Lately, the Affordable Care Act and its future have been daily topics in the news, but, for business owners, insurance is almost always forefront in their minds. Whether considering health insurance or workers’ compensation or general liability, trying to manage the costs of necessary insurance while still providing adequate protection to the company and appropriate benefits to employees is a difficult balance for many owners to strike. Companies often explore two options outside of traditional insurance coverage, although there are tax and financial reporting matters to consider in both.
Even with the ACA, health insurance costs are continuing to increase. One potential area of savings in medical insurance can be found through self-insuring. Under a self-insurance setup, a business essentially takes more of the risk for its employees’ health costs instead of using a third-party insurer. It covers the costs of medical matters itself, although other parties are involved. There is traditionally an administrative agent versed in the setup of these plans, and an insurance company is usually involved because most businesses want to have a stop-loss provision.
A stop-loss policy will limit the business’ costs once a specific event goes over a certain dollar threshold. The limit may be $50,000, so the company would pay the first $50,000 of costs for a medical claim, but the insurance company would cover the remaining costs. Lengthy hospital stays or complicated surgeries typically require stop-loss coverage to kick in.
In addition to medical insurance, workers’ compensation is a common coverage that is self-insured. Similar to health coverage, the employer covers the cost of work-related injury claims, again up to a stop-loss limit.
In the long run, self-insuring medical costs and workers’ compensation costs have a good chance to save a company money, but there are some financial statement repercussions to self-insuring.
Trailing claims liability
Under traditional insurance, a business expenses its premiums as it pays them and at the end of the year may have an asset on the balance sheet for premiums that are paid for a future period or could have a liability for an anticipated workers’ compensation audit premium. In self-insurance, however, there is a much greater chance for a significant liability to be on the books.
At the end of a reporting period, a business must estimate, with the help of the administrator, the number of claims that were incurred in the reporting period but not paid until the following period. For businesses that have a short timeframe from their year-end until the financial statements are released, these estimates are more volatile. Companies that have large workforces will often have a substantial liability at the end of the year, and even though there may be a cash savings throughout the year, it is possible that, at least in the initial year of self-insurance, that those savings will not translate to a higher bottom line on financial statements because of the trailing claims liability.
Audit of the plan
Employee benefit plans with 100 or more eligible participants are typically subject to audit (although this number can essentially be 120 instead of 100). Self-insured health insurance plans can be excluded from this requirement unless there is a trust involved.
If a business pays a set monthly amount a trust, which then pays the claims, an audit of the plan will be required at the end of the plan year. The positive aspect of the trust is that the business typically has an asset in the form of deposits remaining in the trust, which may offset the trailing claims liability. The drawback is the additional compliance that an audit requires. Although the cost of a health and welfare audit is not so great that it negates the savings in the self-insurance setup, many businesses are not aware that they are subject to audit and then risk being subject to fines and penalties by the Department of Labor.
A subset of self-insurance is captive insurance, a scenario in which a group of companies forms to provide coverage for its members. Each member company typically makes an initial investment to buy into the captive and then makes monthly premium payments to the captive.
Captives can hold all types of insurance, including health, workers’ compensation and general liability. In addition to potentially lower premiums, there are added benefits to a captive. One is that the captive often declares a dividend, which pays the members at the end of the plan year. Another is that captives require their members to attend annual meetings, and since captives are often held off-shore (off-shore insurance is the leading industry in Bermuda, for instance), executives can travel to an exotic location for a business purpose (although any personal vacation time spent there subsequent to the insurance meeting should not be paid by the company).
There are two major tax ramifications of captive insurance participation, however. One is that there may be foreign interest filings required by the business, its officers and/or its directors. The IRS is paying more attention to off-shore captives, and the failure to file compulsory forms can lead to significant non-compliance penalties.
The second thing that investors in a captive must be cognizant of is their ownership percentage. Often, a small business will have less than a one percent stake in a captive, but an investment of 20 percent or more requires additional elections and filings.
Overall, we have seen many companies enjoy the benefits of self-insurance or captive insurance frameworks. Those benefits are even more enjoyable if the businesses are able to avoid the potential surprises that accompany such arrangements.
By Dan Massey, CPA, Manager