Title IV: Plan Termination Insurance

Title IV of ERISA established the Pension Benefit Guaranty Corporation (PBGC), a governmental body that insures payment of plan benefits under certain circumstances.

Most defined benefit pension plans (those that provide a fixed monthly benefit at retirement) are required to participate in the program and pay premiums to the PBGC.

There are certain restrictions and limitations on the amount of benefits insured, and the amount is adjusted annually to reflect the increasing average wages of the U.S. workforce. The limit applies to all plans under which a participant is covered so it is not possible to spread coverage under several plans to increase the guaranteed benefit. To be fully insured, the benefit must have been vested before the plan terminated, and the benefit level must have been in effect for 60 months, or benefits are proportionately reduced. Further, the guarantee applies only to benefits earned while the plan is eligible for favorable tax treatment.

In an effort to protect against employers establishing plans without intending to continue them, ERISA introduced the concept of contingent employer liability in the event of plan termination for single-employer plans and for multi-employer plans in the event of employer withdrawal or insolvency. Additional complex requirements that apply to multi-employer plans also were established by Congress in 1980.

The PBGC has served to substantially change the environment in which plans operate. The PBGC now has substantial ability to involve itself in mergers, acquisitions, and sales when the sponsor of an under-funded plan is involved. For present sponsors, and for those thinking of establishing new defined benefit plans, Title IV should be carefully reviewed so that its implications are fully understood.

Title I: Protection of Employee Benefit Rights

Title I of ERISA placed primary jurisdiction over reporting, disclosure, and fiduciary matters in the Department of Labor. The Department of the Treasury is given primary jurisdiction over participation, vesting, and funding. During the first years of ERISA, this "dual jurisdiction" led to a number of problems, which were addressed in 1979 by Reorganization Plan Number 4, discussed later in this chapter. As a result of reorganizations and administrative experience under ERISA, many requirements have been adjusted, resulting in a reduction of the regulatory burden.

Reporting and Disclosure

Plan sponsors are required to provide plan participants with summary plan descriptions and benefit statements for the plan. Participants also are provided access to the plan's financial information. These documents are to be written in "plain English" so they can be easily understood.

Plan sponsors file an annual financial report (Form 5500 series) with the IRS through the Employee Benefit Security Administration (EBSA), which is made available to other agencies. In addition, sponsors must file amendments when modifications to the plan are made. Taken together, these provisions seek to ensure that the government has accurate information on employer-sponsored plans.

Fiduciary Requirements

Plan sponsors are subject to an ERISA fiduciary standard mandating the plan be operated solely for the benefit of plan participants. The fiduciary standard, or "prudent man standard," requires the plan fiduciary perform duties solely in the interest of plan participants with the care a prudent person acting under like circumstances would use. This means any person who exercises discretion in the management and maintenance of the plan or in the investment of the plan assets must do so in the interest of the plan participants and beneficiaries, in accordance with the plan documents, and in a manner that minimizes the risk of loss to the participant. The standard applies to plan sponsors, trustees, and co-fiduciaries, as well as to investment advisers with discretionary authority over the purchase and sale of plan securities.

Underlying the standard, are prohibitions against business or investment transactions between the plan and fiduciaries or interested parties.

Upon violation of the prohibitions, the fiduciary may be held personally liable to the plan for any misuse, fraud, or mismanagement. Exemptions can be applied for when parties feel that actions are not to the detriment of the plan and its participants and should be allowed. Both the IRS and the Department of Labor are responsible for enforcing the fiduciary standards. The Department of Labor may file charges on behalf of the participants if the fiduciary has breached or violated the standards imposed by ERISA. The IRS may fine the employer and revoke the plan's favorable tax treatment. Both civil and criminal actions may arise from violations.

Private Pension And Welfare Plans | Regulatory Environment of Employee Benefit Plans

Pre-ERISA

Before the enactment of the Employee Retirement Income Security Act (ERISA) on Labor Day 1974, only three principal statutes governed private pension plans: the Internal Revenue Code (IRC), the Federal Welfare and Pension Plans Disclosure Act of 1958 (WPPDA), and the Taft-Hartley Act, more formally known as the Labor Management Relations Act of 1947. The latter regulated collectively bargained multi-employer pension plans.

Amendments to the Internal Revenue Code enacted in 1942 established standards for the design and operation of pension plans. The principal purposes were to prevent plans from discriminating or disproportionately benefiting one group of employees over another and to prevent plans from taking excessive or unjustified tax deductions. Until 1974, the Internal Revenue Service was not concerned with the actuarial soundness of plans.

The Federal Welfare and Pension Plans Disclosure Act was enacted to protect plan assets against fraudulent behavior by the plan administrator. The act mandated that, upon request, participants concerned with plan malpractice would be provided with information concerning the plan. If misuse or fraud were suspected, it was up to the participant to bring charges against the administrator. A significant amendment to the WPPDA was enacted in 1962. That amendment authorized the Department of Justice to bring appropriate legal action to protect plan participants' interests and authorized the Department of Labor to interpret and enforce the act. For the first time, the burden of plan asset protection was placed upon the government, rather than on the individual participants.

Employee Retirement Income Security Act of 1974 (ERISA)

The shift to government protection of participants' rights enacted in 1962 would carry through to ERISA. It reflected a concern for workers, which was confirmed by President John Kennedy in 1962 with the appointment of the Committee on Corporate Pension Funds and Other Retirement and Welfare Programs. That committee issued its report in 1965, concluding that private pension plans should continue as a major element in the nation's total retirement security program. The report advocated many changes in the breadth of private plan regulation.

The report received widespread attention and led to the introduction of a number of legislative proposals. Congress concluded that most plans were operated for the benefit of participants on a sound basis, but some were not. To solve this problem, Congress enacted ERISA to govern every aspect of private pension and welfare plans and require employers that sponsor plans to operate them in compliance with ERISA standards.

Insurance And Insurable Risk | Risk Concepts and Employee Benefit Planning

Insurance is one of the most popular methods of funding employee benefit plans, but, as explained in later chapters of the Handbook, many other options exist. The advantages and disadvantages of using insurance in the design of a benefit plan are discussed:

Advantages of Insurance

A number of reasons account for why insurance can be used effectively in an employee benefit plan. One advantage is the known premium (cost); it is set in advance by the insurance company. The employer may have better control over its budget with a known premium, because any high shock losses would be the problem of the insurance company and not the insured. Having an outside administrator also can be an advantage to the employer. The employer does not have to get involved in disputes involving employees over coverage of the plan, because these would be handled by the insurance company. Employees may prefer insurance to some other form of funding in order to obtain the financial backing of an outside financial institution. This, of course, depends upon the financial strength of the insurance company selected, and care should go into this choice. Insurance companies often are leaders in the area of loss control and may help in the design and implementation of systems designed to control costs for the employer. A final advantage is that it may be more economical for an employer to use insurance rather than other alternatives. The insurance company may be more efficient and able to do the job at a lower total cost.

Disadvantages of Insurance

Insurance is not always the preferred method of funding employee benefit plans. A number of costs are involved that must be considered. Insurance companies charge administrative expenses that are added to the premium (or loaded) to compensate for their overhead expenses. Home office costs, licensing costs, commissions, taxes, loss-adjustment expenses, and the like all must go into the loading. One must realize that the premium covers not only direct losses but also the insurance company's overhead as well. The amount may vary from a small percent of the premium (e.g., 2 percent to 5 percent) to potentially a very high amount (25 percent or more) depending on the type of contract involved. Another potential disadvantage is that employer satisfaction is directly affected by the insurer's ability to handle claims and solve problems. Slow payment or restrictive claim practices can have an adverse effect on employees.

Whether something is an advantage or disadvantage often depends upon the specific insurance company involved. It is important to use care in the selection of an insurer. Checking out the insurer with other clients and carefully analyzing the carrier's financial stability are critical elements in the selection process.

Characteristics of an Insurable Risk

It often is said that anything can be insured if one is willing to pay the premium required. Insurance companies, however, normally will insure a risk only if it meets certain minimum standards. These standards or prerequisites are needed for an insurer to manage the company in a sound financial manner. Without suitable risks, an insurance company can find itself in serious financial trouble. An insurance company is subject to the same problems as any other business—inadequate capitalization, a weak investment portfolio, or poor management. Insurance companies have the additional problem of insuring risks that could result in catastrophic losses.

The following is a list of the characteristics of a risk that are desired in order for it to be considered an "insurable risk":

1.  There should be a large number of homogeneous risks (exposure units).

2.  The loss should be verifiable and measurable.

3.  The loss should not be catastrophic in nature.

4.  The chance of loss should be subject to calculation.

5.  The premium should be reasonable or economically feasible.

6.  The loss should be accidental from the standpoint of the insured.

It should be noted that this list is what is considered ideal from the standpoint of the insurance company. Most risks are not perfect in all aspects, and insurance companies have to weigh all aspects of a risk to determine if, overall, it meets the criteria of an insurable risk.

Large Number of Homogeneous Risks

The insurance company must be able to calculate the number of losses it will incur from the total number of risks it insures. Assume that a life insurance company has just been formed and it is to insure its first two people. Each wants $100,000 of life insurance. The company needs to know what the chance of dying for each of the two people is in order to calculate a premium. Without this information, the company will have no idea of whether these people will live or die during the policy period. Should both die during this period, $200,000 would be needed for the claims. If neither dies, the company would need nothing for the claims. The conclusion one reaches is that the premium should be somewhere between $0 and $200,000. This information is not very helpful, and the insurance company could not insure the risk. What is needed is a large number of similar risks so statistics can be developed to determine an accurate probability of loss for each risk being evaluated. Insurance is based on the law of large numbers, which means that, the greater the number of exposures, the more closely the actual results will approach the probable results that are expected from an infinite number of exposures. For example, life insurance companies have accumulated information over the years that enables them to develop mortality tables that reflect the expected mortality for a given type of risk. They are able to do this because of the large number of lives that have been insured over the years. Medical, dental, disability, and life risks all require large numbers of cases to determine proper premium rates.

Employee benefit plans may or may not have the numbers needed to determine loss expectations accurately. This would depend upon the specific plan. Those plans with large numbers of homogeneous risks can be experience rated. This means the premiums will be calculated with the data from the plan experience itself. Smaller plans would not have an adequate number of risks, and other alternatives would be needed. For example, small plans can be combined with other small plans to get creditable statistics, or insurance companies might ignore small-plan statistics and rely on loss statistics developed independently of the plan.

Loss Should Be Verifiable and Measurable

It is important that an insurance company be able to verify a loss and to determine the financial loss involved. Certain risks pose no problem in determining if a loss has taken place. Examples would be fire and windstorm losses with a home or a collision loss with one's auto. Furthermore, the financial value of these losses can be determined accurately by the use of appraisals and other forms of valuation. Other risks are harder to evaluate. An example is a claim for theft of money from a home. Did the theft take place? Did the person have any money at home to be stolen? With risks that are difficult to evaluate, the insurance company has to take other precautions to protect itself from false and inflated claims.

Employee benefits are subject to the same types of problems. Death claims and retirement benefit claims probably would be the easiest in which to determine whether a loss has taken place or not. Once a death claim is verified, the amount of loss is normally the face value of the insurance contract. Few problems result from death claims. The same is true of retirement benefits. Assuming the age of the retiree can be verified, then the benefit promised by the plan will be paid. The other extreme might be disability income claims. In some situations, an insurer might be uncertain whether a valid claim exists or not. Some disability losses, such as back injuries, are very difficult to determine. Is the insured actually disabled or not? Still other employee benefit losses may fall between these two extremes. Medical and dental losses might fall into this category. When an employee benefit loss is difficult to verify or measure, the insurer may attempt to overcome the problem through several methods. Policy provisions are helpful in such situations. Benefit maximums, waiting periods, preexisting conditions clauses, alternate medical verification, required second opinion on certain surgical procedures, and hospital-stay monitoring are a few of the provisions that help in these situations.

Loss Should Not Be Catastrophic in Nature

A serious problem occurs when a large percentage of the risks insured can be lost from the same event. Assume a fire insurance company insured all of its risks in one geographical location. A serious fire could result in catastrophic losses to the company. This did happen in the early history of fire insurance. Fires in London, Chicago, Baltimore, and San Francisco resulted in insurance company bankruptcies and loss of confidence in the industry. It became obvious that a geographic spread of the risks insured was essential, because a concentration of losses from one event could seriously impair or even bankrupt a company. Cases exist in which it is almost impossible to obtain a spread of the risks. In such cases, insurance becomes difficult or impossible to obtain. Flood and unemployment losses would be examples. Unemployment can cover wide geographic areas, and a geographic spread would not help prevent a catastrophic loss. The same could be true for flood losses. The federal or state government might insure this type of risk, but it would be necessary for it to subsidize the premium rates to make them affordable.

Employee benefits are seldom subject to problems relating to inability to get a geographic spread of the risk. Benefit plans often insure life risks, hospital and dental risks, and disability income losses. For the most part, these types of risks are not subject to catastrophic loss due to geographic location, but examples can be imagined in which catastrophic losses might exist. The possibility of a plant explosion or a poison gas leak causing a large number of deaths or medical losses, or a concentration of certain diseases because of the exposure to certain elements that are indigenous to a specific employee group theoretically exist. Usually, however, this is not an important consideration in underwriting typical benefit plans. Policy limitations, reinsurance, and restrictions on groups insured all can be used to minimize the problem to the extent it exists.

Chance of Loss Should Be Subject to Calculation

For an insurance company to be able to calculate a premium that is reasonable to the insured and that represents the losses of a particular risk, certain information is essential. Data on both the frequency of losses and the severity of the losses must be available to determine the loss portion of the premium. This often is referred to as the pure premium portion of the premium. Essential to the pure premium calculation would be a large number of homogeneous exposure units as previously discussed. If an employer is large enough, the plan losses alone could be used to determine the pure premium portion. The meaning of "large" depends upon the type of risk involved. At least several hundred employees probably would be needed for full reliance upon the data.

Premium Should Be Reasonable or Economically Feasible

For an employee benefit plan to be acceptable to an employer and to employees, the plan must have a premium that is considered reasonable relative to the risk being insured; that is, the insured must be able to pay the premium. An insurance company's expenses not related to the losses covered by the pure premium must be added to that premium to obtain the total premium. The expense portion may be referred to as the loading associated with the risk. The "pure premium" plus the "loading" would make up the total premium to be paid by the plan. Employees who pay a part or all of the premium (participating plan) will not participate if they can obtain a lower premium in an individual insurance plan or if they can be insured through a spouse's plan at a lower cost, and the employer will be unable or unwilling to pay the premium if the rate is not reasonable.

Why would a premium be noncompetitive? This could happen for any number of reasons. For example, a plan could be populated by a high number of older employees. The resulting rate may mean that the younger employees can find lower-cost insurance outside of the plan. The younger employees are unwilling to subsidize the rates for the older employees. Also, the employer may not want to pay the needed premiums. Other reasons for noncompetitive plans could be poor loss experience from a high number of sick and disabled in a plan, or a plan having specific benefits that have resulted in high loss payout. For example, a plan may provide unlimited benefits for drug- or alcohol-related sickness, and the plan member makeup may have resulted in heavy payout for these problems. The bottom line is that the resulting loss experience has made the plan noncompetitive. It is not unusual for an employee group initially to pay a rate that is considered reasonable only to have the plan premiums become unreasonable over time. Failure to keep the average age of the members in the plan low or a higher incidence of illness could be the reason.

The employer must keep track of the factors contributing to premium increases. Inflation related to medical benefits has in recent years resulted in plan costs increasing beyond the regular cost-of-living index. This is particularly true with plans covering prescription drugs. The cost of this coverage has dramatically increased over the past 15–20 years. Constant review of benefits, benefit levels, employees covered by the plan, and competitive rates for alternative plans must take place. It has become common for plans to move away from "first dollar" medical benefits and to incorporate deductibles, waiting periods, and other cost-saving features. An obvious factor to review is the cost of alternative plans. Would it be financially sound to use an alternative insurance plan or an alternative method of delivering the benefits, such as a health maintenance organization (HMO) or a preferred provider organization (PPO)?

Loss Should Be Accidental from the Standpoint of the Insured

This problem can be serious in some forms of insurance, such as property and liability coverage, but is of less importance in the life and health areas of employee benefits. The insurance company does not want to pay for a loss if it is intentionally caused by the insured. It is obvious that payment should not be made if one intentionally destroys his or her home by arson or purposely wrecks an automobile.

An employee could intentionally cause a personal loss, but it would mean causing harm to himself or herself. For example, suicide or attempted suicide could result in death or medical claims. This type of problem can be reduced or eliminated by policy provisions restricting benefits in some manner if it is necessary. Determining whether a loss is accidental normally is not a problem in life, medical, and disability claims.

Insurable Risk Summary

Insurance companies consider providing insurance to employee benefit plans if they meet the minimum standards of an insurable risk. Benefit plans in general fit the minimum standards as set forth above. Such plans would include life insurance, medical and dental insurance, disability income, and retirement programs. Policy provisions, benefit restrictions, and reinsurance can be used to help alleviate problems to the extent they exist. Life insurance probably is the best example of a plan that meets all the desirable standards of an insurable risk. Disability income, although normally insurable, creates more of a problem from an insurability standpoint. Although not a common employee benefit, excess unemployment insurance would be a benefit that borders on being uninsurable.

Handling Adverse Selection

Adverse selection is the phenomenon in the insurance mechanism whereby individuals who have higher-than-average potentially insurable risks "select against" the insurer. That is, those with the greater probabilities of loss, and who therefore need insurance more than the average insured, attempt to obtain the coverage. For example, people who need hospitalization or surgical coverage seek to purchase medical insurance, those who own property subject to possible loss by fire or flood obtain insurance, and individuals who own valuable jewelry or objects of art purchase appropriate coverage. This tendency can result in a disproportionate number of insureds who experience losses that are greater than those anticipated. Thus, the actual losses can be greater than the expected losses. Because adverse selection is of concern to insurers for both individual and group contracts, certain safeguards are used in each case to prevent it from happening.

Under a block of individual insurance contracts, the desirable situation for an insurance company is to have a spread of risks throughout a range of acceptable insureds. The so-called spread ideally will include some risks that are higher and some that are lower than the average risk within the range. Insurers attempt to control adverse selection by the use of sophisticated underwriting methods used to select and classify applicants for insurance and by supportive policy provisions, such as preexisting-conditions clauses in medical expense policies, suicide clauses in life insurance policies, and the exclusion of certain types of losses under homeowners policies.

The management of adverse selection under group insurance contracts necessarily is different from the approach used in individual insurance. Group insurance is based on the group as a unit and, typically, individual insurance eligibility requirements are not used for the group insurance underwriting used in employee benefit plans. As an alternative, the group technique itself is used to control the problem of adverse selection.

Self-Funding/Self-Insurance

Self-funding, or self-insurance, is a common method of providing financing for employee benefit plans. Essentially this means that the organization is retaining the risk. It is important to realize, however, that many of the activities performed by the insurance company under an insured plan still have to be done. The identical problems associated with insurable risks for an insurance company exist for the firm that is self-funding or self-insuring. Therefore, the characteristics of an ideally insurable risk would be just as important for those firms that use self-funding as they are for an insurance company. The mechanism used for funding is not directly related to the question of whether a risk is a good one to include in the benefit plan. One should realize that only large firms with many employees would be able to meet all the characteristics of the ideally insurable risk. It is not uncommon to find that firms that say they self-fund or self-insure have, in fact, some arrangement with an insurance company or companies to insure part or all of a particular benefit. Many firms use insurance to provide backup coverage for catastrophic losses or coverage for losses the firm feels cannot be self-funded. The self-funded or self-insured plan has most of the characteristics found in the definition of insurance and has many of the same problems.