METHODS OF ALTERNATIVE FUNDING

Totally self-funded (or self-insured) employee benefit plans are the opposite of traditional, fully insured group insurance plans. Under totally self-funded plans, the employer is responsible for paying claims, administering the plan and bearing the risk that actual claims will exceed those expected. However, very few employee benefit plans that use alternative methods of funding have actually turned to total self-funding. Rather, the methods used typically fall somewhere between the two extremes.

The methods of alternative funding can be divided into two general categories: those that primarily modify traditional, fully insured group insurance contracts and those that have some self-funding (either partial or total). The first category includes these methods:

• Premium-delay arrangements

• Reserve-reduction arrangements

• Minimum-premium plans

• Cost-plus arrangements

• Retrospective-rating arrangements

These alternative funding methods are regarded as modifications of traditional, fully insured plans because the insurance company has the ultimate responsibility for paying all benefits promised under the contract. Most insurance companies allow only medium-sized and large employers to use these modifications, and although practices differ among insurance companies, generally a group insurance plan must generate between $150,000 and $250,000 in claims or have a minimum number of covered persons, such as 50 or 100, before these funding methods become available to the employer.

The second category of alternative funding methods consists of the following:

• Total self-funding from current revenue and self-administration

• Self-funding with stop-loss coverage and/or ASO arrangements

• Funding through a 501(c)(9) trust

In contrast to the first category of alternative funding methods, some of these alternatives can be used by small employers.

Premium-Delay Arrangements

Premium-delay arrangements allow the employer to defer payment of monthly premiums for some time beyond the usual 30-day grace period. In fact, these arrangements lengthen the grace period, most commonly by 60 or 90 days. The practical effect of premium-delay arrangements is that they enable 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 three months' worth (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 this credit is offset by either an interest charge on the delayed premiums or an increase in the insurance company's retention.

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 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

A reserve-reduction arrangement is similar to a premium-delay 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 is 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 arrangement, the employer purchases from the insurance 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.

Minimum-Premium Plans

Minimum-premium plans were designed primarily to reduce state premium taxes. However, many minimum-premium plans also improve the employer's cash flow.

Under the typical minimum-premium plan (sometimes called limited self-funding), the employer assumes the financial responsibility for paying claims up to a specified level, usually from 80 percent to 95 percent of estimated claims (with 90 percent most common). The specified level may be determined on either a monthly or an annual basis. The funds necessary to pay these claims are deposited into a bank account that belongs to the employer. However, the actual payment of claims is made from this account by the insurance company, which acts as an agent of the employer. When claims exceed the specified level, the balance is paid from the insurance company's own funds. No premium tax is levied by the states on the amounts the employer deposits into such an account, as would have occurred if these deposits had been paid directly to the insurance company. In effect, for premium-tax purposes the insurance company is considered to be only the administrator of these funds and not a provider of insurance. Unfortunately, the Internal Revenue Service considers these funds to belong to the employer, and death benefits represent taxable income to beneficiaries. Consequently, minimum-premium plans are used to insure disability income and medical expense benefits rather than life insurance benefits.

Under a minimum-premium plan, the employer pays a substantially reduced premium, subject to premium taxation, to the insurance company for administering the entire plan and for bearing the cost of claims above the specified level. Because such a plan may be slightly more burdensome for an insurance company to administer than would a traditional group arrangement, the retention charge may also be slightly higher. Under a minimum-premium arrangement, the insurance company is ultimately responsible for seeing that all claims are paid, and it must maintain the same reserves that would have been required if the plan had been funded under a traditional group insurance arrangement. Consequently, the premium includes a charge for the establishment of these reserves, unless some type of reserve-reduction arrangement has also been negotiated.

Some insurance regulatory officials view the minimum-premium plan primarily as a loophole used by employers to avoid paying premium taxes. In several states, there have been attempts to seek court rulings or legislation that would require premium taxes to be paid either on the funds deposited in the bank account or on claims paid from these funds. Most of these attempts have been unsuccessful, but court rulings in California require the employer to pay premium taxes on the funds deposited in the bank account. If similar attempts are successful in the future, the main advantage of minimum-premium plans will be lost.

Cost-Plus Arrangements

Cost-plus arrangements (often referred to by other names such as flexible funding) may be used to fund other types of employee benefits, but they generally are used by large employers to provide life insurance benefits. Under such an arrangement, the employer's monthly premium is based on the claims paid by the insurance company during the preceding month, plus a specified retention charge that is uniform throughout the policy period. To the extent that an employer's claim experience is better than that assumed in a traditional premium arrangement, the employer's cash flow is improved. However, an employer with worse-than-expected experience, either during the early part of the policy period or during the entire policy period, could also have a more unfavorable cash flow than if a traditional insurance arrangement were used. To prevent this from occurring, many insurance companies place a maximum limit on the employer's monthly premium so that the aggregate monthly premiums paid at any time during the policy period do not exceed the aggregate monthly premiums that would have been paid if the cost-plus arrangement had not been used.

Retrospective-Rating Arrangements

Under retrospective-rating arrangements, the insurance company charges 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 percent and 10 percent 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 usually has 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 retrospective-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. In this manner, some of the risk associated with claim fluctuations is passed on to the employer, reducing both the insurance company's risk charge and any reserve for claim fluctuations. The amount of the 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 subject to negotiations between the insurance company and the employer. In general, the lower the percentage that triggers the retrospective-rating arrangement, the higher the percentage above which the insurance company is fully responsible for claims. In addition, the better the cash-flow advantage to an employer, the greater the risk of claim fluctuations.

In all other respects, a retrospective-rating arrangement is identical to the traditional group insurance contract.