How Level Funded Got Here: The ACA, the Small Group Market, and Regulatory Arbitrage

Level funded is not product innovation. It is regulatory arbitrage made operational. The distinction matters because innovation creates value that persists independent of the regulatory environment. Arbitrage creates value that depends on a gap between two regulatory regimes persisting. If the gap closes, the value disappears. The level funded market exists because of a specific gap: the ACA transformed small group fully insured economics through community rating, essential health benefits mandates, and guaranteed issue, while ERISA preserved the self-funded alternative where employers can be underwritten on their own health status, design benefits outside state mandated requirements, and avoid state premium taxes. Employers with healthy populations had a financial incentive to move from the first regime to the second. Stop loss carriers and TPAs built the product that made the move possible.

Self-Insurance Before ERISA

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Employer self-insurance is not new. Large employers began self-insuring health benefits in the 1960s and 1970s. The primary motivations were cost control and cash flow management. Employers could earn investment income on unspent claims reserves. They could avoid the administrative complexity of dealing with multiple state insurance regulations. The practice was largely ad hoc, unregulated at the federal level, and limited to employers large enough to absorb claims variance from their operating capital.

ERISA, enacted in 1974, did not invent employer self-insurance. It created the federal regulatory framework that formalized and protected it. The preemption provisions that LFP-01.03 examines gave self-funded plans a consistent legal foundation across all states, shielding them from the patchwork of state insurance regulations that fully insured products must meet. After ERISA, self-insurance grew steadily among large employers through the 1980s and 1990s.

By the late 1990s, the Kaiser Family Foundation’s Employer Health Benefits Survey showed that the majority of covered workers at large firms were enrolled in self-funded plans. The growth was driven by cost control advantages that allowed employers to retain favorable claims experience rather than ceding it to a carrier. Access to claims data enabled plan management decisions that fully insured employers could not make. ERISA preemption benefits reduced regulatory friction for multi-state employers. Paul Fronstin’s research at the Employee Benefit Research Institute tracked this growth in detail, documenting how self-funded prevalence increased steadily by firm size through the 1990s and 2000s, with the largest firms leading adoption and mid-market firms following as the administrative infrastructure matured. Small employers, defined in most states as groups with fewer than 50 employees, remained almost entirely in the fully insured market. They lacked the capital reserves to absorb claims variance. They lacked the administrative infrastructure to manage a self-funded plan. Their employee population sizes made claims statistically unpredictable. The small group barrier to self-funding was structural, not informational. Even well-informed small employers with sophisticated advisors stayed fully insured because the economics did not work at small group sizes without a mechanism to cap catastrophic exposure while preserving the self-funded architecture.

The ACA and the Small Group Price Shock

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The Patient Protection and Affordable Care Act, signed into law in 2010 and phased into implementation through 2014, transformed small group fully insured economics in ways that created the demand for an alternative.

Community rating was the largest single change. Before the ACA, small group insurers could rate based on health status, age, gender, industry, and group size. A 20-person technology company with young, healthy employees paid a premium that reflected their specific risk profile. The ACA restricted rating factors to age within a 3:1 ratio, geography, tobacco use, and family size. Health status was eliminated as a rating factor. The practical effect: small employers with young, healthy workforces saw their premiums increase because the community-rated pool now included higher-risk populations whose costs were distributed across all purchasers. The healthiest groups were subsidizing the least healthy groups, by design. The ACA’s architects understood this as a feature: community rating spreads risk broadly and ensures that sick populations can obtain coverage at the same price as healthy populations. But for the employer writing the check, the consequence was a premium increase that reflected someone else’s claims.

Essential health benefits compounded the effect. The ACA required all small group and individual market plans to cover ten categories of essential health benefits, including maternity care, mental health and substance use disorder services, prescription drugs, rehabilitative services, and pediatric dental and vision. Employers who previously purchased lean benefit designs, covering hospitalizations and major medical but excluding some of these categories, saw premiums increase to fund the mandated coverage. The EHB mandate reduced plan design flexibility in the fully insured small group market. An employer could no longer design a plan that matched its specific workforce’s needs and budget. The benefit floor was set by federal regulation.

Guaranteed issue and modified community rating broadened the risk pool further. Carriers could no longer decline to cover small groups or charge more based on health status. The risk pool expanded to include groups that would previously have been rated up or declined, including groups with members who had pre-existing conditions that would have produced significant surcharges or outright declination under pre-ACA underwriting. The cost of insuring that expanded pool was distributed across all small group purchasers through community rating. For the insurer, the math worked at the pool level. For the individual healthy employer looking at a renewal increase driven by pool-level costs rather than their own claims experience, the math felt like a subsidy they had not agreed to pay.

The combined effect was not subtle. Healthy small groups cross-subsidized less healthy groups. Premiums for the healthiest small groups increased relative to pre-ACA levels. The increase was not uniform and depended on the group’s pre-ACA rating relative to the community rate, but for groups that had previously enjoyed favorable health-status-based rates, the shift to community rating produced meaningful premium increases. These employers had a financial incentive to exit the community-rated risk pool, and the exit mechanism was self-funding under ERISA, where health-status underwriting remained legal because the ACA’s community rating requirements applied to insurance products, not to self-funded employer plans.

The Stop Loss and TPA Response

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The demand side was clear: healthy small employers wanted out of community rating. The supply side responded.

Stop loss carriers recognized the market opportunity and developed level funded products that bundled specific and aggregate stop loss with TPA administration into a single monthly payment. The underwriting was health-status-based, permitted under ERISA because self-funded plans are not insurance products subject to ACA community rating. Healthy small groups could now be underwritten individually, paying a monthly amount that reflected their own expected claims rather than the community-rated pool. Industry estimates of level funded savings for healthy small groups vary widely, with broker and carrier sources citing figures ranging from approximately 15 to 30 percent or more below equivalent fully insured community rates, depending on the group’s demographics, plan design, and the stop loss carrier’s pricing. UnitedHealthcare has cited average savings of 19 percent for fully insured groups migrating to level funded.

TPAs that previously served mid-market and large self-funded employers adapted their platforms for small group administration. New TPAs entered the market specifically to serve the level funded segment. Carrier-affiliated level funded products emerged: UnitedHealthcare Level Funded, Aetna Funding Advantage, Cigna’s level funded offerings, and Trustmark’s Starmark subsidiary all brought branded products to market. These products used existing carrier networks and administrative infrastructure to offer level funded alongside their fully insured lines. The carrier-affiliated products blurred the line between fully insured and level funded in ways that served the carriers’ distribution interests but sometimes confused employers about what they were actually purchasing. An employer offered UnitedHealthcare Level Funded through the same broker and the same sales channel as UnitedHealthcare fully insured could reasonably assume the products were similar. The structural differences in risk ownership, regulatory treatment, and surplus economics were substantial, but the distribution channel did not always make those differences visible.

The level funded market grew rapidly after 2014, concentrated in the 10 to 50 employee segment. Industry analysts tracked the growth through the late 2010s and into the 2020s, and the KFF Employer Health Benefits Survey began reporting level funded enrollment as a distinct category. By 2024, KFF reported that 36 percent of covered workers at small firms were enrolled in level funded plans, up from 7 percent in 2019. Precise market sizing beyond the KFF survey remains difficult because level funded plans are not reported as a distinct category in most state and federal data collections. The Self-Insurance Institute of America (SIIA) and various industry analysts have estimated level funded enrollment in the range of several million covered lives, but the estimates depend on how level funded is defined and which products are included.

Regulatory Arbitrage, Not Innovation

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The framing matters. Level funded exploits the gap between ACA small group rating rules and ERISA self-funded plan treatment. Community rating, essential health benefits, and guaranteed issue apply to fully insured plans. Health-status underwriting, plan design flexibility, and premium tax exemption apply to self-funded ERISA plans. Level funded uses the self-funded architecture to access the second set of rules while the employer’s employees work in a market governed by the first set.

The market-structure consequence is adverse selection operating at the system level. Healthy groups exit the community-rated fully insured pool through level funded. The remaining fully insured pool becomes less healthy on average. Premiums in the fully insured pool increase to reflect the higher average cost. The premium increase drives more healthy groups to consider level funded. The cycle reinforces itself. This is not a theoretical concern. State insurance departments and health policy researchers have documented the dynamic in states where level funded penetration is high enough to measurably affect the fully insured small group risk pool.

The durability question follows from the framing. If the regulatory gap narrows, the arbitrage advantage shrinks. States that reclassify level funded plans as fully insured close the gap within their borders. Federal legislation restricting ERISA preemption for level funded plans would close it nationally. Relaxation of ACA community rating rules would narrow it from the other direction by making fully insured more competitive for healthy groups. The level funded market depends on the persistence of the regulatory gap. Product innovation survives regulatory change because the value is in the product. Regulatory arbitrage does not survive because the value is in the gap.

This framing is not a criticism of level funded. The arbitrage is legal. The products serve real employer needs. The market has produced genuine operational improvements in small group benefits administration: better claims data access, more flexible plan design, and competitive pricing for groups that were overcharged under community rating. The framing matters because it clarifies the market’s structural vulnerability. Level funded exists because of a regulatory condition. If that condition changes, the market must adapt or contract. LFP-03.01 through LFP-03.07 examine the regulatory conditions and the active legislative and judicial challenges to the level funded model in detail.