Defined Contribution Health Insurance

Policy Backgrounders | Health

No. 154
Thursday, October 26, 2000
by Greg Scandlen


Regulatory Obstacles

While the tax code seems favorable to a Defined Contribution approach, other sections of federal law create severe obstacles. The essential concept of Defined Contribution is not only that employers will have better control over their health care costs, but also that employees will be able to control the resources available to them.

Employee resources may include an employer contribution, of course, but may also include their own funds, federal and state tax advantages, funds from a spouse or a spouse's employer, in some cases direct payments from government programs or charitable organizations and refundable tax credits.

Defined Contribution assumes that the worker can merge all those resources into a single package and purchase coverage in keeping with his or her values and priorities. Some workers are more comfortable with risk than others. Some have greater family responsibilities. Some have different health care needs.

"Two federal laws - ERISA and HIPAA - present problems in switching to Defined Contributions."

Defined Contribution also is intended to solve the problems of portability and accountability. As with pension programs, Defined Contribution in health care means that workers "own" their own policies. They no longer "borrow" the coverage from their employer or lose it once the employment stops. The worker, not the employer, controls how funds are invested - in this case, in a health program rather than a retirement fund. As with 401(k) retirement accounts, workers and health insurers may want to enter into a long-term contract for coverage. The insurer would be able to reduce its marketing costs, and the worker would have continuity of coverage without fear of annual renewal decisions. Defined Contribution implies health coverage that is "personal and portable."

A Defined Contribution environment would be initiated and partly supported by the employer, but the coverage would be individualized to the needs and resources of each worker. Unfortunately, federal and state law chops the insurance market into discrete markets, with very different rules for each. Substantially different rules apply to individual (also referred to as "nongroup" coverage), small group, and large group insurance. Some laws cut across even these categories. Some apply only to groups with at least 20 or 25 employees, while others apply only to groups with fewer than 50 employees.

Two federal laws present particular problems in switching to Defined Contribution: the Employee Retirement Income Security Act of 1974 (ERISA) and the Health Insurance Portability and Accountability Act of 1996 (HIPAA).

ERISA. ERISA - the Employee Retirement Income Security Act of 1974 - may be one of the most widely misunderstood laws on the books.34 ERISA governs "employee welfare benefit plans," which are defined as: "(A)ny plan, fund or program...established or maintained by an employer or by an employee organization...for the purpose of providing for its participants or their beneficiaries, through the purchase of insurance or otherwise, medical, surgical, or hospital care or benefits, or benefits in the event of sickness, accident, disability, death, or unemployment."35 This definition applies to all employers, regardless of size, whether they acquire benefits through an insurance company or provide them directly. The only exceptions are church and government plans.36

While nothing is ever certain until the Supreme Court says it is so, a Defined Contribution system clearly would be a "program...established... by an employer...for the purpose of providing...medical, surgical, or hospital care or benefits." It is, therefore, an "employee welfare benefits plan," subject to ERISA.

HIPAA. ERISA regulations are minimal, mostly involving plan disclosure and reporting and fiduciary responsibilities. HIPAA - the Health Insurance Portability and Accountability Act of 1996 - is another story. HIPAA was written as an amendment to ERISA, and so takes ERISA's definitions as its starting place. For example, a "group health plan" is defined in HIPAA as "an employee welfare benefit plan to the extent that the plan provides medical care...to employees...directly, or through insurance, reimbursement, or otherwise."37

"Despite having 'Portability' in its title, HIPAA does not deal with portability at all."

Briefly, HIPAA requires that insurers "guarantee issue" all products available in the small group market, limit the waiting period for preexisting condition coverage, and credit prior coverage towards the waiting period.38 An insurer may set premiums according to a group's experience, but may not vary premiums for individuals within the group based on health status. Presumably, premiums may be varied for "similarly situated" individuals, based on demographic factors other than "health status" such as age, sex, geography and participation in health promotion programs.39

HIPAA also requires states to enable certain eligible individuals leaving group coverage to join an individual plan without new underwriting. States may do so in a variety of ways, including mandatory guaranteed issue of individual coverage, requirements that insurers offer some limited guaranteed issue plans, enrollment in a state high-risk pool, or states can default to federal regulation if they fail to act. To be eligible, an individual must have had 18 months of prior group coverage with no gaps longer than 62 days and must have exhausted any COBRA continuation opportunities.

Despite its name, HIPAA does not deal with "portability" at all. It does not provide for individual plan ownership, or allow workers to keep their coverage when they change jobs. HIPAA in fact locks in the employer as the locus of coverage. It is solely the employer who decides what kind of coverage to purchase and what sort of benefits will be covered. All HIPAA does is limit the ability of employers and insurers to medically underwrite new enrollees.

"True Defined Contribution appears to be impossible under current law."

HIPAA's guaranteed issue provisions may have increased instability in the market by providing a perverse incentive for the smallest employers to enter and exit the market as the needs of their employees change. Since every carrier must offer all their products to all employers, it is easy for an employer to purchase rich benefits during times of special need and drop coverage or go to a cheaper plan when the need passes.

HIPAA also makes Defined Contribution difficult by reinforcing the wall of separation between "group" and "individual" insurance. This is a meaningless distinction at best. When a worker purchases health insurance coverage, the money must come from somewhere, presumably from his job - the same source as if the employer purchased the coverage on his behalf. There is only one difference: when the employer buys it, there is a huge tax advantage amounting, on average, to 40% of the cost of the coverage. Other state and federal regulations controlling individual, small group and large group health insurance are substantially different as well.

Thus, to own their own policies and take the coverage with them from job to job, individual workers must have "nongroup" coverage. But if an employer contributes to the cost of the premium, and the employee wants to enjoy the exclusion from taxes, the coverage is defined as "group." So, true Defined Contribution appears to be impossible under current law.

Two caveats should be noted here:

  1. A few companies are exploring other sections of the tax and benefits laws for creative ways of making Defined Contribution possible. One firm is looking at using a "dual purpose profit-sharing program," possibly in combination with a voluntary employees benefit association (VEBA or 501(c)9). This may enable employees to withdraw profit-sharing funds on a tax-free basis to purchase health insurance or health care services. Another company believes it can use a combination of Section 125 and Section 105 to create tax-advantaged "personal care accounts" in which unused funds may roll over to pay for future health care expenses. These or other approaches may be perfectly legal and achievable, but most employers will probably not rush to embrace them until it is well established that the product falls comfortably within existing laws and regulations. As with 401(k)s, the first firms to package and market such a new approach may be very successful indeed.
  2. There is a widespread and growing consensus in Congress that refundable tax credits are one way to level the playing field between employer and individual insurance, and to encourage more people whose employers do not offer coverage to purchase insurance. If a tax credit were substantial enough - equaling at least 40% of premium cost - some employers might decide to stop offering coverage and let their employees purchase insurance on the individual market. Such a credit would be identical to the existing tax advantage provided to employer-based coverage, except it would be more fair to lower-income employees. The main problem would be that some workers might ignore the 40% subsidy and still prefer to spend the money elsewhere. To address this concern, Congress could include a provision that enables employers to set aside a sum of money that could be used solely for health care costs. Doing this would create an almost perfect Defined Contribution scenario.

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