Now that the constitutionality of health care reform has been decided, insurers, employers and participants must all focus on complying with its onerous regulations. In December 2011, the United States Department of Health and Human Services (HHS) released final medical loss ratio (MLR) regulations which, among other requirements, require health insurers to provide rebates to policyholders for certain costs which are not spent on medical care.
Reports indicate that the rebates to employers and consumers will total as much as $1.3 billion, with the first rebates being issued by the insurers in August 2012. For employers and participants, realizing this benefit is not as simple as cashing a rebate check or receiving a discounted health insurance premium. The manner in which the rebates are distributed and handled are governed by fiduciary standards, and there are also noteworthy tax consequences with regard to the receipt and distribution of the rebates.
The substance of the MLR requirements can be found in Section 2718 of the Public Health Service Act, as amended by the Patient Protection and Affordable Care Act. The rationale behind the MLR requirements is that a majority of premiums for health insurance (85% for large-group plans and 80% for small-group or individual policies) should be spent on actual medical care, testing and research, rather than allocated to administrative, marketing and profit expenditures. Costs exceeding this ratio are to be reimbursed to policyholders in the form of cash rebates or reduced health insurance premiums. When HHS issued the final MLR regulations, the United States Department of Labor (DOL) and Internal Revenue Service (IRS) issued contemporaneous guidance on the fiduciary ramifications of rebate distributions as well as the tax consequences of the receipt and distribution of such rebates.
- Are MLR rebates plan assets?
A threshold issue for ERISA plans is whether MLR rebates constitute "plan assets" subject to ERISA's fiduciary rules. DOL guidance provides that MLR rebates are considered "plan assets" under ERISA if a plan has “a beneficial interest in the distribution under ordinary notions of property rights." This requires a careful analysis of the plan and the insurance policy. In the absence of any plan or policy language to the contrary, where the plan (or its trust, such as VEBA) is the policyholder, any rebates attributable to such policy will be considered "plan assets.” On the other hand, where the employer is the policyholder, and the insurance policy, together with other instruments governing the plan, can fairly be read to provide that some part or the entire MLR rebate belongs to the employer, then that language will generally govern, and the employer may retain the rebate.
If the policy and governing instruments are ambiguous, the DOL will look to the source of insurance premiums to determine whether the plan or the employer has a beneficial interest in the MLR rebate, as follows:
If the premium is paid entirely out of trust assets, or if participants pay the entire cost of plan premiums, then the entire amount of the MLR rebate is considered a plan asset;
If the employer pays the entire cost of insurance coverage, then none of the MLR rebate is considered a plan asset, and it may be retained by the employer; and
If the employer and participants each contribute a percentage of the premium, then the MLR rebate is a plan asset to the extent attributable to participant contributions and the balance is not a plan asset.
- If any portion of the MLR rebate is a plan asset, how must that portion be held?
ERISA generally requires plan assets to be held in trust or applied to pay insurance premiums. DOL’s MLR guidance contains specific directions on how plan fiduciaries can avoid the trust requirement for rebates. Employers can either (i) use the MLR rebates within three months of receipt to pay premiums or provide refunds to participants, or (ii) direct insurers to hold MLR rebates, such as in a premium stabilization reserve, to offset participants’ share of future premiums or to pay for benefit enhancements.
- What fiduciary requirements apply to distributions of MLR rebates?
Under ERISA, fiduciaries generally can use plan assets only to pay plan benefits and expenses and must act prudently with respect to a plan’s administration and operation. DOL has provided some helpful guidance on applying the ERISA fiduciary rules to MLR rebates:
- The fiduciary does not have to distribute the MLR rebate to former participants if the cost of distribution approximates the amount of the proceeds; instead, the fiduciary can allocate the rebate among current participants if the allocation method is reasonable, fair and objective.
- The fiduciary may use the rebate for other permissible plan purposes, including applying the rebate toward participants’ future premium payments or benefit enhancements if the amount of the rebate would be de minimis or have tax consequences for participants.
- The fiduciary should ensure any MLR rebates treated as plan assets benefit the participants and beneficiaries covered by the policy that generated the rebate.
Income Tax Considerations
For individuals who purchase insurance on the individual market, MLR rebates will be subject to federal income tax only if the individual took a tax deduction for the premium payments on his or her tax return for the previous year. For participants in group health plans that receive a MLR rebate benefit (whether in the form of decreased premiums or cash rebates), the taxation of such benefits will depend on whether the participant paid his/her portion of the premium on a pre-tax or after-tax basis.
- Pre-tax payments
Participants who pay for their health coverage through a qualified pre-tax cafeteria plan will have to pay taxes on the rebate benefit. For participants who receive a cash rebate, it will be subject to federal income and employment taxes when paid to the participant. For participants who receive reduced premiums, the amount of the reduction will result in a corresponding increase in taxable compensation.
- After-tax payments
Participants who pay for their health coverage premiums with after-tax dollars have already paid taxes on the insurance benefit, and thus will not have to pay taxes on rebates attributable to such benefit. Premium reductions are treated similarly for after-tax premium payments in the prior year, and are not subject to income tax. The only situation where a cash rebate or reduction in premium could be taxable is where the premium was paid with after-tax dollars and deducted as a medical expense on the participant’s tax return in the prior year.
As insurers begin to issue MLR rebates in August 2012, there are a few key considerations employers should keep in mind. A detailed review of plan documents and insurance arrangements is required to determine if rebates are addressed and to fully understand the employer’s obligations once they receive the rebates. If the documents do not address rebates, employers may want to consider amendments to carefully spell out how rebates will be handled. Insurers will also be notifying participants individually about the rebate. Employers should be prepared for participant questions about their rights, whether they will receive a rebate, and the tax consequences of such rebates. By proactively addressing such issues and understanding potential issues raised as discussed by the DOL and IRS guidelines, employers will be well-prepared for one of the first waves of health care reform.