In this section we elaborate on the following insurance aspects of employee benefits:
- Administration of group insurance
- Ways of providing group insurance
- How premiums are paid
- Key underwriting determinants for placing a group insurance program and for pricing a group insurance program
- Cost advantages of group coverage
- Cost features of group coverage
- Tax treatment of payments and benefits
Individuals receive economic security from individually purchased insurance and from group insurance. Both types of coverage may provide protection against economic loss caused by death, disability, or sickness. To the covered person, the differences between the two types of coverage (shown in Table 20.2) may not be noticeable.
|Individual Insurance Contract
|Group Insurance Contract
|Issued to the person insured
|Master contract issued to employer or a trust; each employee is issued a certificate of insurance (not a contract)
|Evidence of insurability
|Characteristic of the group to minimize adverse selection and administrative costs
|At inception of contract
|Related to employment periods
|Experience of the insurance company
|Experience of the large group
The administration of group insurance differs from individual insurance because the contract is made with the employer rather than with each individual. The employer receives a master contract that describes all the terms and conditions of the group policy. The employer, in turn, provides each insured employee with a certificate of insurance as evidence of participation. Participants in the benefit plan may include employees, their dependents (including a spouse and children under a specified age, such as twenty-one, when enrolled in school), retirees, and their dependents. Participants receive a booklet describing the plan, distributed by the employer at the time the plan goes into effect or when eligibility begins, whichever is later.
Administration of group insurance also differs from individual insurance because the employer may be responsible for the record keeping ordinarily done by the insurer, especially if the group is large. Administration is simplified by the employer paying periodic premiums directly to the insurer. If employees are required to contribute toward the premium, the employer is responsible for collection or payroll deduction of employee contributions, as well as for payment to the insurer of the total group premium amount.
Many large employer plans are self-insured, and employers, rather than insurers, pay claims and bear the risk that actual claims will exceed expected claims. Some employers with self-insured plans also administer the benefits themselves. However, insurers and third-party administrators (TPAs) administer many (even large) self-funded plans under an administrative services only (ASO) contract. The employer transfers record keeping and claim payment functions to the insurer or TPA, paying about 5 to 10 percent of the normal premium for administrative services.
In addition, the employer may purchase stop-loss insurance from the same or another insurer through the TPA for protection against unexpectedly high claims. Stop-loss coverage is a form of reinsurance or excess insurance for self-insured plans. The two basic forms of coverage are specific stop loss, in which a limit is set per claim, and aggregate stop loss, in which a limit is set for the total claims in a year. The insurer reimburses the employer for claim amounts above the limit, also called the attachment point. Purchase of an ASO contract and stop-loss insurance gives the employer the potential cash flow and expense advantage of self-funding, while reducing the employer’s administrative burden and potential for catastrophic risk.
Individually purchased life and health insurance contracts involve individual underwriting. The purchaser files an application and, in some cases, takes a medical examination. On the basis of this and other information, the underwriter decides whether or not to issue insurance, and on what terms. The merits of each application are decided individually. Group underwriting does not involve an application to the insurer by each participant, or a medical examination (except in some very small employer groups). The group as a whole is being underwritten. The employer makes one application for the entire group and, instead of selecting individual insureds, the insurer makes an underwriting decision based on group characteristics.
Characteristics of the Group as Key Underwriting Determinants
Reason for the Group’s Existence
It is imperative that the group was not created for insurance purposes. Insurance should be incidental to the group’s formation. Under state laws, the following are eligible groups for group insurance:
- Individual employer groups
- Negotiated trusteeships
- Trade associations
- Labor union groups
- Multiple-employer trusts (METs) or multiple-employer welfare arrangements
Some, mostly smaller, employers may have trouble finding an insurance carrier willing to service their group if one or more individuals are in ill health. Many of these firms, however, have access to group insurance by participating in a multiple-employer trust (MET). The MET makes available to small employers, often in the same industry group and with as few as one or two employees each, benefits similar to those available to large groups. METs are often organized for a trade association, union, or other sponsoring organization by an insurer or third-party administrator. When small employers come together through a MET to purchase insurance, they have access to group underwriting treatment, products, and services similar to those available to large employers.
Financial Stability of the Employer
Insurers prefer to work with firms that will exist from year to year and be able to pay the premium. Because the cash flow is very fast in group insurance such as health insurance, financial stability is critical to underwriters accepting the business. This requirement is really fundamental to all types of underwriting, not only group underwriting.
Your Employer’s Bankruptcy: How Will It Affect Your Employee Benefits?
The Department of Labor’s Employee Benefits Security Administration (EBSA) administers the Employee Retirement Income Security Act (ERISA) of 1974, which governs retirement plans (including profit sharing and 401(k) plans) and welfare plans (including health, disability, and life insurance plans). ERISA also includes the health coverage continuation and accessibility provisions of the Consolidated Omnibus Budget Reconciliation Act (COBRA) and the Health Insurance Portability and Accountability Act (HIPAA).
EBSA educates and assists the nation’s 200 million participants and beneficiaries in pension, health, and other employee benefit plans and the more than 3 million sponsors of those plans. In carrying out its responsibility to protect participants’ and beneficiaries’ benefits, EBSA has targeted populations of plan participants who are potentially exposed to the greatest risk of loss. One such group of individuals is the group of participants and beneficiaries of plans whose sponsor has filed for bankruptcy. In such cases, EBSA provides the following.
If an employer declares bankruptcy, it will generally take one of two forms: reorganization under "11: Property Risk Management" of the Bankruptcy Code or liquidation under "7: Insurance Operations". A "11: Property Risk Management" (reorganization) usually means that the company continues in business under the court’s protection while attempting to reorganize its financial affairs. A "11: Property Risk Management" bankruptcy may or may not affect your pension or health plan. In some cases, plans continue to exist throughout the reorganization process. In a "7: Insurance Operations" bankruptcy, the company liquidates its assets to pay its creditors and ceases to exist. Therefore, it is likely your pension and health plans will be terminated. When your employer files for bankruptcy, you should contact the administrator of each plan or your union representative (if you are represented by a union) to request an explanation of the status of your plan or benefits. The summary plan description will tell how to get in touch with the plan administrator. Questions that you may want to ask include the following:
- Will the plan continue or will it be terminated?
- Who will act as plan administrator of the health and pension plans during and after the bankruptcy, and who will be the trustee in charge of the pension plan?
- If the pension plan is to be terminated, how will accrued benefits be paid?
- Will COBRA continuation coverage be offered to terminated employees?
- If the health plan is to be terminated, how will outstanding health claims be paid, and when will certificates of creditable coverage (showing, among other things, the dates of enrollment in your employer’s health plan) be issued?
Prior Experience of the Plan
This factor is important not only in accepting a group for coverage but also in pricing the group plan. Insurers look at past losses—the frequency, severity, and length of illnesses or disabilities—when deciding whether to accept a business and then how to price it. Pricing factors will be discussed later in this section.
Size of the Group
As you recall from the first two chapters of this text, the law of large numbers is very important to the functioning of insurance. Therefore, large groups can be rated on their own experience, while small groups have to be rated based on the insurer’s experience with groups of similar type and size.
Source and Method of Premium Payment
Insurance laws may require that a minimum percentage of the group be enrolled in the benefit plan to ensure that there are enough healthy employees and dependents to help offset the high claims that can be expected from unhealthy employees or dependents. Every group, insured or self-insured, can anticipate enrollment by the unhealthy. The likelihood of achieving minimum participation (meaning at least 75 percent) is increased by employer sharing of costs. Most states and insurers require that noncontributory plans, in which employees do not pay for the cost of their coverage, enroll 100 percent of employees. In contributory plans, where employees pay all or part of the premium amount, 75 percent of employees must participate. This helps protect the plan from adverse selection.
Stability of the Group
To avoid the problems associated with high employee turnover, employers use waiting periods or probationary periods before insurance coverage begins. There are some advantages to turnover, however; for one, the age composition does not get older when more new employees join the plan.
Persistency of the Group
Group business is costly for the insurer in the first year. An employer that changes carriers every year is an undesirable client. Insurers look for a more permanent relationship with employers.
Method of Determining Benefits
To avoid adverse selection, employers are required under nondiscrimination laws to offer the same benefits package to all employees. In reality, many groups provide flexible benefit programs, which allow employee input into the amount of each benefit, and supplemental plans, which allow employees to purchase additional amounts of a specific benefit on a fully contributory basis. These options undoubtedly invite adverse selection, which is reflected in higher rates for flexible and supplemental benefits. However, given the diversity in needs among single, married, divorced, younger, older, male, and female employees in the typical group, the advantages of giving employees a voice in benefit decisions may well outweigh the cost of some adverse selection. Flexible benefit programs, also known as cafeteria plans, are discussed later in this chapter.
Supplemental plans allow employees to choose additional group insurance coverage paid for entirely by the employees themselves. For example, supplemental life coverage can allow an employee to increase the face amount of group life insurance coverage, and supplemental group disability coverage can allow for a cost-of-living benefit increase for periods of long-term disability. In recent years, the use of supplemental plans has grown, largely due to the flexibility they provide to employees at little or no cost to employers, other than facilitating the payroll deductions.
The potential for adverse selection may be greater with supplemental benefits than with nonsupplemental benefits. Because employees pay the premium for supplemental coverage, it is likely that those who anticipate that they need the benefit are more willing to participate. Despite this, supplemental plans are popular because they allow employees to tailor benefits to meet their individual needs through a convenient payroll deduction plan.
Provisions for Determining Eligibility
Generally, employees are first eligible for benefits either immediately upon hiring or following a three- to six-month probationary period. Following hiring or the probationary period (whichever the employer requires), the employee’s eligibility period usually extends for thirty-one days, during which employees may sign up for group insurance coverage. This period is called open enrollment. In order for coverage to become effective, most group plans require that the employee be actively at work on the day that coverage would normally become effective. Being at work provides some evidence of good health and helps reduce adverse selection.
Enrollment after the eligibility period usually means that the employee will have to provide evidence of insurability. The employee may have to complete a questionnaire or have a medical examination to show that he or she is in good health. This provision helps reduce adverse selection. Most employers allow only full-time employees to participate in the benefit plan. (The definition of full-time differs from employer to employer; the minimum may be as low as twenty hours per week, but it is more often thirty-two to thirty-five hours). To lower adverse selection, part-time employees are not included (some part-time employees join the work force only for the benefits). Some employers provide minimal benefits for part-time employees, such as burial cost only instead of full death benefits.
The most important part of this requirement is to what extent the employer plans to help in the enrollment and claims process.
Some employers pay the entire cost of the group insurance premium. These are noncontributory plans. In contributory plans, employees pay part of the cost. Frequently, group life and disability insurance plans are noncontributory, but they require the employees to contribute if other family members are covered. Health insurance is more likely to be contributory because of rising premiums, a situation described in the box “What Is the Tradeoff between Health Care Cost and Benefits?” in "22: Employment and Individual Health Risk Management". The employer makes the premium payment to the insurer; contributory amounts, if any, are deducted from the employee’s paycheck.
Important factors in underwriting for pricing are (1) the age and gender composition of the group, (2) the industry represented by the group, and (3) the geographical location of the group.
Group insurance is usually less expensive than individual insurance for several reasons: (1) with group coverage, the insurer deals with one insured instead of many, streamlining marketing costs; (2) the employer takes care of much of the administrative detail; (3) commission scales on group business are lower than they are on individual policies; (4) medical examinations are not needed because the employees are at least healthy enough to work; (5) the employer collects the premiums and pays the insurer in one lump sum, which is more efficient for the insurer; and (6) the employer often does some monitoring to eliminate false or unnecessary claims for health care benefits. In addition, group insurance theory maintains that the replacement by younger employees of employees who retire or quit keeps average mortality and morbidity rates from rising to prohibitive levels. That is, a flow of persons through the group tends to keep average costs down. This is often true when the number of employees in a group is growing, but it is less true for an organization that is downsizing.
Group life and health insurance rates are usually quoted by insurers as one monthly rate (e.g., $0.15 per $1,000 of coverage in the case of life insurance) for all employees. This rate is based on a weighted average, taking into account the age, sex, and accompanying mortality and morbidity rates for each employee in the group. Because mortality and morbidity rates increase with age, life insurance rates are quoted in age brackets. Someone in the thirty-one to thirty-five age bracket will pay slightly more than someone in the the twenty-six to thirty bracket. Thus, groups with a higher proportion of older people will have relatively higher premiums.
Most small organizations (e.g., those with fewer than fifty employees) have their entire premium based on pooled claims experience for similar-size firms. However, larger employers are likely to have experience-rated premiums in which the group’s own claims experience affects the cost of coverage, as described in "16: Risks Related to the Job - Workers’ Compensation and Unemployment Compensation" for worker’s compensation. Experience rating allows employer groups to benefit directly from their own good claims experience, and it provides a direct economic incentive for risk managers to control claims.
With experience rating, the weight or credibility given to a group’s own experience increases with the number of participants. The experience of smaller groups (e.g., those with fewer than 500 or 1,000 employees) is not considered sufficiently statistically credible or reliable to determine premiums completely. Therefore, insurers use a weighted average of the group’s loss experience and the pooled experience for groups of similar size and characteristics in developing the claims charge. For example, the group’s actual loss experience may be weighted at 70 percent of the claims charge, and the pooled experience for groups of similar attributes may carry a weight of 30 percent. If the group had a loss experience of $80,000 and the pool experience was $100,000, then the claims charge for the experience-rated premium would be $86,000 per year. A larger group would have more statistically reliable experience and might receive an 80 percent weighting for its own experience and a 20 percent weighting for the pooled experience, resulting in a claims charge of $84,000. Thus, the larger the group, the more credit the group receives for its own claims experience. The experience-rated claims charge makes up the bulk of the total premium due, but the final experience-rated premium also includes administrative charges and fees.
Premiums for larger organizations, however, may reflect only the group’s own loss experience. With prospective experience rating, the group’s claims experience for the previous few years, plus an inflation factor, partly or completely determines the premium for the current year. A retrospective experience rating plan uses loss experience to determine whether premium refunds (or dividends) should be paid at the end of each policy year.
Group insurance premiums paid by the employer are a deductible business expense and are not taxable income to employees except for amounts of term life insurance in excess of $50,000 per person and all group property-liability insurance. Employee premium contributions are not tax deductible, except if they are allowed to be used in a cafeteria program under a premium conversion plan or flexible spending account (FSA), discussed later in this chapter. The other tax-sheltered accounts available under health savings account (HSA) plans are discussed in "22: Employment and Individual Health Risk Management". Proceeds paid from group life insurance at death are not taxable income to the beneficiary, as noted in "19: Mortality Risk Management - Individual Life Insurance and Group Life Insurance", but are included in the estate of the insured, if he or she is the owner, for federal estate tax purposes.
Group disability insurance (discussed in "22: Employment and Individual Health Risk Management") premiums paid by the employer are also a deductible business expense for the employer, and they do not result in an immediate tax liability for the employee. If an employee receives disability benefits, the portion paid for by the employer is taxable to the employee. For example, if the employer pays one-third of the premium amount for disability coverage, and if the employee becomes disabled and receives benefits, one-third of the benefits are taxable income to the employee. Benefits attributable to coverage paid for by the employee with after-tax dollars are not taxable. Thus, in this example, two-thirds of the disability benefit amount would not be taxable income. Explaining taxation of disability income to employees can be a challenge for the benefits manager. However, many employers are successful in conveying the importance of after-tax premium payment to the level of benefits if disability occurs. The tax savings on the premiums are very small relative to the tax savings on the disability benefits.
Ten Warning Signs That Pension Contributions Are Being Misused
Increasingly, employees are asked to make voluntary or mandatory contributions to retirement and other benefit plans. This is particularly true for 401(k) savings plans (as will be discussed in "21: Employment-Based and Individual Longevity Risk Management"). These plans allow you to deduct from your paycheck a portion of pretax income every year, invest it, and pay no taxes on those contributions until the money is withdrawn at retirement.
An antifraud campaign by the Department of Labor uncovered a small fraction of employers who abused employee contributions by either using the money for corporate purposes or holding on to the money too long. Here are ten warning signs that your pension contributions are being misused.
- Your 401(k) or individual account statement is consistently late or comes at irregular intervals.
- Your account balance does not appear to be accurate.
- Your employer failed to transmit your contribution to the plan on a timely basis.
- You notice a significant drop in account balance that cannot be explained by normal market ups and downs.
- Your 401(k) or individual account statement does not reflect a contribution from your paycheck.
- Investments listed on your statement are not what you authorized.
- Former employees are having trouble getting their benefits paid on time or in the correct amounts.
- You notice unusual transactions, such as a loan to the employer, a corporate officer, or one of the plan trustees.
- Investment managers or consultants change frequently and without explanation.
- Your employer has recently experienced severe financial difficulty.
If you think the plan trustees or others responsible for investing your pension money have been violating the rules, you should call or write the nearest field office of the U.S. Department of Labor’s Employee Benefits Security Administration (EBSA). The Labor Department has authority to investigate complaints of fund mismanagement. If an investigation reveals wrongdoing, the department can take action to correct the violation, including asking a court to compel plan trustees and others to put money back in the plan. Courts can also impose penalties of up to 20 percent of the recovered amount and bar individuals from serving as trustees and plan money managers.
If you suspect that individuals providing services to the plans have gotten loans or otherwise taken advantage of their relationship to the plan, the Employee Plans Division of the Internal Revenue Service may want to take a closer look. The Internal Revenue Service is authorized to impose tax penalties on people involved in unlawful party-in-interest transactions.
Cases of embezzlement or stealing of pension money, kickbacks, or extortion should be referred to the Federal Bureau of Investigation or the Labor Department field office in your area. If illegal activities are discovered, the case can be referred to the U.S. Department of Justice for prosecution. Criminal penalties can include fines or prison sentences, or both.
Federal pension law makes it unlawful for employers to fire or otherwise retaliate against employees who provide the government with information about their pension funds’ investment practices.
Sources: Portions reprinted from “10 Warning Signs,” U.S. Department of Labor, Employee Benefits Security Administration, www.dol.gov/ebsa/publications/10warningsigns.html, accessed April 12, 2009; “What You Should Know About Your Retirement Plan,” a handbook from the U.S. Department of Labor, at www.dol.gov/ebsa/publications/wyskapr.html, accessed April 12, 2009. This booklet is available online. You can find explanation of all qualified retirement plans discussed in this chapter.
In this section you studied the following:
- Employers handle many administrative aspects of group insurance that are normally dealt with by insurers.
- Employers may purchase group insurance from a private insurer or they may self-insure programs.
- Employers and employees may share in the cost of insurance premiums, and it is an important underwriting issue.
- Key underwriting determinants of accepting a group for insurance and pricing the group insurance include the reason for the group’s existence, the employer’s financial stability and persistency, prior experience of the plan, the size of the group, the source and/or method of premium payment, stability of the group, eligibility provisions, geographical location, industry, and employees mix.
- Group insurance is less expensive than individual insurance due to streamlined marketing costs, employer responsibilities, and lack of medical examinations.
- Monthly life and health insurance rates in group plans are weighted to account for age, sex, mortality, and morbidity features of employees in the group.
- Large employers can pay experience-rated premiums based on employer’s own experience.
- Group health insurance premiums paid by the employer are tax deductible and not taxable income to employees; benefits are not taxable to the employees as well.
- Employee premium contributions are not tax deductible unless they are used in cafeteria plans under premium conversion arrangements or flexible spending accounts.
- Benefits attributable to coverage paid for by employees with after-tax dollars are not taxable.
- What is the difference between the probationary period and the eligibility period in group insurance?
- What factors do underwriters consider when accepting an employer group plan?
- Describe several group insurance underwriting requirements that reduce the potential for adverse selection.
- What are the factors for pricing a group plan?
- Why might a large employer self-insure?
- How do employers protect themselves from the risk of catastrophic financial loss when they self-insure a benefits program?
- Under what circumstances are benefits that are received by employees under a group arrangement considered taxable income?