Topic 8: Managing Human Capital Risk

Employee Benefits

Any type of compensation other than direct current salary or wages

Total Compensation

Current Wages (Cash/Salary) + Value of Employee Benefits

Benefit Financing: Non-Contributory

The Employer (ER) pays the full cost of the plan. The Employee (EE) is covered without making any financial contribution

Benefit Financing: Contributory

The Employer (ER) and Employee (EE) share in the cost of the plan. For an eligible EE to become a participant, they must make a financial contribution

Benefit Financing: Voluntary

The Employee (EE) pays the entire cost of the insurance plan

Eligibility

For an EE, this is equivalent to their participation in the plan

Approximate % of Payroll for EE Benefits

Benefits are approximately 40% of payroll

Primary Reasons Firms Offer Employee Benefits

Attract and retain capable EEs

Tax Advantages

Productivity

Better ER-EE relations

ER can take advantage of group insurance

Section 125 Plan (Cafeteria Plan)

An ER-sponsored benefit plan that allows employees to choose between receiving cash and receiving certain taxable and nontaxable pretax benefits

Pretax Benefits

Benefits where the employee’s contribution is deducted from their salary before federal, state, and/or local income taxes are calculated

Tax Treatment of Cafeteria Plan Contributions

EE Contributions are not usually subject to FICA taxes, SUTA taxes, and Workers Compensation Premium

Tax Treatment of Employer Benefit Cost

The Employer (ER) can deduct the cost of EE benefits as an ordinary business expense (just like salary)

Income Taxes and EE Benefits

The Employee (EE) is sometimes not taxed on the value of their Employer-provided benefits. This is a method to compensate an EE tax-free 

Tax Treatment of Health Insurance Premium

The premium cost is entirely income tax-free for the Employee (EE) with no limit

After-Tax Salary

The amount of cash an employee takes home after taxes (Income, FICA, etc.) are deducted from their gross salary

Tax Deductible (Health Insurance)

Both the Health Insurance benefit and an increase in Salary (used to buy the same insurance) are often treated the same way for Employer (ER) view

Salary Equivalent of a Tax-Free Benefit

The higher the salary an EE would need to receive, given their tax rate, to have the same amount of after-tax cash as the value of the tax-free benefit

Flexible Spending Accounts (FSA)

An account an Employee (EE) funds by agreeing to reduce their salary pretax by a certain amount; the money is then used to pay for qualified expenses

Three Types of FSAs

Dependent Care

Medical Care

Transportation

Dependent Care FSA

Used to pay for qualified expenses like Child Care or Elder Care expenses

Medical Care FSA

Used for certain medical procedures not covered by a medical plan and for expenses like Co-Payments

Transportation FSA

Used to pay for Public Transit or Parking expenses

“Use It or Lose It Rule”

The rule stating that any unused funds at the end of the plan year remaining in an FSA are forfeited to the Employer (ER) who uses them to cover administrative costs of the FSA

FSA Maximums in 2025

Medical - $3,300

Dependent - $5,000

Transportation - $4,000

FSA Tax Advantages

The amount contributed to the FSA is Tax-free (reduces taxable income and taxes paid), resulting in higher Net Income compared to not using an FSA

Qualified Plans (Section 125)

Plans that receive favorable tax treatment because they follow rules like not discriminating in favor of Highly Compensated Employees (HCEs) as set by the IRS

HCEs

Highly Compensated Employees

Mandated / Compulsory Benefits (Social Insurance Program)

Benefits that the employer is required by law to provide and/or pay for

Employer’s Role in Mandated Benefits

The employer is required to act in a risk bearing capacity to provide the insurance and/or pay benefits

Examples of Mandated Benefits

Social Security

Workers’ Compensation

Unemployment Compensation Insurance

Group Insurance (GI)

Insurance where the exposure unit is a group of individuals (all employees of a firm) and the insurer assesses the group as a whole

Individual Insurance

Insurance where the exposure unit is a single individual, and the insurer assesses the risk of that person

No Individual Underwriting (GI)

The insurer does not assess the risk of each individual in the group. They look at the broad characteristics of the group to determine rates

Experience Rated (GI)

Premiums are usually based upon the past claims experience of the specific group

Advantages of Group Insurance Rates

Rates are generally lower than Individual Insurance (II) rates for the same level of expected costs

Advantage of GI (No Individual Underwriting)

Eliminates adverse selection problem for the insurer, especially helpful when employees have a potential adverse selection problem

GI Advantage: Lower Commissions/Expenses

Commissions tend to be fewer and the Employer (ER) helps collect the money, making GI less expensive per employee than II

Methods to Control Adverse Selection

• Waiting Periods

• Pre-existing Condition Exclusions (PCEs)

• Minimum Participation Requirements

• Minimum Group Size

• Steady Flow of Persons

• Ensuring an Optimal Coverage

Waiting Period

A period of time an Employee (EE) must wait before being covered by Group Insurance (GI)

Pre-existing Condition Exclusion (PCEs)

A rule that prevents coverage for losses or medical conditions that existed before the insurance policy began

Minimum Participation Requirement

The requirement that the insurer may require a minimum percentage (ex. 75%) of eligible EEs to be covered under the group plan

Minimum Group Size

A rule that requires an insurer to rate smaller groups separately (not experience rating) and may involve some individual underwriting

Steady Flow of Persons

The concept that newer, younger, better risks should enter to replace older, less healthy risks dropping out

Reason for Group Exists

The group should exist for reasons other than the purchase of insurance

ex. ER-based groups, Professional Associations, Alumni Associations

Disadvantages of Benefit Plans

Coverage may be Temporary (it can terminate if the EE leaves the group)

Benefit Over-Compensation

The situation where an Employee is compensated too much by virtue of the value of their benefit plan relative to another employee (single vs. married)