Health Reform and Perverse Incentives
Health reform has been a highly contentious issue and after spending some time digging, I have reached the opinion that if left in its current form, it will corrupt the incentive system largely responsible for entrepreneurial and small-business growth. The major changes, which don’t roll out until 2014, will affect the cost structure of employers to such a degree that it will create perverse incentives and discourage growth among small to medium sized business owners and franchisees. Left intact, the new rules will likely have a major impact on QSRs, restaurants, retailers, grocery chains, etc. Investors should be aware of the potential consequences and adjust their portfolios accordingly.
Most of the regulations that will affect small businesses won’t go into effect until 2014, but the consequences of the changes may appear much earlier than that. In regards to franchisees, the new rules and additional costs of paying for health insurance may make smaller franchisees reluctant to grow and potentially put some out of business.
Starting in 2014, employers with 50 or more full-time equivalent employees will be required to pay for coverage or pay a penalty. Employers will NOT have to provide coverage for seasonal and temporary workers (working fewer than 90 days), for full-time workers during a 90 day waiting period, or if they have less than 50 full-time equivalent employees.
- Full-time equivalent employees: A full-time employee is defined as someone who works over 120 hours per month (an average of 30 hours per week). The number of full-time equivalent employees is the sum of all part-time employee hours worked in a month divided by 120. For example, a firm with 100 employees, each working an average of 15 hours per week (60 hours a month), has 50 full time equivalent employees.
When these rules go into effect in 2014, it is my understanding small business owners will have three options:Provide “affordable” coverage.
- Coverage is affordable as long as the employee’s premium contribution is less than 9.5% of their adjusted gross income.
- If an employee believes the coverage provided by their employer is NOT affordable, they must opt out of the plan, go to the exchange and demonstrate their employer was charging them over 9.5% of their AGI, demonstrate their AGI is less than 300% of the federal poverty level, and then qualify for a government subsidy.
- If an employer offers affordable coverage and the employee opts out, the employer doesn’t have to pay a penalty.
Pay a fine, either by not providing coverage or providing coverage deemed unaffordable (over 9.5% of the employees AGI).
- The fine is the lesser of:
- $3,000 x # of full time employees receiving subsidies.
- $2,000 x # of all full-time employees.
- Note: You won’t be subject to a penalty if your employees are eligible for Medicare or Medicaid.
Below is a time line of when the various regulations will go into effect.
Changes in 2010
- Reinsurance for retiree medical coverage.
- $250 rebate for seniors for coverage through the Medicare Part D gap of “donut hole”
- Tax Credits for small employers.
- Starting this year and going through 2013, small businesses will receive a tax credit to offset up to 35% of their health insurance costs, provided the firm contributes at least half of the employee's premium.
- Eligibility: Small businesses with 10 or fewer employees earning average annual incomes less than $50,000 a year will receive a pro-rata credit. Small businesses with 25 or fewer employees earning less than $25,000 a year will receive a full tax credit.
Changes in 2011 (Calendar year plans)
- Insurance and Employer-Sponsored Plans Must:
- Cover dependent up to age 26 (if they have dependent coverage;
- No lifetime limits, restrictive annual limits on essential benefits; rescissions (unless fraud), and cost sharing on certain prevention and wellness services (unless plan is grandfathered plan).
No changes in 2012
Changes in 2013
- Tax Credits for small employers increases to 50% of the employer contribution (as long as the employer contributes at least half of the employee’s premium) and will be available to firms with the equivalent of 10 or fewer full-time workers paid, on average, less than $25,000; it phases out as the payroll, excluding seasonal workers, grows to 25 and wages rise to $50,000.
Changes in 2014
- Employer obligations go into effect. If you have more than 200 employees you must auto-enroll those employees in an insurance plan if you offer coverage. If you have over 50 full-time equivalent employees, you must offer affordable plans or pay a penalty.
- Coverage is only required for full-time employees (work more than 30-hours per week or 120 hours a month) unless they are seasonal/temporary workers (working fewer than 90 days).
Depending on the circumstances, the fine employers will have to pay for not purchasing insurance from the state-based exchanges will be $2,000 - $3,000, an amount that will likely be less than the cost of insuring an employee. With that said, any half-intelligent employer will just pay the fine. But even if insurance policies offered on the exchanges cost less than the fines, they won't cost less by much. So either way, anyone with over 50 FTEs will have a significant cost added to their business. The effect of the cost will be passed on to consumers somehow, probably via price increases. This creates a perverse incentive for small business owners (businesses with fewer than 50 FTEs) and will encourage them to avoid growth. Basically, it will create a profitability "dead zone" (see graph below).
The graph below demonstrates what I believe this will look like. The graph contains profitability on the y-axis and size (in this case FTEs) on the x-axis. From the 50 FTE point on there is a curve that resembles a pothole at the beginning of an uphill road. The front lip of the pothole is the 50 FTE point on the x-axis. This is because profitability will shrink somewhere between 50 FTEs and enough FTEs where economies of scale trump the costs associated with insurance obligations. You could call this the profitability inflection point. So the sweet spots for operators will either be owning a business that is large enough that the fines are relatively immaterial (right side of the pothole), or owning a business that is small enough that you aren't exposed to the fines (left side of the pothole, i.e. fewer than 50 FTEs). I would argue this creates an advantage for businesses with fewer than 50 FTEs because they won't have the costs employers operating in the “dead zone” will have. Essentially, the firms with fewer than 50 FTEs will become the low-cost providers and therefore have pricing power.
So, let’s say you own three Jack in the Box franchises, each with 15 employees, and you are hoping to expand. Your next location will put you over the 50 FTE limit and your profits will significantly decline. Faced with this scenario, you will have a few options; 1) Expand as quickly as possible to reach the profitability/FTE inflection point by 2014, 2) Accept lower profitability and grow into the “dead zone”, or 3) Maintain your current size. I can’t predict how operators will respond, but I imagine many will resist growth. This creates a problem for Jack in the Box and Jack in the Box shareholders (or any comparable business).
This is how I am interpreting Health Care Reform. If anyone can tell me why this isn’t the case, I am all ears as I sincerely hope I am wrong. Until then, I encourage investors to consider the effects these new rules may have on their portfolio holdings.
Disclosure: No positions