rates in the grandfathered market. These firms would be unlikely to switch to the exchange in the short run. Over time, as expenditures revert to a more typical level, these firms may experience premium growth in the grandfathered market and eventually switch to the exchange. As a result, we modeled both first-year and equilibrium effects of the reform and reported results from the equilibrium.

PPACA allows states the option of combining the nongrandfathered small group and individual markets for the purposes of risk pooling. Since people who would be eligible to enroll in the individual exchange market may tend to have higher expenditures than people who would be eligible to enroll in the small group market, the decision to combine or split risk pools may affect premiums faced by firms who choose to offer coverage in the exchange. In our main scenario, we considered a situation in which the individual and small group markets were split for the purposes of risk pooling. However, in scenario testing, we also reported results in which risk pools were combined.

An important area of uncertainty in modeling firms' decisions to take coverage in the exchanges is the degree of status quo bias, or inertia, in firm decisionmaking. Prior studies have documented inertia in individual decisionmaking, such that people remain loyal to a status quo decision (e.g., a stock portfolio allocation, a health insurance plan) even if standard models of economic behavior suggest that switching would be optimal. Because most studies of inertia in decisionmaking focus on individual rather than firm choices, and because PPACA introduces new health insurance options that have not been previously studied, it is unclear how much inertia we should expect following the reform. As a result, the main results considered in this analysis do not account for inertia in firm decisionmaking. We do not consider inertia in premium prices, as would be the case if grandfathered premiums did not fall to actuarially fair values even after higher-risk enrollees moved into the exchanges.**

Summary and Discussion

As with any modeling results, these findings are subject to a large degree of uncertainty stemming from factors such as the level of administrative costs in health insurance exchanges, inertia in decisionmaking, and the government's ability to effectively enforce the individual mandate. Because of these factors, we are more confident about the directionality and the general magnitude of the results than we are about the specific point estimates. With these caveats, we find that the elimination of grandfathering in the small group market is associated with a reduction in employer offer rates and a reduction in the number of people enrolled in ESI. The decline in employer offer rates leads to a decline in the number of people with insurance, with reductions ranging from 200,000 to 1,400,000, depending on assumptions about risk pooling and inertia.

Because some employers drop coverage and others reduce the generosity of benefits offered when grandfathering is eliminated, employer spending for small businesses is lower if there is no option to offer a grandfathered plan. As the number of people enrolled in employer-sponsored coverage falls, the number of people enrolled in Medicaid and subsidized exchange policies increases. These factors lead to an increase in government spending. When equals 0.25 (potentially the most realistic representation of the current status quo), the increase in government spending following the reform would be 3.4 percent higher if grandfathering were eliminated. However, this result should be interpreted cautiously because we do not account for potential increases in tax revenue that might occur if employers who eliminate or reduce the generosity of health benefits pass some of these savings back to workers in the form of taxable wages.

To partially address this issue, we did a rough calculation where we assumed that 100 percent of prior health insurance spending would be passed back to workers as wages if an employer dropped coverage due to the elimination of grandfathering. By applying the average marginal tax rate at each firm to the estimated wage pass-back, we calculate that the government would receive $2.2 billion dollars in additional tax revenue if grandfathering were to be eliminated.*** However, this result rests on the assumption that 100 percent of savings among firms that drop coverage would be passed back to workers. Simultaneously, it assumes that no savings would be passed back to workers if firms decreased the actuarial value of plans in response to the elimination of the grandfathered market.

We analyzed the effects of grandfathering under a variety of assumptions about the degree of community rating in the traditional ESI market, the degree of inertia in firm decisionmaking, and whether individual and small group risk pools are combined or segregated in the health insurance exchanges. The main results are very stable to all of these alternative assumptions. In all of the scenarios considered, when the grandfathered market is eliminated, ESI enrollment falls, Medicaid enrollment increases, government spending increases, and employer spending falls. Overall, these results suggest that, while grandfathering may lead to slightly higher exchange premiums (1.3 percent higher when = 0.25), grandfathering is also associated with higher ESI enrollment and lower government spending. As a result, grandfathering may be an effective policy if the goal is to maximize the number of people enrolled in employment-based coverage.

References

PPACA—see Patient Protection and Affordable Care Act.

Patient Protection and Affordable Care Act, Public Law 111-148, 111th Cong., 1st Sess., March 23, 2010. As of May 27, 2010:
http://www.govtrack.us/congress/bill.xpd?bill=h111-3590

Rotemberg JJ, “Sticky Prices in the United States,” Journal of Political Economy, Vol. 90, No. 6, December 1982, pp. 1187–1211.

Notes

* See Section 1251 of PPACA, 2010, for a complete definition of grandfathered plans.

** Economic theory and evidence suggest that—in general—prices may be sticky, especially in the short run (see, for example, Rotemberg, 1982). To the extent that traditional ESI premiums remain at high levels after the exchanges are opened, we would expect an increase in the number of firms offering coverage through the exchanges.

*** This calculation includes federal income taxes, Social Security (Federal Insurance Contribution Act [FICA]) taxes, and state income taxes. We do not incorporate multiplier effects (i.e., any additional economic stimulus caused by the wage change that could increase the tax base even further). The calculation applies to the equals 0.25, no inertia scenario.