Medical stop loss captives: answering the questions

Medical stop loss captives have enjoyed niche-level popularity for several years but the level of acceptance has risen to a more mainstream level during this past year. Increasing familiarity with alternative financing options, rising healthcare and insurance costs, and increasing Affordable Care Act regulatory discomfort are most likely responsible for a commensurate rise in comfort with stop loss captives.

A recent member survey by the Captive Insurance Companies Association (CICA) ascertained that 12 percent of respondents were already writing medical stop loss in their captives, and 26 percent said it was likely or possible within the next three years. So here are the answers to some typical frequently asked questions.

What are the benefits of a stop loss captive?

The first and most obvious benefit is being able to reduce the costs associated with delivering healthcare insurance to employees—ideally, on a long-term basis. The premise of any alternative risk structure is achieving the most appropriate balance between risk assumption and risk transfer to optimise savings while supporting the organisation’s risk management, financial and business objectives. In most cases, self-insurance is the most efficient alternative risk transfer mechanism. Captive participation in an excess coverage (medical stop loss) that insures a self-insured plan further amplifies the benefits that can be derived from self-funding alone.

Adding stop loss to a captive can effectively augment an organisation’s HR objectives by enhancing the efficiency of how employee benefits are financed and delivered to employees. Although many stop loss policies will provide coverage that mirrors an employer’s Plan Document, some stop loss policies may contain exclusions (differences in conditions [DICs]) that conflict with the Plan Document.

Stop loss carriers will also frequently identify that specific individuals having large ongoing medical conditions should be excluded—or ‘lasered’—from stop loss coverage. DICs and lasers are examples of terms and conditions that can be effectively absorbed by a captive to help maintain long-term continuity to self-funded benefit delivery.

Surplus derived from the underwriting and investment return from the captive can be strategically deployed to offset future plan costs, used to expand benefits or returned as dividends to the captive owners.

What are the main structural types?

Captives for medical stop loss generally follow the same structure as the more traditional casualty captives: single parent (pure) captive and group captive structures are both becoming widely used.

Single parent captives

The primary opportunities will be for large individual employers that already have an established captive (single parent) to which the stop loss can be added. Many self-funded employers of this size previously did not purchase stop loss, but since the enactment of the ACA and its mandate of unlimited lifetime benefit maximums within a health plan, they now purchase high (unlimited) levels of coverage and assume lower layers into their captive.

Stop loss coverage by itself would not typically generate enough premium to justify forming a captive solely for that purpose, but it can be used effectively to expand the use and enhance the efficiency of an existing captive.

Adding the stop loss to a captive that primarily writes long-tail coverage, such as workers’ compensation or liability, can provide a protective short-tail stability hedge by diversifying the captive’s risk portfolio.

Group captives

There generally are two types of group captives: heterogeneous (varied industries) and homogeneous (similar industries). The objective of both types of groups is to enable a grouping of mid-market employers to replicate the risk profile of a single larger employer to spread risk, promote stability, and achieve cost savings from different service providers.

Heterogeneous groups generally require a larger size in order to achieve an appropriate spread of risk among its diversity of participants. A larger size and risk spread are necessary to mitigate the increased risk variability and potential for increased underwriting volatility caused by the differing demographics among the participating employer populations. 
For example, the risk profile of the employee population of a 250-life professional services firm is very different from the risk profile of a 250-life construction firm. Both could be members of the same heterogeneous group captive; size and risk spread needs to be in appropriate proportion to achieve sustainable stability.

Homogenous groups: being industry-specific in their composition, these can be smaller as the underlying risk and underwriting profile is similar. The required size to achieve an appropriate spread of risk is not as great as in heterogeneous groups. Group captives are especially effective when formed by closely aligned groups (or associations) of like-minded employers within the same industry. 
Having the ability to leverage their combined strength helps mid-sized firms strategically balance risk retention and risk transfer to reduce the cost of risk and ultimately promote long-term stability for participants.

Are group stop loss captives MEWAs?

Group captives are not considered multiple employer welfare associations (MEWAs) which is an important distinction. In a MEWA, premium contributions from several employers are commingled into a single trust or custodial account and used to either purchase insurance or pay claims directly to providers or employees. All MEWA funds are controlled and managed by a centralised administrator leaving little or no control by the employers. MEWAs are also heavily regulated by the few states that actually permit them.

In a group stop loss captive, each employer will separately establish a self-funded benefit plan and then purchase a separate (individual) medical stop loss policy. There is no comingling of plan assets or joint risk-sharing among benefit plans of the individual participating employers. Each employer maintains full control of its benefit plan including the ability to set funding levels, select, appoint, and control plan administrators, third party administrators and most other related service components. The captive participates only in the medical stop loss coverage which is separate and not directly connected to the benefit plan itself.

Do stop loss captives need to be fronted?

Since medical stop loss is not a statutorily mandated coverage, single parent captives do not usually need to be fronted by an insurance company. The captive itself is recognised as an insurance company by its domicile and can issue a stop loss policy to its own parent organisation. This allows a single parent captive to purchase stop loss as a reinsurance transaction. As reinsurance, much of the expense associated with the issuance of an insurance policy (front fee, premium taxes, collateralisation, etc) has been stripped out thus significantly reducing the cost of the coverage.

Group captives will normally be required to have an authorised carrier issue an approved stop loss policy to its member-owners. In most cases, captive insurance companies are recognised as ‘non-authorised’ insurers by the National Association of Insurance Commissioners (NAIC) and states. Since stop loss insurance is regulated by states, most will require that any entity acting as an insurance company must be recognised as an authorised insurer and appropriately licensed by the individual state(s) to issue an insurance policy to non-affiliated entities, ie, group members.

Does a stop loss captive require DOL approval?

Any employee benefit insurance (other than voluntary coverages) that provides coverage directly to an employee will require an Employee Retirement Income Security Act (ERISA) Prohibited Transaction Exemption (PTE) from the Department of Labor (DOL) for inclusion into a captive. Since the self-funded medical plan itself is not part of the captive, it does not require a PTE. Medical stop loss is not recognised by the Internal Revenue Service (IRS) as a plan asset as it insures the employer rather than the employees. It is not considered employee benefit coverage and therefore does not require a PTE.

Does medical stop loss enhance the tax advantages of a captive?

Even though medical stop loss can provide beneficial portfolio diversification for a single parent captive it should not be considered third party risk for tax purposes. Stop loss provides coverage to the employer for its obligations—ie, potential liabilities—relative to the self-funded benefit plan. It does not provide any coverage directly to employees. In other words, no third party risk exists.

Employee benefit insurance coverage that pays benefits directly to the employee or to healthcare providers on behalf of the covered person is, however, considered third party risk by the IRS. The distinguishing element for tax purposes is determined by whose liabilities are actually being insured: the employer’s or the employee’s.

Are there any domicile selection considerations specific to stop loss captives?

Unlike captives that provide employee benefits requiring a DOL PTE, a medical stop loss captive is not required to be domiciled onshore. Since more offshore captives have made the 953(d) election to be taxed as US-based corporations, the advantages of incorporating offshore have eroded. With regard to single parent captives, most stop loss coverage will be added to an existing captive so the domicile decision becomes automatic.

In most cases, the existing domicile will require only an expansion or amendment to the original captive business plan and ensure that appropriate surplus has been established to accommodate the new line of business.

Domicile selection for group captives is a bit different. More of these are being established solely to write stop loss and as such, the incorporations have gravitated to domiciles that are friendlier to and familiar with the nuances specific to group captives such as Cayman, Bermuda and Vermont.

Phillip C Giles is the vice president, sales and marketing, QBE North America–Accident & Health. He can be contacted at: phillip.giles@us.qbe.com.