The Curious Case of Professional Employer Organizations

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Why’d my PEO give me a more expensive plan?

My favorite posts are the ones that a total of five of you will care about, but those five will lose their goddamn minds over. This is one of those posts.

If you’ve worked at a small company, you’ve probably gotten your paycheck from a company like Rippling, ADP, Sequoia One, etc. These are called Professional Employer Organizations, or PEOs. If you’re the employee, you might be wondering why your paycheck comes from these companies and not your actual company. If you’re a Head of People or CEO, you might be wondering why you get different prices than other companies for the same benefits. Today you’ll find out.

A PEO is basically a company that takes over the back-office of a small business. They handle human resources, payroll, 401(k), compliance, and get health insurance for your employees. The pitch is that by bundling all of their customers together, they can negotiate Fortune 500 level benefits and prices. It generally makes sense at ~200 people and below. Your business has lots of other existential things to worry about that aren’t back-office like “wait is technology actually a differentiator in my business or did I just build an agency?”. 

I never really thought about PEOs much until a friend recently told me that a PEO refused to work with them and they suspected it’s because they had a few employees who were sick. Wait but how were PEOs doing that? They’re allowed to do that? Am I friends with this person or is it like a “work acquaintance” thing? Some reddit threads have confirmed it’s happened to them, too.

Suddenly this made me realize that I had no idea how PEOs worked, so it sent me down a rabbit hole. And wow I learned a lot because like me, it’s way more complicated and interesting than it seems at first glance.

So, I’m here to talk about how PEOs work and how they highlight the incredible strangeness that happens when health insurance is tied to employment.

Context: How employer insurance is underwritten and ERISA

Before I get into PEOs specifically, it’s worth level setting with some background info. 

First, you need to understand how group insurance is underwritten. We did an entire post about this, which you can read here. But at a high level, there are two ways it can happen:

• Community Rating - This type of underwriting uses a specific set of non-healthcare characteristics about the patient to underwrite their risk. This is pretty limited - things like age, gender, smoking status, and industry they work in. Each state allows some different permutation of these factors in their underwriting, which you can see here.
• Experience Rating - This type of underwriting looks at how groups of patients USE the healthcare system. What was their spend? What kinds of conditions might they have? What types of medications are they on? Etc.

Community rating is pretty limited in what it can use and specifically does not let insurance companies use things like medical conditions. Experience rating does let you use medical conditions (at a group level) and tends to be more accurate.

A second thing you need to understand is that there are two different sets of regulations that govern health insurance plans. 

• State Insurance Agencies - If your company is fully-insured, that means the health insurance company is taking on the financial risk of employees. This is usually what most small companies do. The laws that govern these small group health insurers are enforced by state insurance agencies. Shoutout to my bureaucratic homies.
  • State insurance usually wants to make sure when an insurer enters a market that it has enough money to stay solvent. So one thing they do is impose minimum capital requirements. 
• ERISA - if you're a big enough company, then you’re probably taking on the financial risk of your own employees and paying their medical bills. This is called self-insurance, and you’re governed by a completely different set of regulations under something called ERISA (Employee Retirement Income and Securities Act). These regulations focus on employee benefits, are much more flexible, and are governed by the Department of Labor. 
  • One of the key presumptions behind ERISA is that employers are bound by fiduciary duty to their employees - they are supposed to be acting in the employees best financial interest. If employees think they are not doing a good job, they can sue their employer but it might be…a little awkward lol.
  • ERISA governed plans do not need to maintain minimum capital requirements and prove they have the money.

So combining these together now: 

• If you’re a small business, most likely you’re fully insured. So if you have <50 or <100 employees (depending on the state), then your health insurance must be underwritten using community rating rules and follow the rules set by a state insurance plan.
• If you’re self-insured or you’re a large group, you can actually see how your patients use the healthcare system and underwrite it based on that. More likely than not you’re governed under ERISA and the Department of Labor. 
• If you’re still reading this, I already know you spend too much time in Excel.

This is important context to understand why PEOs play in a very weird area.

A Little backstory: Multiple Employer Welfare Arrangements

When ERISA came out in 1974, immediately some enterprising young regulatory hackers saw an opportunity. These companies without minimum capital started offering really cheap health plans to businesses, who obviously were interested and signed their employees up. These were called Multiple Employer Welfare Arrangements, or MEWAs.

After some complaints about these cheap plans not covering medical bills, the government said, “hey you’re a health insurance plan, you need to have capital reserves” to which the companies said, “actually we’re regulated by ERISA, so we don’t.”

It was very confusing because there wasn’t a clear cut definition of what an employer or employee actually was and these plans lived in the purgatory of being regulated by the Department of Insurance and the Department of Labor. 

In 1983 they added an exception - a plan that is maintained by two or more employers would be considered a MEWA, and they would be regulated as if they were regular health insurance. However, enforcement was still lax and gray so for years there were issues. A government report from 1992 talks about how in the three years between 1988 and 1991, there were 400K people with $123M of unpaid claims in MEWAs. MEWAs still exist today, but many of them are much more tightly regulated due to the 1983 exception.

The specification is that “multiple employers” would be considered a MEWA. But what if…technically…all the employees were under one “employer”? 

The Rise of the Professional Employer Organization

Starting sometime in the 90s/early 2000s, you started seeing a different arrangement. Outsourcing companies would instead come to companies and say “how about you make your employees an employee of us, but you still get to handle all the day to day parts like giving them tasks, setting their pay, etc. But for legal purposes, they’re our employees.” It’s basically employment polyamory and the relationship is just as confusing as real polyamory.

This “co-employing” relationship has led to the modern PEO. This has become much more popular over the years as running a business has gotten way more complex and compliance requirements increase. 

Essentially by making all of the employees under one company, they now can sort of bypass the “multiple employer” part of “multiple employer welfare arrangements”. 

Here’s how it works practically:

1. As the CEO, you get a complaint that you didn’t withhold tax on payroll. This is the straw that breaks the camel’s back, you’re done with compliance. So you call up a PEO. 
2. You decide what set of services you want the PEO to offer - usually there’s a menu of things like 401(k), human resources, health insurance, etc.
3. From here, the PEO will sign a Client Services Agreement with you. Basically this outlines who is in charge of each employee responsibility (e.g. hiring and firing employees, deciding compensation, etc.). This document establishes the PEO of the co-employer. 
   • Here’s an example of an agreement - it’s worth noting that each of these can be pretty bespoke and very state-specific, so it’s worth reading carefully to understand how things like arbitration work if an employee sues the company.
   • There are also two different versions of this. A PEO is a “co-employer”, but you can also have a company be the “employer of record”. Nuances here aren’t super important for the post, but definitely important if you’re considering this route, so I would read up. 
4. The PEO will basically be an outsourced HR team for you and handle things like issuing pay stubs for your employees, helping sign them up for health plans and benefits and answering questions, pretend they’re friends with the employees and be a rat to the C-suite (jk, maybe), etc.
   • Some PEOs will choose plan options from insurance carriers for their clients and act as a broker. It can then receive commissions from the insurance carrier which are a % of premiums. 
5. Your company pays the PEO for administering all this stuff and for access to the group deals they negotiated.
   • The payment is usually a flat fee per employee per month ($40-160) or a % of the total payroll the PEO runs (3-10%). You then separately pay all the vendors.

I’ve made a little diagram below that might sort of explain some of this. For all you “visual learner”-ass people, this one's for you.

You might be asking yourself - “is this not a multiple employer welfare arrangement?”. For a while, it was kind of in this limbo zone because it was technically under one “employer”, the PEO. 

But in the last five years, the Department of Labor has become more explicit about PEOs. Certain states have passed regulation like the New York Professional Employer Act that explicitly says PEOs won’t be considered multiple employers if they have a co-employment relationship. In Tennessee a PEO can launch a self-funded plan if it gets approval from the Department of Insurance. Several other states require a PEO to have a level of financial solvency, and you can see the other variances here.

It’s still a regulatory gray area depending on the state, but in general, it seems like PEOs actually get treated as one big pool of employees as long as they’re taking on the fiduciary duty that an employer is expected to have, and can be monitored by the state.

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PEOs and Risk Shifting

PEOs seem like a regulatory wild west that’s still being figured out. The part that’s interesting and confusing to me is the role that PEOs seem to play in health insurance underwriting.

If a small business does not use a PEO, then the insurance plans they are offered are underwritten using the community rating system that just looks at the demographics of your employee. The problem is that these rates are almost always pretty bad partially because the underwriting is less accurate and the pool of people is usually sicker. 

Employees of small businesses with healthy employees WANT to be underwritten using experience rating because they’ll get better rates. PEOs essentially give them that option.

PEOs seem to get large group health plan benefits by grouping all these small businesses together, and then they underwrite the risk of small businesses themselves and parcel out different rates to them. My understanding:

1. PEOs get some large group plan rate by saying they have like 1,000 “employees”.
2. Small businesses come to them, the PEO takes a look at their employees and assesses what risk level the employees are. 
3. The PEO adjusts the premiums accordingly or says the small business is too high-risk or too expensive for the PEO to take on.**
4. A small business pays the PEO the per employee per month admin fee for all the other stuff. That’s essentially the “toll” you pay to the PEO in order to access their health insurance rates. 

Employers need to do math if they’re saving more on the health insurance vs. the admin fee they’re paying to use the PEOs other services like payroll. Very primitive example - you might pay $100 per employee per month for payroll, compliance, etc. so your savings from health insurance using the PEO would have to be at least $100 per employee per month.

**[One of my outstanding questions when going down this rabbit hole. Technically a single “employer” can’t give their employees different premium amounts for the same plan for different health conditions. It seems like the PEO is basically doing this if it underwrites employees and gives companies different rates? Or are they offering different employers different plans to get around this? 

What I’ve been told is that they’re able to do this because they change rates based on geography and all of the companies they represent are in different zip codes, but this seems like a pretty flimsy premise. If you have more insight, let me know.]

The Encapsulation of the Employer<>Health Insurance Problem

I’ve said many times that this is one of the original cardinal sins of US healthcare. It’s literally the second thing I ever wrote on this newsletter.

This rabbit hole into PEOs only further confirms this for me because it highlights some of the biggest issues with having this kind of system.

Multiple Risk Pools and Risk-Skimming - In the employer model, every single pool of employees has a different level of healthiness so they get different rates. In any other functioning insurance market, you explicitly want to make sure that everyone is in the same risk pool because you need the healthy people to subsidize the sick people.

Because the employer health insurance market completely fragments the risk pool, the entire game is about figuring out how to exit the regulated risk pool if you have healthy employees. PEOs are a means for small businesses to do that. 

The unfortunate reality is that the only people that remain in the regulated risk pool are employers with the sickest employees. Here’s an example from a public hearing in DC, where they show how employers with younger employees leave the small group pool for PEOs and leave older members or women in child-bearing age behind.

It’s these high cost and sicker people that end up getting the short end of the stick, the exact people our health insurance regulations were supposed to protect.

Patchwork Laws - The employer based system basically splits regulation into two completely different worlds: rules that apply to employer plans (more than half the population) and rules that apply to health insurance plans (the other half). This whole system is very confusing for everyone and you need to pay an army of lawyers and consultants to basically figure out which rules apply to you. We need more simplicity!

But on top of that, the regulating body always gets split between the Department of Labor and the State Insurance Department. This always leaves some gray area in between the two for companies to take advantage of. There’s a whole “catch me if you can” element where companies find loopholes that exist, it takes decades to patch up the loophole, and then a new one appears. MEWAs popped up, then PEOs found a way around it. There’s always going to be a company that creatively claims someone is an “employee” so they should get treated like an employer plan. 

Look at this case happening right now. A company called Data Marketing Partnership had people download an app to track their data and sign a “partnership” agreement with the company. Data Marketing Partnership sold the data to marketing firms to get cheaper premiums AND are claiming that all of these people are “employees” of the company so they should get treated like an employer plan. It’s like watching an interpretative dance, except it’s labor law.

We’re never going to have a pinned down definition of employee, which means this problem will always exist. 

The Fiduciary Duty of Employers - One big assumption around employers choosing health benefits is that they’ll be good fiduciaries and do a good job. But if we’re being honest with ourselves, employers have 0 idea what’s going on with their health benefits. 

Most employers default to third-parties to help them figure out how to provide health coverage and benefits to their employees. In a PEO context, it seems even more complicated since the PEO becomes a fiduciary on behalf of the employer and therefore on behalf of their employees?

Plus, fiduciary duty has a very specific financially oriented view of patients, which doesn’t necessarily need to be one that maximizes health outcomes or things patients want. For example, here’s how some employer consulting groups frame being a fiduciary.

However, just as the job of a financial fiduciary isn’t to secure guaranteed financial returns for their clients, the job of a health plan fiduciary isn’t to secure an objectively good deal for their plan members. Instead, fiduciaries are obligated to do the best job they can for their clients, and to do so in a provable and legally defensible manner. 

Inspiring! This makes me feel very confident that my employer is providing the best healthcare to me! Maybe viewing health coverage as fiduciary duty is not aligned with what individuals want from health coverage. Employers are not good stewards of benefits for employees, especially social safety net benefits that are huge expenses for the company. And for a PEO, it’s not even REALLY their employees.

The complexity of healthcare makes employers terrible fiduciaries. That’s why we’re now seeing some class action lawsuits with massive implications like the one against Johnson & Johnson and Mayo Clinic. These suits basically are saying that these employers' plans are not actually acting in employees best interest, and I think we’ll learn a lot about how employers choose their health benefits. Spoiler Alert: Not well! More like fiduciary doody!

Conclusion and Parting Thoughts

I can’t really hate on PEOs since they’re just playing the game. And the number of laws that small businesses need to be compliant with seems to keep going up, so they really do help their customers with a lot of issues.

But it’s worth acknowledging how PEOs actually work and some of the downsides. The big benefit PEOs offer is essentially the ability to discriminate prices based on employees’ health. The whole purpose of the Affordable Care Act was to prevent things like this, and this seems like a loophole.

As health insurance premiums have skyrocketed over the last decade, it dovetails with a widespread ideological belief that if you’re healthy you should pay less in premiums. PEOs are the business version of that.

I stand by my original belief that entangling employment and insurance is the root disease, PEOs are just a symptom of it.

Thinkboi out,

Nikhil aka. “Ay Dios PEO”

Thanks to Nick Soman and Russell Pekala who read drafts of this

Twitter: ​@nikillinit​

IG: ​@outofpockethealth​

Other posts: ​outofpocket.health/posts​

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