Solving a Small Businessman’s Coverage Dilemma

“This is the ultimate twofer. With as little as one month’s coverage in 2018, they can make the full $6,900 family contribution for 2018 (and they have until April 15, 2019, to deposit the funds), then turn around Jan. 1 and place another $7,000 in their HSAs.”

William G. (Bill) Stuart

Director of Strategy and Compliance

Sept. 20, 2018

Several weeks ago, I received a phone call from an old industry colleague. He’s a former chief financial officer for a large regional insurer and has more than 35 years’ experience in the industry. As a CFO, he understands how products work and had the ultimate sign-off on the plans that our company offered to its employees.

Now, he’s in a different position. He retired from the industry and is building a family business in the self-storage industry. He and several of his children are running the new business. He’s now buying insurance in the small-group market, and the choices are nothing like he was used to seeing a decade or more ago in that market segment.

The business is new and hasn’t generated cash-flow. He’s financing it with personal assets, as many bootstrap entrepreneurs do, so he’s very cost-conscious. At the same time, his first employees are two of his adult children, and he wants to make sure that they and their young families have good coverage. He has yet to hire his first non-family employees. When he does, he wants to make sure that he can provide them with good coverage at an affordable cost as well.

Is his situation resonating with you? You probably have a client, a relative, a neighbor, or a fellow parishioner facing the same dilemma.

My old colleague had narrowed his options to two. The first is a plan with no deductibles, but high copays for care in the emergency department ($250), day surgery ($500), and inpatient services ($1,000). The second option is an HSA-qualified plan with a $3,000/$6,000 deductible and then 20% coinsurance up to an out-of-pocket maximum of, as I recall, $12,000.

Not surprisingly, he likes the low patient out-of-pocket responsibility in the first plan, but it’s very expensive. He really likes the HSA-qualified plan’s premium, but he’s worried about the high deductible and coinsurance responsibility.

Aside from premiums and financial responsibility associated with the two plans, he likes the concept of having his children open HSAs when they’re young and healthy. He understands the value of long-term savings and wants them to have an opportunity to enjoy the tax advantages of an HSA. But the out-of-pocket responsibility for a single expensive episode of care (unlikely) or maternity (likely) chills him.

He sought my guidance in sorting through his options.

I suggested the best of both worlds. He can offer the HSA-qualified plan, thus allowing his children and him access to a powerful financial account, while also limiting their exposure to high out-of-pocket costs.

How?

By stacking an HRA and an HSA.

The Post-Deductible HRA

Here’s how it works:

He buys the HSA-qualified plan with its $6,000 family deductible and 20% coinsurance. He then integrates a back-end Health Reimbursement Arrangement (HRA) that pays the final $3,000 of the deductible and all coinsurance. Thus, the family is exposed to no more than $3,000 of out-of-pocket expenses, after which the HRA, and then the medical coverage and HRA, assume the remaining financial responsibility.

This HRA design is known as a Post-Deductible HRA. And it’s a powerful tool for employers who want to pay lower premiums for their medical coverage and offer a richer plan to their employees while allowing the employees to open and contribute to an HSA.

The Internal Revenue Code recognizes an HRA as a medical plan. Thus, an employee enrolled in a medical plan with an integrated HRA is covered by two distinct medical plans. Under HSA rules, when an individual is covered by two or more plans, each plan must be HSA-qualified in order for that individual to open and contribute to an HSA.

A Post-Deductible HRA meets this requirement. As long as the HRA doesn’t begin to pay benefits before an employee is responsible for at least $1,350 (self-only coverage) or $2,700 (family coverage), the statutory minimum annual deductible for an HSA-qualified plan in both 2018 and 2019, the HRA itself is an HSA-qualified medical plan.

My old colleague would have to pay for this added coverage since only employers can fund an HRA. No employee money can directly or indirectly pay reimbursements through an HRA.

And best of all, I told him, he and his children would still be eligible to make their full contributions to their HSAs ($6,900 in 2018 and $7,000 in 2019). Neither the presence of an HRA nor any reimbursements that they receive from the HRA offset their maximum HSA contributions.

As an added bonus, I recommended that he start coverage no later than Dec. 1, 2018, rather than wait until the new calendar year. As long as he and his children are enrolled in HSA-qualified plans and meet HSA eligibility criteria as of Dec. 1, they can make full (not pro-rated) contributions to their HSAs as long as they remain HSA-eligible through the end of 2019.

This is the ultimate twofer. With as little as one month’s coverage in 2018, he and his children can make the full $6,900 family contribution for 2018 (and they have until April 15, 2019, to deposit the funds), then turn around Jan. 1 and place another $7,000 in their HSAs. And my old colleague and his wife can each deposit an additional $1,000 catch-up contribution into their HSAs each year.

Application of This Approach

Not enough employers are utilizing this approach. They’re doing what my old colleague did before he talked to me – debating whether to purchase coverage with lower out-of-pocket responsibility and a high premium or higher-out-of-pocket responsibility and a lower premium.

The victims in this dilemma are often their employees. When an employer chooses the plan with the higher premium, employees breathe a sigh of relief that they won’t face high deductibles and coinsurance. On the other hand, their medical coverage is part of their overall compensation. As premiums consume a larger percentage of total compensation, employers often must offer lower (or no) raises to employees.

When an employer chooses the plan with the lower premium and higher out-of-pocket responsibility, employees generally are disappointed or angry at the prospect of paying more for their services, even when the result is more cash compensation than they otherwise would receive. They are much more focused on provider bills with balances due than they are their payroll deductions, even when the two figures match.

The Post-Deductible HRA represents an attractive middle ground. Total premiums are lower, and both employer and employee enjoy the savings in proportion to the percentage of the premium that each pays (assuming that the employer’s contribution is based on a percentage of the premium, as is still the case with most employers).

Where Theory Meets Reality

In theory, the two approaches should cost the employer the same amount. After all, assuming that “the claims are the claims,” the premium of the higher-cost plan should equal the premium of the lower-cost plan plus the reimbursement costs associated with the HRA. In reality, though, the plan with the integrated HRA usually costs less.

Why?

First, premiums include not only claims reimbursement, but also the insurer’s administrative costs. In Massachusetts, a market dominated by not-for-profit insurers, the premium consists of roughly 90% claims reimbursement and 10% administrative costs. So, if the difference in premium between a plan with a $3,000 and a $6,000 family deductible is $2,000, only about $1,800 of the difference represents claims costs. An employer can use an HRA to reimburse those $1,800 in claims for a total of about $1,850 (including $50 to administer the HRA), rather than $2,000.

Second, insurers don’t always price their products accurately. Astute benefits advisors are aware of this phenomenon. They’re expert at looking at the full menu of an insurer’s products and premiums and identifying plans that aren’t priced in line with the others. They steer their clients to their plans and often use an HRA to bring employees’ net financial responsibility back in line.

Third, insurers can’t adjust premiums to reflect utilization in the small-group market, as they can with experience-rated clients. Under community rating, some employers’ good claims experience subsidizes other employers’ bad experience. To make an HRA work, a group must have either a very healthy population (in which case claims costs are low across the board) or only a handful of high-cost claimants (whose effect on HRA payouts is small while their total costs – including high claims costs that the insurer must pay – are high).

Insurers understand the effect that HRAs have on overall utilization. When they price plans with a deductible, the premium differences reflect two phenomena. The first is cost-shifting. A plan with a $3,000 has a lower premium than a plan with a $1,000 deductible because it shifts $2,000 of additional financial responsibility to the patient. The second is utilization reduction. The insurer assumes that an individual with a $3,000 deductible is going to make different treatment decisions (more watchful waiting, more visits to retail clinics versus emergency departments, more physical therapy versus immediate surgery) than someone with only $1,000 of financial responsibility.

The presence of an HRA blows up the utilization-reduction factor. Someone with a $3,000 deductible and an HRA that reimburses the final $2,000 of expenses consumes medical care like someone with a $1,000 deductible. When the group is experience rated, that utilization pattern is borne out in the claims, and future premiums are calculated according to actual utilization. When the group is community rated, insurers can’t capture that difference when delivering future rates. Instead, that employer’s experience is absorbed in the large community pool.

That’s why insurers sometimes place restrictions on the value of an HRA. It’s not uncommon for insurers to require that no more than half the deductible be reimbursed through an HRA. These rules are designed to limit the effect of an HRA on the utilization-reduction factor. Their effect is to limit the gain that one employer experiences when its claims are absorbed into the large community pool.

Back to My Old Colleague

I had one more trick up my sleeve for my old colleague. He can offer the $6,000 plan with a Post-Deductible HRA of $3,000 (which, if he wanted, could be as low as $2,700). If he thinks that the $3,000 burden is too much for his family members, he can fund their HSAs.

That’s right. He can, if he is so inclined, give them a $3,000 employer contribution to their HSAs, thus eliminating their net financial responsibility entirely. In this scenario, he contributes $3,000 cash to their HSAs, covers any deductible expenses between $3,000.01 and $6,000, and then pays any coinsurance costs after the deductible. His children receive full coverage – a plan even richer than the higher-premium plan that he was considering (which had copays for many services).

Alternatively, he can raise their pay by $3,000 and encourage (but he can’t require) them to direct that money on a pre-tax basis into their HSAs to reduce their taxable income.

I don’t recommend this approach of covering 100% of employees’ out-of-pocket responsibility. Employees with no net financial responsibility have no incentive to spend money wisely. On the other hand, this is a family business, and my old colleague may want to take care of family members financially with contributions that are tax-deductible to his company and tax-free to his family members enrolled in the HSA program.

A Universal Approach

My old colleague’s situation isn’t unique. Every day, employers ponder how to manage the cost of medical coverage. They debate the merits of increasing out-of-pocket responsibility and shifting contribution policy as approaches to managing their cost of coverage, which consistently increases faster than revenue, profits, and total compensation budgets.

A good benefits advisor can help employers in their quest for affordable and attractive coverage by using tools like an HRA to combine lower premiums with less onerous employee out-of-pocket financial responsibility. The opportunities are there. There is no magic bullet, but adding an HRA to soften the potential financial blow of higher-deductible, lower-premium financial responsibility can be an option that’s attractive to both employers and employees.

What We’re Reading

How does your state compare to the national average in the cost and quality of medical care? You can get a quick snapshot by clicking here (embed link here) and accessing The Commonwealth Fund’s interactive map.

I’ve been preaching for several years the benefits of an HSA as a retirement account. In fact, it’s the subject of a book that I’ve written, to be released in January. (Don’t worry, I’ll keep you informed as it’s published.) A growing number of financial writers are recommending that employees position their HSAs as retirement accounts and begin funding them either before they contribute to their 401(k) plans or immediately after capturing the full 401(k) employer match. Here’s an explanation of this strategy.

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5 thoughts on “Solving a Small Businessman’s Coverage Dilemma”

  1. Chuck Diamond says:

    Bill,
    Great article. Can I assume when you talk about the Post Deductible HRA that the kids are employees of the company as owners cannot particapte in an HRA?

    1. William G. (Bill) Stuart says:

      Chuck – I may not have made it clear. The adult children (and the owner/father) are employees of a C-corporation that owns the self-storage business. The self-storage business itself is organized as an LLC.

      As employees of the C-corporation, these family members can participate in the HRA. If they were employed by the LLC, they could not receive reimbursements through the HRA.

    2. Bill Stuart says:

      Check with a benefits attorney. Adult children of the owner may fall under the attribution rules and thus not be eligible to receive tax-free reimbursements through an HRA if the company is a partnership, LLC, or Subchapter S Corporation.

  2. Sandra says:

    Bill,
    Thank you, I’ve been researching for my husband’s business, this is the best explanation I’ve seen! Would this scenario also apply to a S-Corp? Also, if the spouse is also an employee would we be able to set up something similar?

    1. Bill Stuart says:

      This particular scenario worked for him because he and the children are employees of a C-Corporation, even though the individual self-storage locations will be run as LLCs. “Owners” of a C-Corporation are treated as employees rather than owners because, under the tax code, they don’t own the business. Rather, the business stands alone and they own shares in the corporation. If your husband’s business is an LLC, partnership, or Subchapter-S Corporation, he (and immediate family members) can’t have an HRA and thus can’t receive tax-free reimbursements from the company. Any payments would be included in their taxable income. You should discuss specific details with a benefits attorney.

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