ALTERNATIVE FUNDING METHODS

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ALTERNATIVE FUNDING METHODS

• CHAPTER 14

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Reasons for Alternative Funding

• Cost savings
• From lower retention Commissions, Premium
  taxes, Risk charges, Profits
• From claims. Focus here is on not providing
  benefits mandated in insurance contracts.
• Improved cash flow
• Postpone payment of premiums
• Release reserves to employer who can earn more on
  funds than insurer will credit

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Premium-delay arrangements

• Premium deferred for 60-90 days
• Allows employer to have use of funds longer
• Insurer must still maintain reserves so a charge
  is made for delay.
• Upon termination, employer is responsible for
  deferred premiums, so insurers are concerned with
  financial responsibility of employer and may want
  some type of security.

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Reserve-reduction arrangement

• Employer allowed to retain an amount of premium
  equal to claim reserve
• In other respects this is like a premium-delay
  arrangement.
• A variation is a limited-liability arrangement
  for LT disability income coverages.
• Insurer pays claims only for one year.
• At renewal a premium is paid to continue
  disability payments for another year.
• Problem for employees No security if employer
  fails to renew coverage

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Minimum-premium plans

• To reduce premium taxes, but may also improve
  cash flow
• Employer is responsible for claims up to some
  level, such as 90 of expected claims.
• Insurer administers all claims and pays employer
  portion as agent of employer. Balance is
  insurance for which premium was paid. Only
  insurance portion is subject to premium taxes.
• Employer must maintain reserves and pay all
  claims.
• Not used for life insurance because of 5,000 IRS
  limit on income-free benefits to beneficiaries

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Cost-plus arrangements

• Employer pays periodic premium that is equal to
  claims of prior period plus retention
• Improves cash flow if experience better than
  average

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Retrospective-rating arrangements

• Employer pays less than justifiable premium.
• Employer must pay additional premium if claims
  exceed a specified level. However, there is a
  maximum additional payment.
• In other respects, this is like a traditional
  group insurance arrangement.

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Self-funding used when

• Predictable claims
• Noncontributory plan.
• Nonunion situation
• Unions concerned about security
• Unions may want a piece of any savings
• Ability to handle claims effectively and
  efficiently
• Ability to perform other administrative services
  normally provided by insurer.

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Extent of use of self-funding

• Little use for death benefits because of 5,000
  limit on income tax-free benefits
• Frequently used for short-term disability income
  benefits
• Long-term disability income is often self-funded
  by large employers. Catastrophic potential of
  claims makes its use difficult by small
  employers.
• Medical expense benefits are more likely to be
  self-funded as the size of the employer
  increases. The problem is predicting average
  severity.

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Stop-loss coverage

• Enables self-funding to be used when level of
  claims is difficult to predict
• Types Aggregate and Specific
• (Next slides)

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Aggregate Stop-loss

• Insurer bears aggregate dollar amount of claims
  that exceed some percentage of expected claims.
  120-140 percent is common.
• Improves cash flow
• Premium taxes paid on stop-loss premium only

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Specific Stop-loss

• There is a large deductible, usually per person
  per year.
• Insurer only responsible for claims in excess of
  deductible
• Large employers often have deductibles of 5,000
  to 10,000. Small employers may have deductibles
  in the 500 to 1,000 range.

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ASO contracts

• Purchase administrative services from insurer or
  an independent TPA.
• Any one service or several can be purchased.
• Claims payment is most often purchased. No
  responsibility for paying claims if employer's
  funds are insufficient.
• ASO contract is not an insurance contract and is
  not subject to premium taxes.
• If ASO contract provider is an insurer, it (for a
  fee) may provide conversion policy to employees.

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501(c)(9) trusts

• Often called VEBAs or voluntary employees'
  beneficiary associations. It is a trust
  established by an employer to pay benefits.
• Delete the rest of this chapter

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Advantages of VEBAs

• Employer can deduct payments to trust.
• Trust assets free of taxation
• More latitude for investing trust assets than if
  same funds held by insurer
• Can be used if a plan is contributory
• Latitude in funding. Employer can underfund in
  bad times and overfund in good times. However,
  no tax deduction is allowed if trust is
  overfunded.

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Disadvantages of VEBAs

• Expensive to establish and maintain
• Possibility of trust depletion by excessive
  claims. However, stop-loss coverage can be
  purchased.

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Requirements for VEBA establishment

• Membership in the trust must be persons who share
  a common employment-related bond. Can
  discriminate in favor of highly compensated
  individuals.
• Participation by employees must generally be
  voluntary.
• The trust may only provide eligible benefits.
• Death, medical, disability, legal, and
  unemployment benefits are acceptable.
• Retirement benefits and deferred compensation are
  among prohibited benefits.
• The sole purpose of trust must be to provide
  benefits to members.

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The trust must be controlled by one of following

• Its members
• Independent trustees (for example, a bank)
• Trustees or fiduciaries, some of whom are
  designed by, or on behalf of, its members

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Limitations on contributions

• Cannot exceed the sum of
• The qualified direct cost of the benefits
  provided for the taxable year, and
• Any permissible additions to a reserve. These
  are basically for claims that have been incurred
  but not paid.
• There are limitations on the benefits for which
  deductions are allowed. For example life
  insurance benefits on retired employees cannot
  exceed what is tax-free under Sec. 79.
• If an employer overfunds, excess contributions
  may be deductible in future years when
  contributions are below permissible limits.

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Potential tax consequences

• Earnings on reserve may be taxable if reserves
  are too high.
• An excise tax is payable if improper benefits are
  provided.