COST CONTAINMENT AND MANAGED CARE

Between 1970 and the early 1990s, the average annual increases in the cost of medical care were approximately twice the average annual increases in the consumer price index. No single factor accounts for these increases. Rather, it was a combination of the following reasons:

Technological advances. In the last few years, many exciting technological advances have taken place. Numerous lives are now being saved by such techniques as CAT scans, MRIs, fetal monitoring, and organ transplants. As miraculous as many of these techniques are, they are also very expensive. Technological advances can also prolong the life of the terminally ill and increase associated medical expenses.

Increasing malpractice suits. The providers of care are much more likely to be sued than in the past, and malpractice awards have outpaced the general rate of inflation. This development has resulted in higher malpractice insurance premiums, a cost that is ultimately passed on to consumers. The increase in malpractice suits has also led to an increase in defensive medicine, with routine tests likely to be performed more often.

Increases in third-party payments. A growing portion of the country's health care expenditures is now paid by private health insurers or the government. Patients and providers of health care often have no financial incentives to economize on the use of health care service.

Underutilization of medical facilities. Currently, the United States has an overabundance of hospital beds, and a surplus of physicians is also beginning to develop. Empty hospital beds are expensive to maintain, and an oversupply of physicians tends to drive up the average costs of medical procedures so that physicians' average income does not drop.

Design of medical expense plans. Many medical expense plans now provide first-dollar coverage for many health care costs. There is often little incentive for patients to avoid the most expensive forms of treatment.

AIDS. The continuing increase in the number of AIDS cases over the past 10 years has resulted in increasing costs to employers. Costs in excess of $100,000 for an employee with AIDS are not unusual.

An aging population. The incidence of illness increases with age. Current demographics indicate that this trend will be a source of cost increases for several years to come.

During the period from 1994 to 1996, several factors caused the cost of medical expense coverage to remain uncharacteristically stable, particularly for managed care plans. Many providers of medical services and medical expense plans were reluctant to raise costs while the Clinton health care proposal was being debated. In addition, managed care plans were holding down premiums while actively increasing enrollments.

However, the late 1990s started to see significant increases in health care costs, particularly because of skyrocketing costs for prescription drugs. There is a feeling among benefit consultants that expanding managed care plans have saturated the market to the point that savings resulting from additional employees moving to managed care plans will be modest. There is also an interesting trend occurring among medical providers. The large number of mergers of hospitals and other providers of medical services in many parts of the country may in fact shift the balance of bargaining power to these providers from managed care plans and other buyers of medical services. In addition, costs will increase somewhat because of federal and state legislation that continues to mandate benefits.

Increasing health care costs have become the concern of almost everyone—government, labor, employers, and consumers. In this introduction to cost containment, many of the measures employers use are enumerated.

Development of Medical Expense Coverage

To understand the wide array of medical expense plans available today, it is appropriate to understand their historic development.

Until the 1930s, medical expenses were borne primarily by ill or injured persons or their families. It was not unusual, however, for hospitals and physicians to provide care on a charity basis if the patient lacked the resources to pay. What have been described as the earliest "health insurance" plans were in reality disability income coverage. However, at that time medical costs were relatively low, and the continuation of income was often the difference between a person's ability to pay medical bills and the need to rely on charity.

Birth of the Blues
The Great Depression saw the development of the first organizations that would later be called Blue Cross. These organizations, which were initially controlled by hospitals, were designed to provide first-dollar coverage for hospital expenses, but with a limited duration of benefits. In the late 1930s, physicians followed the hospitals' approach and established Blue Shield plans. Through the 1940s, the Blues were the predominant providers of medical expense coverage.

Early HMOs
Although it is often thought that health maintenance organizations were a product of the 1970s, some HMOs were among the earliest providers of medical expense coverage. What is usually considered to be the first HMO, the Ross-Loos Clinic, was founded in Los Angeles in 1929. Other HMOs, such as the Kaiser Plans, had their beginnings in the 1930s. However, HMOs remained only a small player in the marketplace for medical expense coverage until the past two decades.

Early Efforts of Insurance Companies
Insurance companies, seeing the success of Blue Cross, entered the market for hospital insurance in the 1930s and later added coverage for surgical expenses and physicians' expenses. However, insurance companies were only modestly successful in competing with the Blues until a new product was introduced in 1949—major medical insurance. As a result, by the mid-1950s insurance companies surpassed the Blues in premium volume and number of persons covered.

The 1960s—Era of Government Involvement
The number of persons covered by medical expense insurance plans grew rapidly during the 1950s and 1960s. Much of this growth was in employer-sponsored plans as a result of a 1949 Supreme Court ruling that employee benefits were subject to collective bargaining.

While the types of products available underwent little change during this period, there were two major developments in the mid-1960s. For the first time, the federal government became a major player in providing medical expense coverage by creating national health insurance programs for the elderly and the poor. Medicare provides benefits for persons aged 65 and older. The financing of the benefits under this program comes from three sources: government revenue, premiums of Medicare beneficiaries, and the FICA taxes paid by most working persons and their employers.

The second program—Medicaid—provides medical benefits for certain classes of low-income individuals and families. There is little doubt that both Medicare and Medicaid provide benefits to major segments of the population with large numbers of persons who would otherwise be unable to receive adequate medical care. However, the effect of so many additional persons with coverage beginning at the same time created shortages of medical facilities and professionals. This increased demand for medical care is one reason for the high rate of inflation for health care costs that soon developed.

The 1970s—First Reactions to Spiraling Costs
In 1950, expenditures for health care equaled 4.4 percent of GNP; they increased to 5.4 percent in 1960 and 7.3 percent in 1970. When these spiraling costs received the attention of employers and the federal government, large employers started turning to the self-funding of medical expense benefits. In addition to improved cash flow, savings were achieved by the avoidance of state-mandated benefits and state premium taxes. The passage of ERISA in 1974 thwarted initial state attempts to bring self-funded plans under their insurance regulations. This federal legislation freed self-funded plans from state regulation and hastened the growth of this financing technique.

The 1970s also saw the first large-scale debate over national insurance. As in the mid-1990s, the majority of the members of Congress supported one of the many plans that were introduced, but opinions were diverse and little common ground was found. However, one significant piece of legislation was passed—the Health Maintenance Organization Act of 1973. This legislation sought to encourage the growth of HMOs by providing funding for their development costs and mandating that certain employers make these plans available to employees. There is little doubt that the growth of HMOs is a result of this legislation.

The 1980s and 1990s—Continued Change
Attempts to rein in the cost of medical care in the 1970s seemed to have little effect. By 1980, expenditures for health care reached 9.2 percent of GNP. This figure was 12.2 percent by 1990, and nearly 14 percent by the end of the decade. In addition, about 14 percent of the population, including many employed persons and their families, remained uninsured.

Reactions to these statistics came from many sources. Many state governments adopted programs to make coverage more available and affordable to the uninsured. At the federal level, there were suggestions that the entire health care system needed an overhaul. While the initial national health insurance proposal by the Clinton administration was dead, there was still continued support by members of Congress for changes in the nation's approach to providing and financing health care. Significant federal legislation was enacted in 1996, but little new and significant legislation was enacted after that.

The many efforts by employers to contain costs included the following:

- Growth in the self-funding of benefits. Much of this growth came from small- and medium-sized employers.

- Cost-shifting to employees. It became increasingly common for employers to raise deductibles and require that employees pay a larger portion of their medical expense coverage.

- Increased use of managed care plans that are alternatives to HMOs, such as PPOs and point-of-service plans. These approaches often overcame the reluctance of some employees to participate in managed care plans.

- Requiring or encouraging managed care plans. Some employers dropped traditional medical expense plans and offered managed care alternatives only. A more prevalent approach was to offer employees a financial incentive to join managed care plans.

Many of these reactions are reflected in changing statistics about the extent of varying types of medical expense coverage; unfortunately, precise statistics are difficult to obtain. For example, many Blue Cross and Blue Shield associations and HMOs report only the total number of persons covered and make no distinction between individual coverage and group coverage. Many persons receive portions of their coverage from different types of providers, such as hospital coverage from a Blue Cross plan and other medical expense coverages from an insurance company under a supplemental major medical contract. In addition, self-funded plans may operate as HMOs, purchase stop-loss coverage, and/or utilize PPOs.

Even though precise statistics cannot be obtained, there is no doubt that a significant change took place in the 1990s. In 1980, approximately 90 percent of all insured workers were covered under "traditional" medical expense plans, and 5 percent were covered under HMOs. Under a traditional plan, if a worker or family member was sick, he or she had complete freedom in choosing a doctor or a hospital. Medical bills were paid by the plan, and no attempts were made to control costs or the utilization of services. It is estimated that between 10 and 15 percent of the employees under these traditional plans were in plans that were totally self-funded by the employer; the remainder of the employees were split fairly evenly between plans written by insurance companies and the Blues.

By the end of the 1990s, the figures had changed dramatically, with the majority of employees covered under plans that controlled costs and the access to medical care. Close to 85 percent of employees were enrolled in managed care plans—HMOs, PPOs, or point-of-service plans, often owned by insurance companies or the Blues. Of the remaining employees, few were in traditional plans. Many were still with insurance companies and the Blues, but under traditional plans that had been redesigned to incorporate varying degrees of managed care.

One important change is hidden in these statistics—the increasing trend toward self-funding of medical expenses by employers. It is estimated that over 50 percent of all workers are covered under plans that are totally or substantially self-funded. Self-funding is more prevalent as the number of employees increases, with between 80 and 90 percent of persons who work for employers with more than 20,000 employees being covered under self-funded plans. However, employers with as few as 25 to 50 employees also use self-funding. It should be noted that the way benefits are provided under a self-funded plan can vary—the employer may design the plan to provide benefits on an indemnity basis or as an HMO or PPO.

Despite the difficulty in obtaining precise statistics, the data collected by the Health Insurance Association of America[1] show that enrollment in medical expense plans that can be characterized as traditional indemnity plans dropped from more than 70 percent to 14 percent since 1990. During the same time period, the number of enrollees in plans that use PPOs increased significantly to 34 percent. Point-of-service plans and HMOs grew more slowly and now account for about 30 percent and 22 percent, respectively, of the number of enrollees.

Into the New Millennium
Just as in past decades, the health care system will continue to evolve in the first decade of the new millennium. What the changes will be is only speculation, but a few observations can be made about the current environment:

- Renewal rates in 2000 for employer-provided medical expense plans are increasing at the highest percentage since the early 1990s, and these high percentage increases are predicted to continue in the foreseeable future.

- Surveys indicate that the vast majority of Americans are satisfied with their own health care plans. The relatively low degree of dissatisfaction, however, is higher for plans with the greatest degree of managed care.

- Despite satisfaction with their own coverage, surveys also indicate that Americans are becoming less satisfied with and less confident about the health care system.

- There is a growing backlash against managed care, particularly HMOs. Two observations can be made about this trend. First, many persons appear to have based their opinions on media reports and stories from friends, not on their own experiences. In this regard, opinions about managed care and Congress tend to be somewhat similar, with a high percentage of negative attitudes, although most persons give high ratings to their own managed care plans and their own Congresspersons. Second, this backlash has gotten the attention of Congress and the states. Some legislation has resulted at the state level. However, managed care plans are also becoming increasingly flexible and consumer-friendly, possibly to prevent further legislation aimed at managed care reform.

- There was little federal health care legislation during Clinton's second term, at least partially due to a Congressional majority of a different political party from the President. While there seems to be bipartisan agreement that there are some problems with the current system, there is bipartisan disagreement about what should be done.

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Federal Taxation

As with group life insurance, employer contributions for an employee's disability income insurance are fully deductible to the employer as an ordinary and necessary business expense under Code Section 162 if the employee's overall compensation is reasonable. Sick-leave payments are similarly tax deductible. Contributions by an individual employee are considered payments for personal disability income insurance and are not tax deductible.

Income Tax Liability of Employees
In contrast to group life insurance, for which employer contributions may result in some taxable income to an employee, Code Section 106 provides that employer contributions for disability income insurance result in no taxable income to an employee. However, the payment of benefits under an insured plan or sick-leave plan may or may not result in the receipt of taxable income. To make this determination, it is necessary to look at whether the plan is fully contributory, noncontributory, or partially contributory.

Fully Contributory Plan
Under a fully contributory plan, the entire cost is paid by employee contributions and benefits are received free of income taxation.

Noncontributory Plan
Under a noncontributory plan, the entire cost is paid by the employer and benefits are included in an employee's gross income. However, the Internal Revenue Code provides a tax credit to persons who are permanently and totally disabled. A tax credit is subtracted from an individual's federal income tax liability, not deducted from gross income. For purposes of this tax credit, the IRS uses the Social Security definition of disability; that is, an employee must be unable to engage in any kind of gainful work because of a medically determinable physical condition that has lasted or is expected to last at least 12 months or is expected to result in death.

The maximum credit is $750 for a single person, $1,125 for a married person filing jointly, and $562.50 for a married person filing separately. The credit cannot exceed the taxable disability benefit actually received. The maximum credit is reduced if a single individual has an adjusted gross income (including the disability benefit) over $7,500, if a married person filing jointly has an adjusted gross income over $10,000, or if a married person filing separately has an adjusted gross income over $5,000. The reduction is equal to 7½ percent of any income over the limit. In addition, the credit is reduced by 15 percent of any tax-free income received as a pension, annuity, or disability benefit from certain government programs, including benefits from Social Security. Because disability income plans are usually integrated with Social Security, the tax credit available to most persons who receive disability benefits from employer plans is substantially reduced or eliminated altogether.

Partially Contributory Plan
Under a partially contributory plan, benefits attributable to employee contributions are received free of income taxation. Benefits attributable to employer contributions are includable in gross income, but employees are eligible for the tax credit described previously.

The portion of the benefits attributable to employer contributions (and thus subject to income taxation) is based on the ratio of the employer's contributions to the total employer-employee contributions for an employee who has been under the plan for some period of time. For example, if the employer paid 75 percent of the cost of the plan, 75 percent of the benefits would be considered attributable to employer contributions and 25 percent to employee contributions. The time period used to calculate this percentage varies, depending on the type of disability income plan and the length of time that the plan has been in existence. Under group insurance policies, the time period used is the three policy years ending prior to the beginning of the calendar year in which the employee is disabled. If coverage has been in effect for a shorter time, IRS regulations specify the appropriate time period to use. Similar provisions pertain to contributory sick-leave plans, the major exception being that the time period is based on calendar years rather than policy years. If benefits are provided under individual disability income insurance policies, the proportion is determined on the basis of the premiums paid for the current policy year.

Tax Withholding and Social Security Taxes
Benefits paid directly to an employee by an employer under a sick-leave plan are treated like any other wages for purposes of tax withholding. Disability income benefits paid by a third party (such as an insurance company or a trust) are subject to the withholding tax rules and regulations only if the employee requests that taxes be withheld. In both cases, benefits that are attributable to employer contributions are subject to Social Security and Medicare taxes. However, taxes are payable only during the last calendar month in which the employee worked and the six months that follow.

INSURED DISABILITY INCOME PLANS : Exclusions

Exclusions
Under certain circumstances, disability income benefits are not paid even if an employee satisfies the definition of disability. Common exclusions under both short-term and long-term disability income contracts specify that no benefits will be paid under the following circumstances:

- For any period during which the employee is not under the care of a physician.

- For any disability caused by an intentionally self-inflicted injury.

- Unless the period of disability commenced while the employee was covered under the contract. (For example, an employee who previously elected not to participate under a contributory plan cannot obtain coverage for an existing disability by deciding to pay the required premium.)

- If the employee is engaged in any occupation for remuneration. This exclusion applies in those situations when an employee is totally disabled with respect to his or her regular job but is engaged in other employment that can be performed despite the employee's condition.

Until the Pregnancy Discrimination Act, it was common for disabilities resulting from pregnancy to be excluded. Such an exclusion is now illegal under federal law if an employer has 15 or more employees. Employers with fewer than 15 employees may still exclude pregnancy disabilities unless they are subject to state laws to the contrary.

Additional exclusions are often found in long-term contracts. These commonly deny benefits for disabilities resulting from the following:

- War, whether declared or undeclared.

- Participation in an assault or felony. Note that some insurers have recently expanded this exclusion to include the commission of any crime.

- Mental disease, alcoholism, or drug addiction. However, some contracts provide benefits if an employee is confined in a hospital or institution specializing in the care and treatment of such disorders; other contracts provide benefits but limit their duration (such as for 24 months per disability).

- Preexisting conditions.

The exclusion for preexisting conditions is designed to counter the adverse selection and potentially large claims that could occur if an employer established a group disability income plan or if an employee elected to participate in the plan because of some known condition that is likely to result in disability. While variations exist, a common provision for preexisting conditions excludes coverage for any disability that commences during the first 12 months an employee is covered under the contract if the employee received treatment or medical advice for the disabling condition both (1) prior to the date the employee became eligible for coverage and (2) within 90 consecutive days prior to the commencement of the disability.

When coverage is transferred from one insurance company to another, it is not unusual, particularly in the case of large employers, for the new insurance company to waive the limitation for preexisting conditions for those employees who were insured under the previous contract. This is often referred to as prior coverage credit or a no-loss, no-gain provision. In some instances, the provision is modified so that benefits are limited to those that would have been provided under the previous contract, possibly for a specified duration, such as one year. Note that a transfer of coverage has no effect on the responsibility of the prior insurance company to continue paying benefits for claims that have already occurred, except in rare cases where some arrangement is made for the new contract to provide benefits.

INSURED DISABILITY INCOME PLANS : definition

INSURED DISABILITY INCOME PLANS
As mentioned, insured disability income plans consist of two distinct products: short-term coverage and long-term coverage. In many respects, the contractual provisions of both short-term and long-term disability income contracts are the same or very similar. In other respects—notably, the eligibility requirements, the definition of disability, and the amount and duration of benefits—there are significant differences.

Eligibility
The eligibility requirements in group disability income insurance contracts are similar to those found in group term insurance contracts. In addition to being in a covered classification, an employee must usually work full-time and be actively at work before coverage commences. Any requirements concerning probationary periods, insurability and premium contributions must also be satisfied.

Short-term and long-term disability income insurance plans frequently differ in both the classes of employees who are eligible for coverage and the length of the probationary period. Employers are more likely to provide short-term benefits to a wider range of employees, and it is not unusual for short-term plans to cover all full-time employees. However, these plans may be a result of collective bargaining and apply only to union employees. In this situation, other employees frequently have short-term disability benefits under uninsured sick-leave plans.

Long-term disability plans often limit benefits to salaried employees. Claims experience has traditionally been less favorable for hourly paid employees for a number of reasons. Claims of hourly paid employees tend to be more frequent, particularly in recessionary times when the possibility of temporary layoffs or terminations increases. Such claims also tend to be of longer duration, possibly because of the likelihood that these employees hold repetitive and nonchallenging jobs. Some long-term plans also exclude employees below a certain salary level because this category of employees, like hourly paid employees, is considered to have a reasonable level of benefits under Social Security.

Long-term disability income plans tend to have longer probationary periods than do short-term disability income plans. While the majority of short-term disability plans (as well as group term insurance plans and medical expense plans) either have no probationary period or have a probationary period of three months or less, it is common for long-term disability plans to have probationary periods ranging from three months to one year. While short-term plans only require that an employee be actively at work on the date he or she is otherwise eligible for coverage, long-term plans sometimes require that the employee be on the job for an extended period (such as 30 days) without illness or injury before coverage becomes effective.

Definition of Disability
Benefits are paid under disability income insurance contracts only if the employee meets the definition of disability as specified in the contract. Virtually all short-term disability income insurance contracts define disability as the total and continuous inability of the employee to perform each and every duty of his or her regular occupation. A small minority of contracts use a more restrictive definition, requiring that an employee be unable to engage in any occupation for compensation. Partial disabilities are usually not covered, but a few newer plans do provide benefits. In addition, the majority of short-term contracts limit coverage to nonoccupational disabilities, because employees have workers' compensation benefits for occupational disabilities. This limitation tends to be most common when benefits under the short-term contract are comparable to or lesser in amount than those under the workers' compensation law. In those cases where workers' compensation benefits are relatively low and the employer desires to provide additional benefits, coverage may be written for both occupational and nonoccupational disabilities.

A few long-term disability income contracts use the same liberal definition of disability that is commonly used in short-term contracts. However, the term material duties often replaces the term each and every duty. Some other contracts define disability as the total and continuous inability of the employee to engage in any and every gainful occupation for which he or she is qualified or shall reasonably become qualified by reason of training, education, or experience. However, most of long-term disability contracts use a dual definition that combines these two. Under a dual definition, benefits are paid for some period of time (usually 24 or 36 months) as long as an employee is unable to perform his or her regular occupation. After that time, benefits are paid only if the employee is unable to engage in any occupation for which he or she is qualified by reason of training, education, or experience. The purpose of this combined definition is to require and encourage a disabled employee who becomes able after a period of time to adjust his or her lifestyle and earn a livelihood in another occupation.

A more recent definition of disability found in some long-term contracts contains an occupation test and an earnings test. Under the occupation test, a person is totally disabled if he or she meets the definition of disability as described in the previous paragraph. However, if the occupation test is not satisfied, a person is still considered disabled as long as an earnings test is satisfied. This means that the person's income has dropped by a stated percentage, such as 50 percent, because of injury or sickness. This newer definition makes a group insurance contract similar to an individual disability income policy that provides residual benefits.

The definition of disability in long-term contracts may differ from that found in short-term contracts in several other respects. Long-term contracts are somewhat more likely to provide benefits for partial disabilities. However, the amount and duration of such benefits may be limited when compared with those for total disabilities, and the receipt of benefits is usually contingent upon a prior period of disability. In addition, most long-term contracts provide coverage for both occupational and nonoccupational disabilities. Finally, short-term contracts usually have the same definition of disability for all classes of employees. Some long-term contracts use different definitions for different classes of employees—one for most employees and a more liberal definition for executives or salaried employees.

SICK-LEAVE PLANS : Eligibility, Benefits

SICK-LEAVE PLANS
Employers use two approaches to provide short-term disability benefits to employees: sick-leave plans and short-term disability income insurance plans. Sick-leave plans, often called salary continuation plans, are uninsured and generally fully replace lost income for a limited period of time, starting on the first day of disability. In contrast, short-term disability income insurance plans usually provide benefits that replace only a portion of an employee's lost income and often contain a waiting period before benefits start, particularly for sickness. While it is impossible to obtain precise statistics, surveys indicate that about half the employees with short-term coverage obtain benefits under sick-leave plans, about one-quarter under insured plans, and about one-quarter under plans that combine the two approaches.

Traditionally, many sick-leave plans were informal, with the availability, amount, and duration of benefits for an employee being at the employer's discretion. Although some plans used by small firms or for a limited number of executives still operate this way, informal plans are generally inappropriate. There is a possibility that the Internal Revenue Service (IRS) will consider benefit payments to be either a gift or a dividend and therefore not tax deductible by the employer. In addition, an informal plan increases the likelihood of suits brought by persons who do not receive benefits. As a result, the vast majority of sick-leave plans are now formalized and have specific written rules concerning eligibility and benefits.

Eligibility
Almost all sick-leave plans are limited to permanent full-time employees, but benefits may also be provided for permanent part-time employees. Most plans require that an employee satisfy a short probationary period (commonly one to three months) before being eligible for benefits. Sick-leave plans may also be limited to certain classes of employees, such as top management or nonunion employees. The latter is common when the union employees are covered under a collectively bargained, but insured, plan.

Benefits
Most sick-leave plans are designed to provide benefits equal to 100 percent of an employee's regular pay. Some plans, however, provide a reduced level of benefits after an initial period of full pay.

Several approaches are used in determining the duration of benefits. The most traditional approach credits eligible employees with a certain amount of sick leave each year, such as ten days. The majority of plans using this approach allow employees to accumulate unused sick leave up to some maximum amount, which rarely exceeds six months (sometimes specified as 180 days or 26 weeks). A variation of this approach is to credit employees with an amount of sick leave, such as one day, for each month of service. Table 1 is an example of a benefit schedule that uses this variation.


Table 1: Benefit Schedule Based on Months of Service

Another approach, illustrated in Table 2, bases the duration of benefits on an employee's length of service.


Table 2: Benefit Schedule Based on Length of Service

An alternative to this approach provides benefits for a uniform length of time to all employees, except possibly those with short periods of service. However, benefits are reduced to a level less than full pay after some period of time that is related to an employee's length of service. Table 8-3 is an illustration of this increasingly common approach.


Table 3: Benefit Schedule With Varied Coverage Based on Months of Service

In some instances, an employee is not eligible for sick-leave benefits if he or she is eligible for benefits under social insurance plans, such as workers' compensation. However, most sick-leave plans are coordinated with social insurance programs. For example, if an employee is entitled to 100 percent of pay and receives 60 percent of pay as a workers' compensation benefit, the salary sick-leave will pay the remaining 40 percent.

A problem for the employer is how to verify an employee's disability. In general, the employee's word is accepted for disabilities that last a week or less. Most sick-leave plans have a provision that benefits for longer periods will be paid only if the employee is under the care of a physician, who certifies that the employee is unable to work.

Group Disability Income Coverage

The purpose of disability income coverage is to partially (and sometimes totally) replace the income of employees who are unable to work because of sickness or accident. While employers expect employees to miss a few days of work from time to time, there is often a tendency to underestimate both the frequency and severity of disabilities that last for longer periods. At all working ages, the probability of being disabled for at least 90 consecutive days is much greater than the chance of dying. One out of every three employees will have a disability that lasts at least 90 days during his or her working years, and one out of every ten employees can expect to be permanently disabled prior to age 65.

In terms of its financial impact on the family, long-term disability is more severe than death. In both cases, income ceases. In the case of long-term disability, however, family expenses—instead of decreasing because of one less family member—may actually increase because of the cost of providing care for the disabled person.

Employers are less likely to provide employees with disability income benefits than with either life insurance or medical expense benefits. It is difficult to estimate the exact extent of disability coverage because often benefits are not insured and workers are sometimes covered under overlapping plans. However, a reasonable estimate would be that at least 75 percent of all employees have some form of short-term employer-provided protection, but only about 40 percent have protection for long-term disabilities. This does not mean that almost all employees have some sort of disability income coverage, because many employees have both short-term and long-term protection and thus are included in both estimates. These estimates are also somewhat misleading because most employees have long-term disability income coverage under Social Security as well as coverage for certain types of disabilities under other government programs.

Group disability income protection consists of two distinct products:

Short-term disability income plans, which provide benefits for a limited period of time, usually six months or less. Benefits may be provided under uninsured plans or under insured plans, often referred to as accident and sickness insurance or weekly indemnity benefits.

Long-term disability income plans, which provide extended benefits (possibly for life) after an employee has been disabled for a period of time, frequently six months.

Two important tasks in designing and underwriting insured group disability income plans are to coordinate these products with each other (if both a short-term and a long-term plan are provided for employees) and to coordinate them with other benefits to which employees might be entitled under social insurance programs or uninsured sick-leave plans. A lack of coordination can lead to such a generous level of benefits for employees that absences from work because of disability might be either falsified or unnecessarily prolonged.

GROUP TERM CARVE-OUTS : Bonus Plans, Determining the Best Plan

GROUP TERM CARVE-OUTS
Prior to 1984, employees had no taxable income if they were provided with postretirement coverage under a group term life insurance plan. After that time, coverage in excess of $50,000 became subject to the imputed income rules of Section 79, based on Table I cost, which are relatively high at older ages. As a result, employers increasingly turned to group term carve-outs. While carve-outs can be used for any employee with more than $50,000 of group term coverage, they typically apply only to shareholders and key executives.

Bonus Plans
In the simplest sense, a carve-out works like this: The employer decides which employees are to be covered under the carve-out plan and limits coverage for these employees under its group term plan to the $50,000 that can be received tax free. The employer then gives any premium savings to each "carved-out" employee in the form of a bonus, which is fully deductible to the employer as long as the employee's overall compensation is reasonable. The bonus amounts are either paid directly to an insurance company for individual coverage on the lives of the participants in the carve-out plan or, in some cases, provided to the employees as compensation to pay life insurance premiums. In most cases, the coverage purchased under the carve-out plan is some form of permanent life insurance protection that provides paid-up coverage at retirement. Traditional whole life insurance, universal life insurance, variable universal life insurance, and variable life insurance are all viable alternatives. At retirement, the employee can either keep the coverage in force (possibly at a reduced paid-up amount) or surrender the policy for its cash value.

The popularity of carve-out plans lies in the fact that a comparable or greater amount of life insurance coverage can often be provided to participants at a lower cost than if the participants had received all their coverage under the group term life insurance plan. Because the carve-out plan does not qualify as a plan of insurance under Section 79, each participant has taxable income in the amount of the bonus. However, this income is offset by the absence of any imputed income from Table I.

In reality, carve-out plans are more complex. In many cases, the cost of permanent coverage for an employee may actually be greater than the cost of group term coverage during the working years. However, this high cost is often more than compensated for by the cash value at retirement and the absence of imputed income after retirement. Under some carve-out plans, participants must pay this increased premium cost with after-tax dollars. Under other plans, the employer increases the bonus amount. In effect, the employer is now paying more than if the carve-out plan did not exist, but this arrangement is often acceptable to the employer as a way of providing shareholders and key executives with a benefit that is not available to other employees. In many plans, the bonus is also increased to compensate the employee for any additional income taxes that must be paid because of the carve-out plan. Such an arrangement is commonly referred to as a zero-tax approach.

A carve-out plan can pose a potential problem if there are rated or uninsurable employees, but the problem is ameliorated if the plan has enough participants that the insurance company will use simplified underwriting or grant concessions on impaired risks. Any employee who is still uninsurable can be continued in the group term plan.

Other Types of Carve-Out Plans
While a bonus arrangement is the most common type of carve-out plan, other alternatives are available. Some carve-out plans are designed as death-benefit-only plans, under which the employer agrees only to pay a death benefit to the employee's beneficiary out of corporate assets. The employer often funds the plan with corporate-owned life insurance on the employee's life. With this approach, the employee has no taxable income, but death benefits will result in taxable income to the beneficiary. In addition, the employer is unable to deduct the premiums as a business expense but does receive the death proceeds tax free.

Some firms also use split-dollar life insurance in carve-out plans. The most common approach is to use a collateral assignment arrangement, under which the employer pays most of the premium and the employee collaterally assigns a portion of the cash value and death benefit to the employer equal to the employer's premium payments. At retirement (or any other predetermined time), the employee withdraws the cash value necessary to repay the employer, who then removes the collateral assignment. At that time, the employee has full control of the policy, and the remaining cash value can be used to keep coverage in force. Many split-dollar arrangements are also used to provide nonqualified retirement benefits to key employees as a supplement to the benefits under the employer's qualified retirement plan.

Determining the Best Plan
In many instances, carve-out plans are the most cost-effective approach for providing benefits to key employees. The best plan depends on the overall benefit objectives of employer. A proper analysis of alternatives involves a complex consideration of many factors, including the employer's tax bracket, the effect on the employer's financial statements, the employee's tax bracket, premium costs, and the time value of money.

GROUP UNIVERSAL LIFE INSURANCE : Employee Options at Retirement and Termination, Enrollment and Administration, Taxation

Employee Options at Retirement and Termination
Several options are available to the retiring employee. First, the employee can continue the group insurance coverage as if an active employee. However, if premium payments are continued, the employee is billed by the insurance company, probably on a quarterly basis. Because of the direct billing, the employee may be subject to a higher monthly expense charge. Second, the employee can terminate the coverage and completely withdraw his or her accumulated cash value. Third, the employee can elect one of the policy settlement options for the liquidation of cash value in the form of annuity income. Finally, some insurers allow the retiring employee to decrease the amount of pure insurance so that the cash value is adequate to keep the policy in force without any more premium payments. In effect, the employee then has a paid-up policy.

The same options are generally available to an employee who terminates employment prior to retirement. In contrast to most other types of group insurance arrangements, the continuation of coverage does not involve a conversion and the accompanying conversion charge; rather, the employee usually remains in the same group. This ability to continue group coverage after termination of employment is commonly referred to as portability. If former employees who continue coverage have higher mortality rates, this is reflected in the mortality charge for the entire group. However, at least one insurer places terminated employees into a separate group consisting of terminated employees from all plans. These persons are subject to a mortality charge based solely on the experience of this group. Thus, any higher mortality due to adverse selection is not shared by the actively working employees.

If the employer terminates the group insurance arrangement, some insurance companies keep the group coverage in force on a direct-bill basis, even if the coverage has been replaced with another insurer. Other insurance companies continue the group coverage only if the employer has not replaced the plan. If replacement occurs, the insurance company terminates the pure insurance amount and either gives the cash value to participants or transfers it to the trustee of the new plan.

Enrollment and Administration
Variations exist in the method by which employees are enrolled in group universal life insurance plans. Some early plans used agents who were compensated in the form of commissions or fees, but several insurance companies have dropped this practice. The actual enrollment is typically done by the employer with materials the insurance company provides. However, salaried or commissioned representatives of the insurer usually meet with the employees in group meetings to explain the plan.

The employer's main administrative function is to process the payroll deductions associated with a plan. As previously mentioned, employee flexibility may be somewhat limited to minimize the costs of numerous changes in payroll deductions.

The insurance company or a third-party administrator performs other administrative functions, including providing employees with annual statements about their transactions and cash-value accumulation under the plan. Toll-free telephone lines are often maintained to provide information and advice to employees.

Taxation
Group universal life insurance products are not designed to be policies of insurance under Section 79. In addition, each employee pays the full cost of his or her coverage. Therefore, the tax treatment is the same to employees as if they had purchased a universal life insurance policy in the individual insurance marketplace.

GROUP UNIVERSAL LIFE INSURANCE : Loans and Withdrawals, Dependent Coverage, Accidental Death and Waiver of Premium

Loans and Withdrawals
Employees are allowed to make loans and withdrawals from their accumulated cash values, but for administrative reasons the frequency of loans and withdrawals may be limited. There are also minimum loan and withdrawal amounts, such as $250 or $500. In addition, an employee is usually required to leave a minimum balance in the cash-value account sufficient to pay mortality and expense charges for some time period, possibly as long as one year. If an option A death benefit is in effect, the amount of the pure insurance is increased by the amount of the loan or withdrawal so that the total death benefit remains the same. With an option B death benefit, the amount of the total death benefit is decreased.

The interest rate charged on policy loans is usually pegged to some index, such as Moody's composite bond yield index. In addition, the interest rate applied to an amount of the cash value equal to the policy loan is reduced. This reduced interest rate may be the guaranteed policy minimum or may also be based on some index; for example, the rate may be 2 percent less than Moody's composite bond yield.

An employee can withdraw his or her entire cash-value accumulation and terminate coverage. Total withdrawals are subject to a surrender charge during early policy years. The charge decreases with policy duration and is usually in addition to any transaction charge that might also be levied.

Dependent Coverage
Most products allow an employee to purchase a rider that provides term insurance coverage on his or her spouse and children. For example, one insurance company allows an employee to elect spousal coverage of $10,000 to $50,000 in $10,000 increments and coverage on children in the amount of either $5,000 or $10,000. Other insurers make varying amounts available.

Some insurance companies allow separate universal life insurance coverage to be elected, but usually only for the spouse. In such cases, the coverage is provided under a separate group insurance certificate rather than a rider.

Accidental Death and Waiver of Premium
A group universal life insurance plan may provide accidental death benefits and a disability waiver of premium. These benefits are not optional for each employee; rather they are part of the coverage only if the employer has elected to include them in the plan. When a waiver of premium is included, all that is waived in case of disability is the portion of the premium necessary to pay the cost of the pure insurance protection for the employee and any dependents.

GROUP UNIVERSAL LIFE INSURANCE : Mortality Charges, Expense Charges, Interest Rates,

Mortality Charges
Most products have a guaranteed mortality charge for three years, after which the mortality charge is based on the experience of each particular group. As with experience rating in general, the credibility given to a group's actual experience is greater for larger groups. Most insurance companies guarantee that any future increases in the mortality charge will not exceed a stated maximum.

The products designed for small groups typically use pooled rates that apply to all groups insured through a particular trust. Therefore, the mortality charge for any employer will vary not with the employer's overall experience but rather with the overall experience of the trust.

Expense Charges
Among group life insurance products, probably the greatest variation occurs in expense charges levied. Typically, a percentage of each premium, such as 2 percent, is deducted for expenses. In addition, there is a flat monthly charge, normally ranging from $1 to $3, to maintain the accumulation account. Some insurance companies levy this charge against all certificate holders, even those who are contributing only enough to have the pure insurance coverage. Other insurance companies levy the charge only against those accounts that have a positive cash-value accumulation. A few insurance companies also load their mortality charges for expenses. Finally, many companies levy a transaction charge, such as $25, that often applies to withdrawals in early policy years. A transaction charge may also apply to policy loans and additional lump-sum contributions. In evaluating the expense charges of different insurers, one should remember that an insurer with a lower-than-average charge may be subtly compensating for this charge by having a higher mortality charge or crediting a lower interest rate to cash-value accumulations than would otherwise be paid.

Interest Rates
Insurance companies guarantee that the initial interest rate applied to cash-value accumulations will remain in effect for a minimum period of time, usually one year. After that time, the rate is typically adjusted quarterly or semiannually but cannot be below some contractual minimum such as 4 percent or 4½ percent. The interest rate credited is usually determined on a discretionary basis but is influenced by the insurance company's investment income and competitive factors. However, some insurers stipulate that it be linked to some money market instrument, such as three-month Treasury bills. In general, the same interest rate is credited to all groups that an insurance company has underwritten.

Premium Adjustments
Employees are allowed considerable flexibility in the amount and timing of premium payments. Premiums can be raised or lowered and even suspended. In the latter case, the contract will terminate if an employee's cash-value accumulation is inadequate to pay current mortality and expense charges. Of course, premium payments could be reinstated to prevent this from happening. Additional lump-sum contributions may also be made to the accumulation account.

Two restrictions are placed on premium adjustments. First, the premium payment cannot be such that the size of the cash-value accumulation becomes so large in relationship to the pure insurance that an employee's coverage fails to qualify as a policy of insurance under IRS regulations. Second, because changes in premium payments through payroll deductions are costly to administer, many employers limit the frequency with which adjustments are allowed.

GROUP UNIVERSAL LIFE INSURANCE : The Death Benefit

The Death Benefit
The policyholder under an individual group universal life insurance policy typically has a choice of two death benefit options. Option A provides a level death benefit in the early policy years. As the cash value increases, the amount of pure insurance decreases so that the total amount paid to a beneficiary upon the insured's death remains constant. Without any provision to the contrary, the cash value would eventually approach the amount of the total death benefit. To prevent this from occurring, and also to keep the policy from failing to qualify as a life insurance policy under existing tax regulations, the amount of pure insurance does not decrease further once the cash value reaches a predetermined level. Thereafter, the total death benefit increases unless the cash value decreases. Figure 1 graphically demonstrates option A. Note that this and the following figure are for illustrative purposes only. The actual death benefit for a particular individual will vary by such factors as the amount of interest credited, premiums paid, loans, and withdrawals.


Figure 1: Universal Life Insurance—Death Benefit Option A

Under option B, the amount of pure insurance is constant, and the death benefit increases each period by the change in the policy cash value. This is shown graphically in Figure 2.


Figure 2: Universal Life Insurance—Death Benefit Option B

With group universal life insurance products, an employee usually has only one death benefit option available, and whether it is option A or option B depends on which one the employer has selected. In general, there seems to be a feeling that the availability of both options makes a plan more difficult to explain to employees and more costly to administer. Most employers select option B, which is more easily marketed to employees because the increasing total death benefit is a visible sign of any increase in their cash value, or "investment." As a result, several insurers now make only option B available with their group products.

Universal life insurance products give the insured the right to increase or decrease the death benefit from the level originally selected as circumstances change. For example, the policyholder might have initially selected a pure death benefit of $100,000 under option B. Because of the birth of a child, this amount might be increased to $150,000. Increases, but not decreases, typically require that the insured provide evidence of insurability.

GROUP UNIVERSAL LIFE INSURANCE : Types of Group Universal Products & Underwriting

Types of Group Universal Products
Two approaches have been used in designing group universal life insurance products. Under the first approach, there is a single group insurance plan. An employee who wants only term insurance can pay a premium equal to the mortality and expense charges so that there is no accumulation of cash values. Naturally, an employee who wants to accumulate cash values must pay a larger premium.

Under the second approach, there are actually two group insurance plans—a term insurance plan and a universal life insurance plan. An employee who wants only term insurance contributes to the term insurance plan, and an employee who wants only universal life insurance contributes to the universal life insurance plan. With this approach, an employee purchasing universal life insurance must make premium payments that are sufficient to generate a cash-value accumulation. Initially, the employee may be required to make minimum premium payments, such as two or three times the cost of the term insurance. If an employee who has only the term insurance coverage later wants to switch to universal life insurance coverage, his or her group term insurance certificate is canceled, and the employee is issued a new certificate under the universal life insurance plan. An employee can also withdraw his or her cash accumulation under the universal life insurance plan and switch to the term insurance plan or can even have coverage under both plans. Typically, an employee is eligible to purchase a maximum aggregate amount of coverage under the two plans. For example, if this amount is three times annual salary, the employee can purchase term insurance equal to two times salary and universal life insurance that has a term insurance amount equal to one times salary.

Underwriting
Insurance companies that write group universal life insurance have underwriting standards concerning group size, the amounts of coverage available, and insurability.

Currently, most group universal life insurance products are limited primarily to employers who have at least 100 or 200 employees. However, a few insurers write coverage for even smaller groups. Some insurance companies also have an employee percentage-participation requirement, such as 20 percent or 25 percent, that must be satisfied before a group can be installed. Other insurance companies feel their marketing approach is designed so that adequate participation will result and, therefore, have no participation requirements.

Employees can generally elect amounts of pure insurance equal to varying multiples of their salaries, which typically start at one-half or one and range as high as three or five. There may be a minimum amount of coverage that must be purchased, such as $10,000. The maximum multiple an insurance company will offer is influenced by factors such as the size of the group, the amount of insurance provided under the employer's basic employer-pay-all group term insurance plan, and the percentage participation in the plan. In general, the rules regarding the amounts of coverage are the same as those that have been traditionally applied to supplemental group term life insurance plans. The initial premium, which is a function of an employee's age and death benefit, is frequently designed to accumulate a cash value at age 65 equal to approximately 20 percent of the total death benefit.

Other approaches for determining the death benefit may be used, depending on insurance company practices and employer desires. Under some plans, employees may elect specific amounts of insurance, such as $25,000, $50,000, or $100,000. Again, an employee's age and the death benefit selected determine the premium. Some plans allow an employee to select the premium he or she wants to pay. The amount of the premium and the employee's age then automatically determine the amount of the death benefit.

The extent to which evidence of insurability is required of individual employees is also similar to that found under most supplemental group term life insurance plans. When an employee is initially eligible, coverage is usually issued on a guaranteed basis up to specified limits, which again are influenced by the size of the group, the amount of coverage provided under the employer's basic group term insurance plan and the degree of participation in the plan. If an employee chooses a larger death benefit, simplified underwriting is used up to a second amount, after which regular underwriting is used. Guaranteed issue is often unavailable for small groups; underwriting on the basis of a simplified questionnaire is used up to a specific amount of death benefit, after which regular underwriting is used.

With some exceptions, future increases in the amount of pure insurance are subject to evidence of insurability. These exceptions include additional amounts resulting from salary increases, as long as the total amount of coverage remains within the guaranteed issue limit. A few insurance companies also allow additional purchases without evidence of insurability when certain events occur, such as marriage or the birth of a child.

GROUP UNIVERSAL LIFE INSURANCE : General Nature

GROUP UNIVERSAL LIFE INSURANCE
Beginning in the mid-1980s, many large writers of group insurance started to sell group universal life insurance, a trend that was greeted with much interest by insurers, employers, and even employees. This interest seems to stem primarily from the following five factors:

1. The success of universal life insurance in the individual marketplace.

2. Tax legislation that made employer-provided term life insurance in excess of $50,000 taxable after retirement.

3. The clarification of the tax treatment of universal life insurance. For the first few years after the introduction of universal life insurance, there was concern that the Internal Revenue Service (IRS) would not grant it the same favorable tax treatment that was granted to traditional cash-value life insurance policies. There was speculation that the interest paid on the cash value might become subject to taxation and also that the death benefit would be considered taxable income for the beneficiary. For the most part these fears were laid to rest by tax legislation, as long as a universal life insurance policy meets certain prescribed guidelines. Therefore, the cash value of a universal life insurance policy accumulates tax free, and death benefits are free of income taxation.

4. The desire of employers to contain employee benefit costs. Little needs to be said about the attempts of employers to minimize the costs of their employee benefit plans. Group universal life insurance plans can make life insurance available to employees with little cost to the employer.

5. Less favorable tax treatment for formerly popular products for prefunding postretirement life insurance, such as retired-lives reserves.

Group universal life insurance products are being marketed primarily as supplemental life insurance plans, either to replace existing supplemental group term life insurance plans or as additional supplemental plans. Some insurers are promoting them as a way of providing the basic life insurance plan of an employee. Marketing efforts tout group universal life insurance as having the following advantages to the employer:

- No direct costs other than those associated with payroll deductions and possibly enrollment, because the entire premium cost is borne by the employee. In this sense, group universal life insurance plans are much like the payroll-deduction-funded plans

- No Employee Retirement Income Security Act (ERISA) filing and reporting requirement as long as the master contract is issued to a trust and as long as there are no employer contributions for the cost of coverage. The current products are marketed through multiple-employer trusts, with the trust being the policyholder.

- The ability of employees to continue coverage into retirement, alleviating pressure for the employer to provide postretirement life insurance benefits.

The following advantages are being claimed for employees:

- The availability of a popular life insurance product at group rates

- The opportunity to continue insurance coverage after retirement, possibly without any postretirement contributions

- Flexibility in designing coverage to best meet the needs of the individual employee

The current plans being marketed are still evolving, and differences do exist among the plans being offered by competing insurance companies. Because of the flexibility given to policyholders, the administrative aspects of a group universal plan are formidable, and most insurers originally designed their plans only for employers with a large number of employees, usually at least 1,000. However, some insurers that write the product now make it available for as few as 50 employees or less.

Skeptics, including employees of some insurance companies offering group universal life coverage, wonder if the administrative problems can be handled so that coverage can be offered at a cost significantly lower than what is found in the individual marketplace. In raising this question, skeptics point out the administrative problems and costs that have arisen when universal life insurance has been included in payroll-deduction individual insurance plans. In addition, the highly competitive market for individual universal life insurance has resulted in rates with extremely low margins for contributions to surplus. These drawbacks, coupled with the lack of employer contributions, make savings to employees through the group insurance approach less likely than for many other types of insurance. Other critics point out that the popularity of universal life insurance in the individual marketplace decreased as interest rates have dropped over the last few years. Nevertheless, plans that are installed are usually well received by employees, and participation generally meets or exceeds expectations.

In 1998, universal life insurance accounted for about 6.5 percent of group life insurance certificates in force, up from 2 percent in 1995.[1]

General Nature
Group universal life insurance is a flexible-premium policy that, unlike traditional cash-value life insurance, divides the term insurance protection and the cash-value accumulation into separate and distinct components. The employee is required to pay a specified initial premium, from which a charge is subtracted for one month's mortality. This mortality charge in effect is used to purchase the required amount of term insurance (often referred to as pure insurance or the amount at risk) at a cost based on the insured's current age. Under some policies, an additional deduction is made for expenses. The balance of the initial premium becomes the initial cash value of the policy, which, when credited with interest, becomes the cash value at the end of the period. The process continues in succeeding periods. New premiums are added to the cash value, charges are made for expenses and mortality, and interest is credited to the remaining cash value. Employees receive periodic disclosure statements showing all charges made for the period, as well as any interest earnings.

Group universal life insurance offers an employee considerable flexibility to meet several life-cycle financial needs with a single type of insurance coverage. The death benefit can be increased because of marriage, the birth of a child or an increase in income. The death benefit can be reduced later when the need for life insurance decreases. Cash withdrawals can be made for the down payment on a home or to pay college tuition. Premium payments can be reduced during those periods when a young family has pressing financial needs. As financial circumstances improve, premiums can be increased so that an adequate retirement fund can be accumulated. The usual settlement options found in traditional cash-value life insurance are available, so an employee can periodically elect to liquidate the cash accumulation as a source of retirement income.