Total Self-Funding from Current Revenue and Self-Administration

The purest form of a self-funded benefit plan is one in which the employer pays benefits from current revenue (rather than from a trust), administers all aspects of the plan, and bears the risk that benefit payments will exceed those expected. In addition to eliminating state premium taxes, avoiding state-mandated benefits, and improving cash flow, the employer has the potential to reduce its operating expenses to the extent that the plan can be administered at a lower cost than the insurance company's retention (other than premium taxes). A decision to use this kind of self-funding plan is generally considered most desirable when all the following characteristics are present:

• Predictable claims. Budgeting is an integral part of the operation of any organization, and it is necessary to budget for benefit payments that will have to be paid in the future. This can best be done when a specific type of benefit plan has a claim pattern that is either stable or shows a steady trend. Such a pattern is most likely to occur in those types of benefit plans that have a relatively high frequency of low-severity claims. Although a self-funded plan may still be appropriate when the level of future benefit payments is difficult to predict, the plan will generally be designed to include stop-loss coverage.
  

• A noncontributory plan. Several difficulties arise if a self-funded benefit plan is contributory. Some employees may resent paying their money to the employer for benefits that are contingent on the firm's future financial ability to pay claims. If claims are denied, employees under a contributory plan are more likely to be bitter toward the employer than they would be if the benefit plan were noncontributory. Finally, ERISA requires that a trust be established to hold employees' contributions until the plan uses the funds; both the establishment and maintenance of the trust result in increased administrative costs to the employer.

• A nonunion situation. Self-funding of benefits for union employees may not be feasible if a firm is subject to collective bargaining. Self-funding (at least by the employer) clearly cannot be used if benefits are provided through a negotiated trusteeship. Even when collective bargaining results in benefits being provided through an individual employer plan, unions often insist that benefits be insured to guarantee that union members will actually receive them. An employer's decision about whether to use self-funding is most likely motivated by the potential to save money. When unions approve self-funding, they also frequently insist that some of the savings be passed on to union members through additional or increased benefits.

• The ability to effectively and efficiently handle claims. One reason that many employers do not use totally self-funded and self-administered benefit plans is the difficulty in handling claims as efficiently and effectively as an insurance company or other benefit-plan administrator would handle them. Unless an employer is extremely large, only one person or a few persons will be needed to handle claims. Who in the organization can properly train and supervise these people? Can they be replaced if they should leave? Will anyone have the expertise to properly handle the unusual or complex claims that might occur? Many employers want some insulation from their employees in the handling of claims. If employees are unhappy with claim payments under a self-administered plan, dissatisfaction (and possibly legal actions) will be directed toward the employer rather than toward the insurance company. The employer's inability to handle claims, or its lack of interest in wanting to handle them, does not completely rule out the use of self-funding. As will be discussed later, employers can have claims handled by another party through an administrative-services-only (ASO) contract.

• The ability to provide other administrative services. In addition to claims, the employer must determine whether the other administrative services normally included in an insured arrangement can be provided in a cost-effective manner. These services are associated with plan design, actuarial calculations, statistical reports, communication with employees, compliance with government regulations, and the preparation of government reports. Many of these costs are relatively fixed, regardless of the size of the employer, and unless the employer can spread these costs out over a large number of employees, self-administration will not be economically feasible. As with claims administration, an employer can purchase needed services from other sources.

• The ability to obtain discounts from medical care providers if medical expense benefits are self-funded. In order to obtain much of the cost savings associated with managed care plans, the employer must be able to secure discounts from the providers of medical care. Large employers whose employees live in a relatively concentrated geographic region may be able to enter into contracts with local providers. Other employers may use the services of third-party administrators who have either established or entered into contracts with preferred-provider networks.

The extent of total self-funding and self-administration differs significantly among the different types of group benefit plans. Plans that provide life insurance or accidental death and dismemberment benefits do not usually lend themselves to self-funding because of infrequent and large claims that are difficult to predict. Only very large employers can expect stable and predictable claims on an annual basis. In addition, federal income tax laws impede the use of self-funding for death benefits, because any payments to beneficiaries are considered taxable income for beneficiaries. Such a limitation does not exist if the plan is insured.

The most widespread use of self-funding and self-administration occurs in short-term disability income plans, particularly those in which the maximum duration of benefits is limited to six months or less. For employers of most any size, the number and average length of short-term absences from work are relatively predictable. In addition, the payment of claims is relatively simple, because benefits can be (and usually are) made through the usual payroll system of the employer.

Long-term disability income benefits are occasionally self-funded by large employers. Like death claims, long-term disability income claims are difficult to predict for small employers because of their infrequent occurrence and potentially large size. In addition, because small employers receive only a few claims of this type, self-administration of such claims is economically unjustifiable.

The larger the employer, the more likely that its medical expense plan is self-funded. The major problem with a self-funded medical expense plan is not the prediction of claims frequency but rather the prediction of the average severity of claims. Although infrequent, claims of $500,000 to $1,000,000 or more do occasionally occur. Most small and medium-sized employers are unwilling to take a chance that they might have to pay such a large claim. Only employers with several thousand employees are large enough to assume the risk that such claims will regularly occur and have the resources that will be necessary to pay any unexpectedly large claims. This does not mean that smaller employers cannot self-fund medical benefits. To avoid the uncertainty of catastrophic claims, these employers often self-fund basic medical expense benefits and insure major medical expense benefits or self-fund their entire coverage but purchase stop-loss protection.

It is not unusual to use self-funding and self-administration in other types of benefit plans, such as those providing coverage for dental care, vision care, prescription drugs, or legal expenses. Initially, it may be difficult to predict the extent to which these plans will be utilized. However, once the plans have "matured," the number and dollar amount of claims tends to be fairly stable. Furthermore, these plans are commonly subject to maximums so that the employer has little or no risk of catastrophic claims. Although larger employers may be able to economically administer the plans themselves, smaller employers commonly purchase administrative services.