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Posted On: Oct. 12, 1997 12:00 AM CST

WASHINGTON-A conflict between federal and state law in some states is blocking the efforts of insurers to sell tax-favored medical savings accounts to small employers throughout the country.

At the same time, regulatory problems combined with sluggish sales have led at least one health insurer to pull out of the tax-favored MSA market.

The conflict involves a 1996 federal law that gives MSAs-if they meet certain conditions-tax-favored status. Employer contributions to MSAs are not added to taxable income. In addition, employees can withdraw money from an MSA tax- and penalty-free to pay for uncovered health care-related expenses, while withdrawals for other purposes are subject to taxes and penalties.

However, to be eligible for tax-favored status, the MSA must be linked to a high-deductible health insurance policy. Currently, annual deductibles for individual coverage can be no less than $1,500 and no more than $2,250, while the deductible for family coverage must be at least $3,000 and no more than $4,500. The federal law also limits the availability of tax-favored MSAs to employers with no more than 50 employees.

But those high-deductible requirements directly conflict with some state requirements that policies sold by health insurers offer either first-dollar coverage or very low deductibles for certain benefits, especially mental health and home health care. For example, a Connecticut law says $50 is the maximum deductible for home health care.

This puts in an impossible position insurers that want to sell tax-favored MSAs to small employers in states with benefit laws mandating first-dollar or low deductibles for certain health care benefits.

If they meet the state requirements, the MSA will no longer qualify for tax-favored status. That would mean that employer contributions to the MSA would be added to employees' taxable income as would interest earned on assets held by the account.

But if the insurer does not follow state laws and sells policies with high-deductibles for all health care-related conditions, it would violate those laws and be subject to fines and other penalties.

"This is a real problem. At the state level, you can't legally sell a health insurance policy unless you offer certain coverages. Yet, the Treasury Department says if you offer that coverage the policy does not qualify for favorable tax benefits," said Tom Wildsmith, policy research actuary with the Health Insurance Assn. of America in Washington.

"It puts you between a rock and a hard place," Mr. Wildsmith added.

No one knows how extensive the problem is, though insurers say it could be an issue in about a dozen states.

However extensive the problem is, insurers say a remedy does exist: amending state laws. One way this could be done, they say, is to clarify that amounts contributed to an MSA would be considered first-dollar coverage. Another approach would be to exempt insurance policies linked to tax-favored MSAs from state mandated benefit requirements.

"I think the states are going to take care of it. It is matter of time before it is resolved," said Jim Perry, director of state affairs at the Alexandria, Va.-based Council for Affordable Health Insurance, an insurer group that lobbied Congress for the MSA legislation.

At least one state is likely to resolve the conflict.

Wisconsin Gov. Tommy Thompson is expected to sign legislation, A.B. 100, that would allow group health insurers to impose the same deductibles for mental health, drug and alcohol abuse as they do for other health care conditions. This would change current law that bars deductibles for mental health, drug and alcohol abuse.

Alternatively, Congress could pre-empt state laws that interfere with MSAs, though MSA lobbyists say that such action is unlikely.

Meanwhile, Employers Health Insurance Co. in Green Bay, Wis., says it has stopped writing insurance policies linked to tax-favored MSAs and will not renew already-issued policies when they come up for renewal. Employers Health says it has sold about 1,000 high-deductible policies linked to MSAs.

The health insurer, a unit of Humana Inc., cites regulatory policies as well as sluggish sales for its decision to leave the MSA market.

Given the regulatory problems and limited consumer interest, "It makes more sense to spend our energy elsewhere. Why should we spend so much time on a product that has only 1,000 policies when we can spend time on products that have many more customers," an Employers Health spokesman said.

But Golden Rule Insurance Co., which through the end of last month had sold 17,300 insurance policies linked to tax-favored MSAs, says it is satisfied with sales of the product.

"We believe in the product, and the agents we work with are getting more and more enthusiastic about MSAs all the time," said Lee Tooman, a Golden Rule vp in Indianapolis