To self-insure or not, that is the question

If yes, sponsors bear greater financial liability

Among the many challenges facing HR departments, one of the most common and challenging is how to rein in the rising costs of employee benefits.

In 2005, once again, group benefit plan renewals have been characterized by double-digit health and dental inflation and utilization factors.

With health and dental benefits representing the lion’s share of group benefit costs — anywhere from 60 to 80 per cent — and group benefit plans costing up to eight per cent of payroll, organizations are increasingly compelled to look for ways to reduce these mounting costs.

While most have opted to make changes in plan designs and introduce cost-sharing arrangements, others are exploring the option of changing their funding arrangement and are asking themselves, “Should we insure or self-insure?”

What does it mean to self-insure?

Self-insured benefits are also known as self-funded or ASO benefits — administrative services only. In this type of funding arrangement, an organization contracts with an insurance company or a third-party administrator to adjudicate and pay group benefit claims on its behalf — hence, administrative services only.

In an insured arrangement, the financial liability for benefit payments rests solely with the insurance company and the risk is fully borne by the insurance company. Both the financial liability and risk are completely transferred to the plan sponsor on an ASO basis.

Why self-insure?

Historically, organizations going the self-insured route have been motivated to do so by cost savings from the elimination of premium tax, which only applied to insured plans.

However, in Ontario, Quebec and Newfoundland, this cost advantage disappeared in the 1990s when those governments introduced premium taxes on group benefit plans regardless of funding basis.

Depending on the province or jurisdiction, savings from the elimination of premium tax range from two per cent to 3.5 per cent of the plan’s net premium (premium less any refund).

Another source of savings is the elimination of risk charges since the organization now bears the risk. Depending on the type of benefit and the size of the plan, this option has the potential to save an organization anywhere from 0.5 per cent to two per cent of the plan’s premium.

Lastly, there’s the elimination of the insurance company’s requirement to hold reserves such as the Incurred But Not Reported (IBNR) reserves, and Claims Fluctuation Reserves (CFR).

There is currently no legislation that requires organizations that are self-insuring to fund “reserves” and so the freed up funds can be used for whatever purpose the organization wants.

Should an organization set aside funds in reserve, there is still an advantage in that it still holds total control over what investment vehicle to use, which would have otherwise been dictated by the insurance company in an insured arrangement.

Although elimination of insurance company reserves may be attractive to some plan sponsors, moving to ASO funding is not the only means to this end.

Even in an insured arrangement, IBNR reserves could be eliminated depending on the benefit (typically for health and dental benefits only) and the size of the plan.

This may be done under a “Hold Harmless Agreement” whereby the insurance company is indemnified by the organization for any liability associated with claims incurred but not reported upon the termination of the plan. In absence of these reserves, insurance companies normally introduce a cost of capital charge or increase the risk charge.

What can be self-insured?

The most common self-insured benefits are short-term disability, health and dental benefits. These claims are relatively less costly than life and long-term disability (LTD). Short-term, health and dental benefits also occur more frequently, are more predictable and, therefore, more manageable for organizations in terms of risk.

In rare circumstances, basic life and LTD benefits are also self-insured by very large organizations.

For protection against infrequent but potentially huge high-dollar claims such as out-of-Canada hospital and physician fees or catastrophic drug claims, organizations should consider stop loss arrangements with insurance companies.

This may be in the form of an individual high amount pooling (HAP) or an aggregate stop loss pooling. HAP is an arrangement where claims of an individual plan member in excess of a predetermined amount in any given contract year are removed from the experience of the plan and, therefore, do not form part of the organization’s financial responsibility.

An aggregate stop loss arrangement is one where total claims for the organization in a particular benefit line exceed a predetermined percentage of deposits or expected claims, and the excess claims above this percentage are removed and are no longer the financial responsibility of the organization.

For these arrangements, the insurance company levies a pooling charge, which varies depending on the type and level of pooling, and is typically based solely on the insurance company’s book of business experience. In exchange for this pooling charge, any claims in excess of the predetermined HAP or aggregate stop loss level become the responsibility of the insurance company and are, therefore, not included for ASO rate-setting and financial accounting purposes. This helps limit the risk, which is particularly helpful for organizations that do not want an open-ended liability.

With the infrequency of death claims and wide variations in life insurance amounts, predictability becomes difficult and, therefore, risk is also harder to manage. In addition, amounts in excess of $10,000 are taxable in the hands of beneficiaries. These considerations normally outweigh the cost advantages of self-insuring life benefits.

Similarly, predictability is a challenge for LTD benefits. Even when claims are rampant, duration of claims may be difficult to predict. This type of benefit creates financial liability that could go on for years, up to when the disabled plan member turns 65, if the plan is so designed.

In the wake of Jetsgo’s bankruptcy, one cannot help but be wary about an organization’s ability to take on such a liability that could potentially leave disabled plan members exposed without any recourse. And, in fact, this exact predicament transpired with Massey Combines Corp., which went into receivership in 1988, and Eaton’s declaration of bankruptcy 10 years later.

With this in mind, Alberta was first to introduce changes to regulate self-insured disability benefits. According to changes to its Insurance Act and Regulations enforced in September 2001 and amended two years later, regardless of the province or jurisdiction where the plan was established, plans that cover Alberta residents for disability benefits must disclose to plan members that the benefits are not underwritten by an insurer and that the benefits would be payable from the net income or retained earnings of the organization. In addition, self-insured disability benefits for Alberta residents may not include a death benefit payable provision.

Who can self-insure?

With the financial implications that come with ASO benefits, it is not surprising that not all organizations can self-insure. When considering ASO benefits, the financial stability of the organization is paramount. Each insurance company has underwriting guidelines that include a minimum annual premium that a plan should generate before it agrees to offer benefits on an ASO basis.

This minimum ranges from $150,000 to $500,000 depending on the insurance company, and the type and combination of benefits to be self-insured.

Equally important is the stability of the organization’s infrastructure. The predictability of claims is critical to managing the risk and, therefore, an organization that expects significant growth, downsizing, relocation, expansion or diversification should consider waiting until it is stable before switching to an ASO basis.

Organizations that are stable, but subject to tighter fiscal constraints, should think twice before self-insuring. On a pure or conventional ASO basis, the amount of deposits — cost of claims plus expenses to adjudicate and pay claims — fluctuate from month to month. Yet, this may be mitigated by entering into a budgeted ASO arrangement, whereby the insurance company charges monthly rates similar to monthly premium rates to generate monthly receivables equivalent to its expected average monthly claims plus expenses over a 12-month period.

Alternatively, the expected annual amount of claims plus expenses may be equally divided over 12 months to calculate a level monthly deposit regardless of the number of plan members each month.

Should your organization self-insure?

With limited amount of words and space, it is impossible to discuss all areas that should be considered when an organization is thinking of self-insuring, however, this article should provide the essentials. A closing thought — perhaps the more germane question is simply what is your organization’s tolerance for risk?

Riza Sychangco is a senior consultant in Toronto and Art Babcock is a vice-president in Edmonton with Aon Consulting’s Health Strategies Practice. Riza can be reached at [email protected] and Art can be reached at [email protected].

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