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Cost Savings
Savings can result to the extent that either claims or the insurance
company’s retention can be reduced. Retention—the portion of the insurance
company’s premium over and above the incurred claims and dividends—
includes such items as commissions, premium taxes, risk charges, and profit.
Traditionally, alternative funding methods have not focused on reducing
claims because the same benefits are normally provided (and therefore the
same claims are paid) regardless of which funding method is used. However,
this focus has changed as state laws and regulations increasingly mandate the
types and levels of benefits that must be contained in medical expense
contracts. To the extent that these laws and regulations apply only to benefits
that are included in insurance contracts, employers can avoid providing these
mandated benefits by using alternative funding methods that do not involve
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Reprinted from Group Benefits: Basic Concepts and Alternatives, 11th edition (The American Press, 2006) by
Burton T. Beam, Jr.
Copyright © The American College 1
insurance contracts. Federal mandates apply to benefit plans, not just
insurance contracts, and cannot be avoided by self-funding.
Modifications of fully insured contracts are usually designed either to
lower or eliminate premium taxes or to reduce the insurance company’s risk
and consequently the risk charge. Alternative funding methods that involve a
degree of self-funding also may be designed to reduce other aspects of
retention and to reduce claims by excluding mandated benefits.
• premium-delay arrangements
• reserve-reduction arrangements
• minimum-premium plans
• cost-plus arrangements
Premium-Delay Arrangements
premium-delay A premium-delay arrangement allows the employer to defer payment of
arrangement monthly premiums for some time beyond the usual 30-day grace period. In
fact, this arrangement lengthens the grace period, most commonly by 60 or
90 days. The practical effect of a premium-delay arrangement is that it
enables the employer to have continuous use of the portion of the annual
premium that is approximately equal to the claim reserve. For example, a 90-
day premium delay allows the employer to use 3 months (or 25 percent) of
the annual premium for other purposes. This amount roughly corresponds to
what is usually in the claim reserve for medical expense coverage. Generally,
the larger this reserve is on a percentage basis, the longer the premium
payment can be delayed. Because the insurance company still has a statutory
obligation to maintain the claim reserve, it must use other assets besides the
employer’s premiums for this purpose. In most cases, these assets come from
the insurance company’s surplus.
A premium-delay arrangement has a financial advantage to the extent
that an employer can earn a higher return by investing the delayed premiums
than by accruing interest on the claim reserve. In actual practice, interest is
still credited to the reserve, but an interest charge on the delayed premiums
or an increase in the insurance company’s retention offsets the credit.
On termination of an insurance contract with a premium-delay
arrangement, the employer is responsible for paying any deferred premiums.
However, the insurance company is legally responsible for paying all claims
incurred prior to termination, even if the employer fails to pay the deferred
Copyright © The American College 3
premiums. Consequently, most insurance companies are concerned about the
employer’s financial position and credit rating. For many insurance companies,
the final decision of whether to enter into a premium-delay arrangement, or any
other alternative funding arrangement that leaves funds in the hands of the
employer, is made by the insurer’s financial experts after a thorough analysis of
the employer. In some cases, this may mean that the employer will be required
to submit a letter of credit or some other form of security.
Reserve-Reduction Arrangements
reserve-reduction A reserve-reduction arrangement is similar to a premium-delay
arrangement arrangement. Under the usual reserve-reduction arrangement, the employer is
allowed (at any given time) to retain an amount of the annual premium that is
equal to the claim reserve. Generally, such an arrangement is allowed only
after the contract’s first year, when the pattern of claims and the appropriate
amount of the reserve can be more accurately estimated. In succeeding years,
if the contract is renewed, the amount retained will be adjusted according to
changes in the size of the reserve. As with a premium-delay arrangement, the
monies retained by the employer must be paid to the insurance company on
termination of the contract. Again, the advantage of this approach lies in the
employer’s ability to earn more on these funds than it would earn under the
traditional insurance arrangement.
A few insurance companies offer another type of reserve-reduction
arrangement for long-term disability income coverage. Under a so-called
limited-liability limited-liability arrangement, the employer purchases from the insurance
arrangement company a one-year contract in which the insurer agrees to pay claims only
for that year, even though the employer’s “plan” provides benefits to
employees for longer periods. Consequently, enough reserves are maintained
by the insurance company to pay benefits only for the duration of the one-
year contract. At renewal, the insurance company agrees to continue paying
the existing claims as well as any new claims. In effect, the employer pays the
insurance company each year for existing claims as the benefits are paid to
employees, rather than when disabilities occur. A problem for employees under
this type of arrangement is the lack of security for future benefits. For example,
if the employer goes bankrupt and the insurance contract is not renewed, the
insurance company has no responsibility to continue benefit payments. For this
reason, several states do not allow this type of arrangement.
The limited-liability arrangement contrasts with the usual group contract
in which the insurance company is responsible for paying disability income
claims to an employee for the length of the benefit period (as long as the
employee remains disabled). On average, each disability claim results in the
establishment of a reserve equal to approximately five times the employee’s
annual benefit.
Retrospective-Rating Arrangements
retrospective-rating Under a retrospective-rating arrangement, the insurance company charges
arrangement the employer an initial premium that is less than what would be justified by the
expected claims for the year. In general, this reduction is between 5 and 10 per-
cent of the premium for a traditional group insurance arrangement. However, if
claims plus the insurance company’s retention exceed the initial premium, the
employer is called upon to pay an additional amount at the end of the policy
year. Because an employer will usually have to pay this additional premium,
one advantage of a retrospective-rating arrangement is the employer’s ability to
use these funds during the year.
This potential additional premium is subject to a maximum amount based
on some percentage of expected claims. For example, assume that a retro-
spective-rating arrangement bases the initial premium on the fact that claims
will be 93 percent of those actually expected for the year. If claims in fact are
below this level, the employer receives an experience refund. If they exceed 93
percent, the retrospective-rating arrangement is “triggered,” and the employer
has to reimburse the insurance company for any additional claims paid, up to
some percentage of those expected, such as 112 percent. The insurance
company bears claims in excess of 112 percent, so some of the risk associated
with claims fluctuations is passed on to the employer. This reduces both the
insurance company’s risk charge and any reserve for claims fluctuations. The
amount of these reductions depends on the actual percentage specified in the
contract, above which the insurance company is responsible for claims. This
percentage and the one that triggers the retrospective-rating arrangement are
Copyright © The American College 6
subject to negotiations between the insurance company and the employer. In
general, the lower the percentage that triggers the retrospective arrangement,
the higher the percentage above which the insurance company is fully
responsible for claims. In addition, the better the cash-flow advantage of the
employer, the greater the risk of claims fluctuations.
In all other respects, a retrospective-rating arrangement is identical to the
traditional group insurance contract.
Stop-Loss Coverage
aggregate stop-loss Aggregate stop-loss coverage is one form of protection for employers
coverage against an unexpectedly high level of claims. If total claims exceed a
specified dollar limit, the insurance company assumes the financial
responsibility for those claims that are over the limit, subject to the maximum
reimbursement specified in the contract. The limit is usually applied on an
annual basis and is expressed as some percentage of expected claims
(typically between 115 percent and 135 percent). The employer is
responsible for the paying of all claims to employees, including any
payments that are received from the insurance company under the stop-loss
coverage. In fact, because the insurance company has no responsibility to the
employees, no reserve for claims must be established.
Aggregate stop-loss coverage results in (1) an improved cash flow for the
employer and (2) a minimization of premium taxes because they must be
paid only on the stop-loss coverage. However, these advantages are partially
ASO Contracts
ASO contract Under an ASO contract, the employer purchases specific administrative
services from an insurance company or from an independent third-party
administrator. These services usually include the administration of claims,
but they may also include a broad array of other services, such as COBRA
administration, prescription drug cards, employee communications, and
government reporting. In effect, the employer has the option to purchase
services for those administrative functions that can be handled more cost
effectively by another party. It should also be noted that an employer may
purchase different administrative services from more than one source. In
addition, third-party administrators often subcontract some of the services
they provide employers to other administrators that provide specialized
services, such as case management and hospital audits.
Under ASO contracts, the administration of claims is performed in much
the same way as it is under a minimum-premium plan; that is, the
administrator has the authority to pay claims from a bank account that
belongs to the employer or from segregated funds in the administrator’s
hands. However, the administrator is not responsible for paying claims from
its own assets if the employer’s account is insufficient.
In addition to listing the services that are provided, an ASO contract also
stipulates the administrator’s authority and responsibility, the length of the
contract, the provisions for terminating and amending the contract, and the
manner in which disputes between the employer and the administrator are
settled. The charges for the services provided under the contract may be
stated in one or some combination of the following ways:
• a percentage of the amount of claims paid
• a flat amount per processed claim
• a flat charge per employee
• a flat charge for the employer
Payments for ASO contracts are regarded as fees for services performed,
and they are therefore not subject to state premium taxes. However, one
similarity to a traditional insurance arrangement may be present: The
Advantages
The use of a 501(c)(9) trust offers the employer some advantages over a
benefit plan that is self-funded from current revenue. Contributions can be
made to the trust and can be deducted for federal income tax purposes at that
time, just as if the trust were an insurance company. Appreciation in the
value of the trust assets or investment income earned on the trust assets is
also free of taxation. The trust is best suited for an employer who wishes to
establish either a fund for claims that have been incurred but not paid or a
fund for possible claims fluctuations. If the employer does not use a
501(c)(9) trust in establishing these funds, contributions cannot be deducted
by the employer for federal income tax purposes until they are paid in the
form of benefits to employees. In addition, earnings on the funds are subject
to taxation.
The Internal Revenue Code requires that certain fiduciary standards be
maintained regarding the investment of the trust assets. The employer,
however, does have some latitude and does have the potential for earning a
return on the trust assets that is higher than what is earned on the reserves
held by insurance companies. A 501(c)(9) trust also lends itself to use by a
contributory self-funded plan because ERISA requires that, under a self-
funded benefit plan, a trust must be established to hold employees’
contributions until they are used to pay benefits.
There is also flexibility regarding contributions to the trust. Although the
Internal Revenue Service does not permit a tax deduction for “overfunding” a
trust, there is no requirement that the trust must maintain enough assets to
Disadvantages
A 501(c)(9) also has its drawbacks. The cost of establishing and
maintaining the trust may be prohibitive, especially for small employers. In
addition, the employer must be concerned about the administrative aspects of
the plan and the fact that claims might deplete the trust’s assets. However, as
long as the trust is properly funded, ASO contracts and stop-loss coverage
can be purchased.
Limitation on Contributions
The contributions to a 501(c)(9) trust (except collectively bargained
plans for which Treasury regulations prescribe separate rules) are limited to
the sum of (1) the qualified direct cost of the benefits provided for the
taxable year and (2) any permissible additions to a reserve (called a qualified
asset account). The qualified direct cost of benefits is the amount that would
have been deductible for the year if the employer had paid benefits from
current revenue.
The permissible additions may be made only for disability, medical,
supplemental unemployment, severance pay, and life insurance benefits. In
general, the amount of the permissible additions includes (1) any sums that
are reasonably and actuarially necessary to pay claims that have been
incurred but remain unpaid at the close of the tax year and (2) any
administration costs with respect to these claims. If medical or life insurance
benefits are provided to retirees, deductions are also allowed for funding
these benefits on a level basis over the working lives of the covered
employees. However, for retirees’ medical benefits, current medical costs
must be used rather than costs based on projected inflation. In addition, a
separate account must be established for postretirement benefits provided to
key employees. Contributions to these accounts are treated as annual
additions for purposes of applying the limitations that exist for contributions
and benefits under qualified retirement plans.
The amount of certain benefits for which deductions are allowed is
limited. Life insurance benefits for retired employees cannot exceed amounts
that are tax free under Sec. 79. Annual disability benefits cannot exceed the
lesser of (1) 75 percent of a disabled person’s average compensation for the
Copyright © The American College 15
highest 3 years or (2) $175,000. Supplemental unemployment compensation
benefits and severance benefits cannot exceed 75 percent of average benefits
paid plus administrative costs during any 2 of the immediately preceding 7
years. In determining this limit, annual benefits in excess of $66,000 cannot
be taken into account. (The $175,000 and $66,000 amounts are for 2006 and
subject to periodic indexing.)
In general, it is required that the amount of any permissible additions be
actuarially certified, although deductible contributions can be made to reserves
without such certification as long as certain specified limits on the size of the
reserve are not exceeded. The specified limits for supplemental unemployment
compensation benefits and severance benefits are the same as the amounts
previously mentioned. For short-term disability benefits, the limit is equal to
17.5 percent of benefit costs (other than insurance premiums for the current
year), plus administrative costs for the previous year. For medical benefits, the
limit is 35 percent. The Internal Revenue Code provides that the limits for life
insurance benefits and long-term disability income benefits will be those
prescribed by regulations. However, no regulations have been issued.
Employer deductions cannot exceed the limits as previously described.
However, any excess contributions may be deducted in future years to the
extent that contributions for those years are below the permissible limits.
There are several potential adverse tax consequences if a 501(c)(9) trust
does not meet prescribed standards. If reserves are above permitted levels,
additional contributions to the reserves are not deductible and earnings on the
excess reserves are subject to tax as unrelated business income. (This effec-
tively negates any possible advantage of using a 501(c)(9) trust to prefund
postretirement medical benefits.) In addition, an excise tax is imposed on
employers maintaining a trust that provides disqualified benefits. The tax is
equal to 100 percent of the disqualified benefits, which include (1) medical and
life insurance benefits provided to key employees outside the separate accounts
that must be established, (2) discriminatory medical or life insurance benefits
for retirees, and (3) any portion of the trust’s assets that revert to the employer.