SELF-INSURANCE DOES NOT MEAN unlimited liability when it comes to employee benefits, says Craig I. Hasday, president of New York-based employee benefits consultant and broker Frenkel Benefits L.L.C. While stop-loss coverage seldom is used by the largest self-insured employers, it can be an effective strategy for middle-market employers that do not have the financial resources to withstand large claims. Understanding self-insurance and the issues associated with stop-loss coverage can be a powerful tool to take back control of this important expense, he says.

Self-insuring is a method to fund employee benefits where the employer pays the insurer an administration fee to process claims and use their provider network to access discounts.

However, self-insurance does not mean unlimited liability. To protect against catastrophic losses, the employer can purchase stop-loss insurance to protect against having to pay large claims on any one plan member as well as total claims for the entire group.

While stop-loss coverage is a strategy seldom used by jumbo self-funded employers, it is one that can be effective for midsize employers that do not have the financial wherewithal to withstand large claims.

Stop-loss insurance is a contract between the employer and the insurer to cover costs that exceed those expected at the beginning of the plan year. It is critically important that the terms of the stop-loss agreement be aligned with the underlying employee benefit plans or gaps can result.

There are two types of stop-loss insurance coverage: individual, or “specific” stop-loss, which is designed to protect against the risk that any one plan member's costs will exceed the preselected per-claimant limit; and aggregate stop-loss, which limits a self-funded employer's total claims liability in a plan year to a projected amount plus a margin typically set at 25% of the total expected liability.

A contract can be written on a “prefunding” basis or a “fund-and-refund” basis. A prefunding basis means that once claims exceed the threshold, the insurer begins to pay claims. A fund-and-refund approach to stop-loss coverage requires the employer to first pay the claims and then seek recovery from the insurer.

Stop-loss insurers require information concerning potential high-cost claimants during the initial application period and at renewal. Contracts are rigidly enforced, and insurers can require extensive audits when a claim is presented.

In a typical stop-loss relationship with a national insurer, the carrier acts as the claims administrator and reinsurer for large claims. This mitigates potential disputes and provides seamless reimbursement in the event of a large claim.

Stop-loss is purchased on a per-employee basis, regardless of how many dependents are enrolled in the plan, costing between $80 and $100 per employee per month for a midsize group. This compares with fully insured premiums of $425 for single coverage and $1,000 for family coverage.

Because the Patient Protection and Affordable Care Act has removed maximum lifetime limits and is gradually lifting annual coverage limits over time before they are eliminated in 2014, individual and aggregate stop-loss contract limits also should be unlimited to provide coverage alignment. This year, employers can set annual coverage limits at $750,000. Those limits grow to $1.25 million in 2012 and $2 million in 2013 and are eliminated entirely beginning in 2014.

While unlimited individual stop-loss coverage is readily available from insurers, aggregate stop-loss is often quoted with annual limits as low as $1 million, which can cause a significant coverage gap for a self-funded employer.

Another critical issue in purchasing stop-loss coverage is the period during which claims are incurred and the period during which they are paid. There is a lag between the time when services are performed (the incurred date) and the actual payment for these services. This lag typically is two months, but it can be reduced by automatic adjudication initiatives and capitated arrangements, in which medical providers are paid monthly stipends for covering plan members, regardless of the amount and cost of services rendered.

More commonly found contracts terms include:

• 12/12, which covers claims incurred during the 12 policy months and paid during that period;

• 12/15, which covers claims incurred during the 12 policy months and paid up to 15 months later. This also is called “run-out” protection; and

• Paid, which covers claims incurred at any time and paid during the policy year.

In the first year of a contract, individual stop-loss coverage can be written on an immature (12/12) basis; however, aggregate stop-loss usually includes run-out protection (12/15). This will result in lower first-year stop-loss premiums for the employer because there is a lag in paying claims that results in about 10 months of claims being paid in the first year. This lower cost for the employer would be made up in the second policy year, when a full 12 months of claims would be paid.

Significant increases and decreases in employee head counts affect the cost of aggregate stop-loss coverage. Such contracts usually include a provision that sets the overall claims trigger to the monthly claims factor based upon the head count at the beginning of the contract. So when there is a significant decline in the number of people covered, the aggregate attachment point can be much higher than had been expected when the stop-loss contract was signed.

When plan members are added during the year, however, the stop-loss cost usually is not adjusted because claims for these added lives would be considered immature.

In underwriting stop-loss insurance, an insurance company will request a disclosure of large claims prior to the start of the first and subsequent plan years. This disclosure must be completely accurate because inaccurate or incomplete disclosure can result in claim denial.

Perhaps the biggest risk faced is not in the year of transition, but during subsequent years in which a large claim may be identified at the time of underwriting the next year's coverage. Emerging or evolving claims can significantly affect pricing of a stop-loss renewal.

In addition, known claims can be “lasered,” which means that a higher stop-loss threshold may be set for that individual or any claims related to that individual could be excluded entirely from stop-loss coverage.

Self-insurance clearly is not for everyone.

Middle-market companies should consider establishing reserves based on the aggregate stop-loss attachment point plus estimated claims so they can begin to build a cushion against the inevitable bad plan year. Budgeting at the minimum expected cost is a recipe for disaster. Smaller companies have greater volatility and therefore need larger cushions against adverse experience.

Expect monthly variance in claims payments and budget accordingly. Fortunately, some insurers have responded to this volatility for middle-market customers by offering “level-funding” products with a fixed monthly payment and an annual settlement if there is a surplus at the end of the policy year.

Taking the time to understand self-insurance and the potential issues associated with stop-loss coverage can be a powerful tool in taking back control of this important expense. Working with a qualified adviser to help in evaluating this decision is a great first step in determining whether this risk is one the organization wants to and is able to absorb. Stop-loss coverage helps midsize firms cope with liability.

Craig I. Hasday is president of New York-based employee benefits consultant and broker Frenkel Benefits L.L.C., a division of Frenkel & Co. Inc. He can be reached at 212-488-0274 or via email at chasday@frenkel.com.