INTRODUCTION Employer-sponsored health insurance covers almost 159 million non-elderly US workers and their dependents,1 and employees and jobseekers alike view group health coverage as the single most important non-cash job-related benefit.2 The enactment of the Affordable Care Act (ACA) in 2010 led to a sharp increase in employers self-funding their group health plans, with the market tripling in size in the decade that followed.3 Large employers (e.g., with more than 500 employees) can, and for the most part do, self-fund their group medical coverage in a relatively efficient manner. Self-funding gives these groups transparency and a measure of control over plan design and operation. But because self-funding relies on the law of large numbers for its efficacy, it does not work well, or at all, for smaller employers. The latter must usually look to commercial group health insurance. For groups of 50 employees or less, this usually means the small group markets, which tend to be opaque and expensive. As overall, year-over-year spending on healthcare in the United States continues to outpace growth in real gross domestic product by wide margins, employers of all sizes continue to seek to make group health insurance coverage available to their employees at a reasonable cost. Group captive-funded medical stop-loss insurance offers a way for smaller employers (ranging, typically, from 50 to 500 or more employees) to obtain the full benefit of self-funding. Employers seeking to adopt these arrangements must, however, navigate a host of complex federal and state laws and regulations. Principally, these include the Employee Retirement Income Security Act (ERISA), the Internal Revenue Code (the Code), and the insurance laws of the various states in which they operate. This Special Report explains what group medical stop-loss captives are and how they are structured and regulated. It opens with a description of group captive structures and how group captives differ from other captive funding plans, programs and arrangements. It also includes a discussion of the criteria that an employer might apply to determine whether a group captive solution is appropriate. Then, it offers an overview of the applicable laws, regulations and other considerations that guide group captive formation, maintenance and operation. Finally, the report concludes with some practical recommendations for employers that either currently participate in, or are considering signing on to, a group captive arrangement. 1 KKF Employer Health Benefits Survey. Oct. 27, 2022, available at: https://www.kff.org/health-costs/report/2022-employer-health-benefits- survey/. 2 “12 Employee Benefits and Perks for Your Hiring and Retention Plan,” Robert Half Talent Solutions, available at: https://www.roberthalf.com/blog/compensation-and-benefits/10-top-perks-and-benefits-that-win-employees-over. 3 Phillip C. Giles, CEBS, Medical Stop-Loss Captives: A Comprehensive Overview, MSL Captive Solutions, Inc. SPECIAL REPORT Funding Employer-Sponsored Group Health Coverage: The Group Captive Solution 4 OVERVIEW Captive insurance is not new. In is most basic form, a “captive” is a subsidiary of an operating company formed to manage one (or more) particular risks, e.g., workers’ compensation, product liability, medical and other professional malpractice, etc. The operating company/parent retains the cost of covering the risk through the captive insurance company instead of paying premiums to a third-party insurer for commercial insurance.4 As insurance companies, captives may offer the tax advantages accorded insurance products under the Code. Not all captive structures need or even intend to benefit from the available tax leverage, however. The term “captive” insurer traditionally referred to a “single-parent” captive, which is a subsidiary of an operating company/parent that insures the risks of the operating company/parent and in some instances its affiliates. Single-parent captives may offer certain tax and risk-management advantages. Historically, single- parent captives insured property and casualty risks and workers’ compensation, but they have more recently been pressed into service to cover employee welfare plan risks.5 Where the covered risk involves ERISA- covered welfare benefits, such as group medical benefits, the ERISA prohibited transaction rules become a factor. These arrangements typically require an exemption from the US Department of Labor (DOL). Single-parent captives seek to leverage the tax rules governing insurance. Captives may be taxed as insurance companies owned by for-profit entities, which are ordinarily allowed a deduction for increases to reserves. The operating company that owns a single- parent captive may be able to deduct premiums paid to 4 For an excellent discussion of the principles underlying captive insurance, see Patricia Born, William T. Hold, A Comprehensive Evaluation of the Member-Owned Group Captive Option, published by The National Alliance Program in Risk Management and Insurance College of Business, Florida State University, April 2021. the captive as ordinary and necessary business expenses under Code §162. The captive thereupon includes the premiums in income, but it may take a deduction to the extent that the premium increases its reserves. In the absence of the captive structure, no deduction for reserves is allowed. Group captive arrangements are different. In contrast to a single-parent captive, a group captive is a legal entity owned by a group of unrelated companies, and it is formed to insure the risks of that group of unrelated, member companies. While single-parent captives are owned by a parent/operating company or are part of a group of companies or other entities under common control, group captives (or, sometimes, cells with an existing sponsored captive structure) are often rented. Under a fronting arrangement, the captive cell acts as a reinsurer rather than a direct insurer. Group-health captives are often managed by a non-risk- bearing “program manager,” which may be a benefits consultant, managing general underwriter, or other sponsor, organizer or promoter. The program manager provides, bundles or otherwise facilitates access to the various products and services required for captive- program maintenance and operation. These services include claims processing and adjudication, actuarial services, banking services, captive management, pharmacy benefits management, compliance and other, related services. A principal advantage of a group captive is the ability to distribute, annually, dividends that result from a favorable claims experience. In contrast to single- parent captives, group captives do not seek to build large reserves. In a sponsored group cell captive arrangement, a commercial stop-loss carrier underwrites the employee 5 DOL, Prohibited Transaction Exemption 2000–48. 65 Fed. Reg., p. 60452 (Oct. 11, 2000) (granting individual prohibited transaction exemption to Columbia Energy Group for long-term disability coverage). SPECIAL REPORT Funding Employer-Sponsored Group Health Coverage: The Group Captive Solution 5 health stop-loss risk in the first instance, and then transfers or “cedes” a portion of the risk under an “insurance treaty” to the captive cell owned by the participating employer. The commercial carrier is sometimes referred to as the “fronting” or “ceding” carrier, and the resulting stop-loss coverage is sometimes referred to as a “fronting” arrangement. Access to the commercial carrier’s paper is important with respect to licensing. Captive insurers are rarely licensed to transact insurance in each state in which the policyholder or insured risks are located. Under a fronting arrangement, the licensed commercial carrier is the primary underwriter of the risk. Fronting is not free, of course. There is administrative overhead and a risk charge that is passed on to the group captive and absorbed by participating employers. Group captives are owned by a group of unrelated member companies, and they are formed to insure the member-owners. Group captives are variously classified as heterogeneous or homogeneous. Heterogeneous programs are made up of employers in disparate industries, while homogeneous programs comprise employers in a single industry. In general, heterogeneous captives have a more diverse risk profile, which requires these groups to be larger than their homogeneous counterparts. It is common for program managers to establish multiple captives along industry lines for this very reason. Irrespective of the type of group, promoters also seek to recruit groups with good claims experience, thereby hedging claims volatility and reducing overall plan expenses, all with the goal of making available dividends to members each year (usually after a one-to-two-year lag). Certain questionable captive employee benefit arrangements have caught the attention of federal and state regulators. These include: • Low attachment points: A stop-loss insurer might offer insurance policies with attachment points set so low that the insurer assumes most of the employer’s claims risk. For example, the attachment point could be set at $5,000 per employee, or $100,000 for a small group. While a plan might purport to be self-funded under these circumstances, the arrangement functions much more like a fully insured, high-deductible health plan. The group captives that are the subject of this Special Report do not take this approach. • Micro-captives/abusive tax shelters: A micro- captive arrangement is one in which a taxpayer endeavors to reduce aggregate taxable income using a combination of an insurance contract and a captive insurance company. The taxpayer claims deductions for insurance premiums, and the captive insurance company elects to be taxed only on investment income, thereby excluding payments it directly or indirectly receives under the contracts from its taxable income. The IRS in Notice 2016-66 said that the way these contracts are interpreted, administered and applied is inconsistent with arm’s-length transactions and sound business practices. The group captives that are the subject of this Special Report do seek this sort of tax leverage. • Fully insured arrangements that include reinsurance: IRS Revenue Ruling 2014-15 describes and sanctions use of a captive to reinsure fully insured health benefits. The ruling describes an arrangement in which an employer makes contributions to a funded welfare trust to provide health benefits to certain retirees and their dependents. The trust then purchases insurance from a commercial carrier, which cedes a portion of the risk to a captive 100% owned by the employer. Thus, this arrangement is like a group captive, except that it is fully insured. It is also worth noting that the employer was required, as one of the conditions for approval of the arrangement, to obtain a prohibited transaction exemption from the DOL. The group captives that are the subject of this Special Report do not take this approach.
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