Alternative Funding Methods*

In recent years, employers have increasingly considered—and often

adopted—benefit funding methods that are alternatives to the traditional fully
insured group insurance contract. Under the traditional group insurance
contract, the employer pays premiums in advance to the insurance company,
which then has the financial responsibility both for paying claims (if and
when they occur) and for assuming the administrative expenses associated
with the contract. In addition, the insurance company bears the risk that
claims will be larger than anticipated.

REASONS FOR ALTERNATIVE FUNDING

The increasing interest in alternatives to the traditional fully insured
group arrangement has focused on two factors: cost savings and improved
cash flow. To a large extent, this interest has grown in response to the rising
cost of medical care that has resulted in an increase in the cost of providing
medical expense benefits. Even though alternative funding methods are most
commonly used for providing medical expense benefits, many of the
methods described here are also appropriate for other types of benefits.

Cost Savings
Savings can result to the extent that either claims or the insurance
company’s retention can be reduced. Retention—the portion of the insurance
company’s premium over and above the incurred claims and dividends—
includes such items as commissions, premium taxes, risk charges, and profit.
Traditionally, alternative funding methods have not focused on reducing
claims because the same benefits are normally provided (and therefore the
same claims are paid) regardless of which funding method is used. However,
this focus has changed as state laws and regulations increasingly mandate the
types and levels of benefits that must be contained in medical expense
contracts. To the extent that these laws and regulations apply only to benefits
that are included in insurance contracts, employers can avoid providing these
mandated benefits by using alternative funding methods that do not involve

*
Reprinted from Group Benefits: Basic Concepts and Alternatives, 11th edition (The American Press, 2006) by
Burton T. Beam, Jr.
Copyright © The American College 1
 insurance contracts. Federal mandates apply to benefit plans, not just
insurance contracts, and cannot be avoided by self-funding.
Modifications of fully insured contracts are usually designed either to
lower or eliminate premium taxes or to reduce the insurance company’s risk
and consequently the risk charge. Alternative funding methods that involve a
degree of self-funding also may be designed to reduce other aspects of
retention and to reduce claims by excluding mandated benefits.

Improved Cash Flow

Under a fully insured contract, an employer has the ability to improve
cash flow because premiums are collected before the funds are actually
needed to pay claims. The employer is generally credited with interest while
these funds are held in reserves. Alternative funding arrangements that are
intended to improve cash flow are designed either to postpone the payment
of premiums to the insurance company or to keep the funds that would
otherwise be held in reserves in the employer’s hands until the insurance
company needs them. Such an arrangement is particularly advantageous to
the employer when the employer can invest these funds at a rate of return
that is higher than the interest rate credited by the insurance company to
reserves. It must be remembered, however, that earnings on funds invested
by the employer are generally subject to income taxation, but interest
credited to reserves by the insurance company is tax free.

METHODS OF ALTERNATIVE FUNDING

Totally self-funded (or self-insured) employee benefit plans are the
opposite of traditional fully insured group insurance plans. Under totally self-
funded plans, the employer is responsible for paying claims, administering
the plan, and bearing the risk that actual claims will exceed those expected.
However, very few employee benefit plans that use alternative methods of
funding have actually turned to total self-funding. Rather, the methods used
typically fall somewhere between the two extremes.
The methods of alternative funding can be divided into two general
categories: those that primarily modify traditional fully insured group
insurance contracts and those that have some self-funding (either partial or
total). The first category includes

• premium-delay arrangements
• reserve-reduction arrangements
• minimum-premium plans
• cost-plus arrangements

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 • retrospective-rating arrangements

These alternative funding methods are regarded as modifications of

traditional fully insured plans because the insurance company has the
ultimate responsibility for paying all benefits promised under the contract.
Although practices differ among insurance companies, generally a group
insurance plan must generate between $150,000 and $250,000 in claims or
have a minimum number of covered persons, such as 50 or 100, before these
funding methods are available to the employer.
The second category of alternative funding methods includes

• total self-funding from current revenue and self-administration

• self-funding with stop-loss coverage and/or administrative-services-
only arrangements
• funding through a 501(c)(9) trust

In contrast to the first category of alternative funding methods, small

employers can use some of these alternatives.

Premium-Delay Arrangements
premium-delay A premium-delay arrangement allows the employer to defer payment of
arrangement monthly premiums for some time beyond the usual 30-day grace period. In
fact, this arrangement lengthens the grace period, most commonly by 60 or
90 days. The practical effect of a premium-delay arrangement is that it
enables the employer to have continuous use of the portion of the annual
premium that is approximately equal to the claim reserve. For example, a 90-
day premium delay allows the employer to use 3 months (or 25 percent) of
the annual premium for other purposes. This amount roughly corresponds to
what is usually in the claim reserve for medical expense coverage. Generally,
the larger this reserve is on a percentage basis, the longer the premium
payment can be delayed. Because the insurance company still has a statutory
obligation to maintain the claim reserve, it must use other assets besides the
employer’s premiums for this purpose. In most cases, these assets come from
the insurance company’s surplus.
A premium-delay arrangement has a financial advantage to the extent
that an employer can earn a higher return by investing the delayed premiums
than by accruing interest on the claim reserve. In actual practice, interest is
still credited to the reserve, but an interest charge on the delayed premiums
or an increase in the insurance company’s retention offsets the credit.
On termination of an insurance contract with a premium-delay
arrangement, the employer is responsible for paying any deferred premiums.
However, the insurance company is legally responsible for paying all claims
incurred prior to termination, even if the employer fails to pay the deferred
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 premiums. Consequently, most insurance companies are concerned about the
employer’s financial position and credit rating. For many insurance companies,
the final decision of whether to enter into a premium-delay arrangement, or any
other alternative funding arrangement that leaves funds in the hands of the
employer, is made by the insurer’s financial experts after a thorough analysis of
the employer. In some cases, this may mean that the employer will be required
to submit a letter of credit or some other form of security.

Reserve-Reduction Arrangements
reserve-reduction A reserve-reduction arrangement is similar to a premium-delay
arrangement arrangement. Under the usual reserve-reduction arrangement, the employer is
allowed (at any given time) to retain an amount of the annual premium that is
equal to the claim reserve. Generally, such an arrangement is allowed only
after the contract’s first year, when the pattern of claims and the appropriate
amount of the reserve can be more accurately estimated. In succeeding years,
if the contract is renewed, the amount retained will be adjusted according to
changes in the size of the reserve. As with a premium-delay arrangement, the
monies retained by the employer must be paid to the insurance company on
termination of the contract. Again, the advantage of this approach lies in the
employer’s ability to earn more on these funds than it would earn under the
traditional insurance arrangement.
A few insurance companies offer another type of reserve-reduction
arrangement for long-term disability income coverage. Under a so-called
limited-liability limited-liability arrangement, the employer purchases from the insurance
arrangement company a one-year contract in which the insurer agrees to pay claims only
for that year, even though the employer’s “plan” provides benefits to
employees for longer periods. Consequently, enough reserves are maintained
by the insurance company to pay benefits only for the duration of the one-
year contract. At renewal, the insurance company agrees to continue paying
the existing claims as well as any new claims. In effect, the employer pays the
insurance company each year for existing claims as the benefits are paid to
employees, rather than when disabilities occur. A problem for employees under
this type of arrangement is the lack of security for future benefits. For example,
if the employer goes bankrupt and the insurance contract is not renewed, the
insurance company has no responsibility to continue benefit payments. For this
reason, several states do not allow this type of arrangement.
The limited-liability arrangement contrasts with the usual group contract
in which the insurance company is responsible for paying disability income
claims to an employee for the length of the benefit period (as long as the
employee remains disabled). On average, each disability claim results in the
establishment of a reserve equal to approximately five times the employee’s
annual benefit.

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 Minimum-Premium Plans
minimum-premium A minimum-premium plan is designed primarily to reduce state premium
plan taxes. However, many minimum-premium plans also improve the employer’s
cash flow.
Under the typical minimum-premium plan (sometimes called limited self-
funding), the employer assumes the financial responsibility for paying claims
up to a specified level, usually from 80 to 95 percent of estimated claims
(with 90 percent most common). The specified level may be determined on
either a monthly or an annual basis. The funds necessary to pay these claims
are deposited into a bank account that belongs to the employer. However, the
actual payment of claims is made from this account by the insurance
company, which acts as an agent of the employer. When claims exceed the
specified level, the balance is paid from the insurance company’s own funds.
No premium tax is levied by the states on the amounts the employer deposits
into such an account, as it would have been if these deposits had been paid
directly to the insurance company. In effect, for premium-tax purposes, the
insurance company is considered to be only the administrator of these funds
and not a provider of insurance. Unfortunately, the IRS considers these funds
to belong to the employer, and death benefits represent taxable income to
beneficiaries. Consequently, minimum-premium plans are used to insure
disability income and medical expense benefits rather than life insurance
benefits.
Under a minimum-premium plan, the employer pays a substantially
reduced premium, subject to premium taxation, to the insurance company for
administering the entire plan and for bearing the cost of claims above the
specified level. Because such a plan may be slightly more burdensome for an
insurance company to administer than would a traditional group
arrangement, the retention charge may also be slightly higher. Under a
minimum-premium arrangement, the insurance company is ultimately
responsible for seeing that all claims are paid, and it must maintain the same
reserves that would have been required if the plan had been funded under a
traditional group insurance arrangement. Consequently, the premium
includes a charge for the establishment of these reserves, unless some type of
reserve-reduction arrangement is also negotiated.
Some insurance regulatory officials view the minimum-premium plan
primarily as a loophole used by employers to avoid paying premium taxes. In
several states, there have been attempts to seek court rulings or legislation
that would require premium taxes to be paid either on the funds deposited in
the bank account or on claims paid from these funds. Most of these attempts
have been unsuccessful, but court rulings in California require the employer to
pay premium taxes on the funds deposited in the bank account. If similar
attempts are successful in the future, the main advantage of minimum-
premium plans will be lost.
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 Cost-Plus Arrangements
A cost-plus arrangement (often referred to by other names, such as
cost-plus arrangement
flexible funding) may be used to fund other types of employee benefits, but
large employers generally use this to provide life insurance benefits. Under
such an arrangement, the employer’s monthly premium is based on the
claims paid by the insurance company during the preceding month, plus a
specified retention charge that is uniform throughout the policy period. To
the extent that an employer’s loss experience is less than that assumed in a
traditional premium arrangement, the employer’s cash flow is improved.
However, an employer with worse-than-expected experience, either during
the early part of the policy period or during the entire policy period, could
also have a more unfavorable cash flow than if a traditional insurance
arrangement were used. To prevent this from occurring, many insurance
companies place a maximum limit on the employer’s monthly premium. The
effect of this limit is that the aggregate monthly premiums paid at any time
during the policy period do not exceed the aggregate monthly premiums that
would have been paid if the cost-plus arrangement had not been used.

Retrospective-Rating Arrangements
retrospective-rating Under a retrospective-rating arrangement, the insurance company charges
arrangement the employer an initial premium that is less than what would be justified by the
expected claims for the year. In general, this reduction is between 5 and 10 per-
cent of the premium for a traditional group insurance arrangement. However, if
claims plus the insurance company’s retention exceed the initial premium, the
employer is called upon to pay an additional amount at the end of the policy
year. Because an employer will usually have to pay this additional premium,
one advantage of a retrospective-rating arrangement is the employer’s ability to
use these funds during the year.
This potential additional premium is subject to a maximum amount based
on some percentage of expected claims. For example, assume that a retro-
spective-rating arrangement bases the initial premium on the fact that claims
will be 93 percent of those actually expected for the year. If claims in fact are
below this level, the employer receives an experience refund. If they exceed 93
percent, the retrospective-rating arrangement is “triggered,” and the employer
has to reimburse the insurance company for any additional claims paid, up to
some percentage of those expected, such as 112 percent. The insurance
company bears claims in excess of 112 percent, so some of the risk associated
with claims fluctuations is passed on to the employer. This reduces both the
insurance company’s risk charge and any reserve for claims fluctuations. The
amount of these reductions depends on the actual percentage specified in the
contract, above which the insurance company is responsible for claims. This
percentage and the one that triggers the retrospective-rating arrangement are
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 subject to negotiations between the insurance company and the employer. In
general, the lower the percentage that triggers the retrospective arrangement,
the higher the percentage above which the insurance company is fully
responsible for claims. In addition, the better the cash-flow advantage of the
employer, the greater the risk of claims fluctuations.
In all other respects, a retrospective-rating arrangement is identical to the
traditional group insurance contract.

Total Self-Funding and Self-Administration

The purest form of a self-funded benefit plan is one in which the employer
pays benefits from current revenue (rather than from a trust), administers all
aspects of the plan, and bears the risk that benefit payments will exceed those
expected. In addition to eliminating state premium taxes, avoiding state-
mandated benefits, and improving cash flow, the employer has the potential to
reduce its operating expenses to the extent that the plan can be administered at
a lower cost than the insurance company’s retention (other than premium
taxes). A decision to use this kind of self-funding plan is generally considered
most desirable when all of the following conditions are present:

• predictable claims. Budgeting is an integral part of the operation of

any organization, and it is necessary to budget for benefit payments
that will need to be paid in the future. This can best be done when a
specific type of benefit plan has a claim pattern that is either stable
or shows a steady trend. Such a pattern is most likely to occur in
those types of benefit plans that have a relatively high frequency of
low-severity claims. Although a self-funded plan may still be
appropriate when the level of future benefit payments is difficult to
predict, the plan will generally be designed to include stop-loss
coverage (discussed later in this chapter).
• a noncontributory plan. Several difficulties arise if a self-funded
benefit plan is contributory. Some employees may resent paying
“their” money to the employer for benefits that are contingent on the
firm’s future financial ability to pay claims. If claims are denied,
employees under a contributory plan are more likely to be bitter
toward the employer than they would be if the benefit plan were
noncontributory. Finally, ERISA requires that a trust must be
established to hold employee contributions until the plan uses the
funds. Both the establishment and maintenance of the trust result in
increased administrative costs to the employer.
• a nonunion situation. Self-funding of benefits for union employees
may not be feasible if a firm is subject to collective bargaining. Self-
funding (at least by the employer) clearly cannot be used if benefits are
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 provided through a negotiated trusteeship. Even when collective
bargaining results in benefits being provided through an individual
employer plan, unions often insist that benefits be insured in order to
guarantee that union members actually receive them. An employer’s
decision about whether to use self-funding is most likely motivated by
the potential to save money. When unions approve of self-funding,
they also frequently insist that some of these savings be passed on to
union members through additional or increased benefits.
• the ability to effectively and efficiently handle claims. One reason that
many employers do not use totally self-funded and self-administered
benefit plans is the difficulty in handling claims as efficiently and
effectively as an insurance company or other benefit-plan adminis-
trator would handle them. Unless an employer is extremely large, only
one person or a few persons are needed to handle claims. Who in the
organization can properly train and supervise these people? Can they
be replaced if they should leave? Will anyone have the expertise to
properly handle the unusual or complex claims that might occur?
Many employers want some insulation from their employees in the
handling of claims. If employees are unhappy with claim payments
under a self-administered plan, dissatisfaction (and possibly legal
actions) is directed toward the employer rather than toward the insur-
ance company. The employer’s inability to handle claims, or its lack of
interest in wanting to handle them, does not completely rule out the use
of self-funding. As discussed later, employers can have claims handled
by another party through an administrative-services-only contract.
• the ability to provide other administrative services. In addition to
claims, the employer must determine whether the other administrative
services normally included in an insured arrangement can be provided
in a cost-effective manner. These services are associated with plan
design, actuarial calculations, statistical reports, communication with
employees, compliance with government regulations, and the prepar-
ation of government reports. Many of these costs are relatively fixed,
regardless of the size of the employer, and unless the employer can
spread them out over a large number of employees, self-administration
is not economically feasible. As with claims administration, an
employer can purchase needed services from other sources.
• the ability to obtain discounts from medical care providers if medical
expense benefits are self-funded. In order to obtain much of the cost
savings associated with managed care plans, the employer must be able
to secure discounts from the providers of medical care. Large
employers whose employees live in a relatively concentrated geo-
graphic region may be able to enter into contracts with local providers.
Other employers often use the services of third-party administrators
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 who have either entered into contracts with managed care plans to use
their networks or possibly established their own networks.

The extent of total self-funding and self-administration differs

significantly among the different types of group benefit plans. Plans that
provide life insurance or accidental death and dismemberment benefits do not
usually lend themselves to self-funding because of infrequent and large
claims that are difficult to predict. Only very large employers can expect
stable and predictable claims on an annual basis. In addition, federal income
tax laws impede the use of self-funding for death benefits because any
payments to beneficiaries are considered taxable income to the beneficiaries.
Such a limitation does not exist if the plan is insured.
The most widespread use of self-funding and self-administration occurs
in short-term disability income plans, particularly those that limit the maximum
duration of benefits to 6 months or less. For employers of almost any size, the
number and average length of short-term absences from work are relatively
predictable. In addition, the payment of claims is fairly simple because benefits
can be (and usually are) made through the employer’s usual payroll system.
Long-term disability income benefits are occasionally self-funded by large
employers. Like death claims, long-term disability income claims are difficult to
predict for small employers because of their infrequent occurrence and poten-
tially large size. In addition, because small employers receive only a few claims
of this type, they become economically unjustifiable to self-administer.
The larger the employer is, the more likely that its medical expense plan
is self-funded. In fact, statistics indicate that about two-thirds of employers
with 500 or more employees self-fund their traditional indemnity plans and
PPOs. About half of point-of-service plans are also self-funded. However,
self-funding is only used with fewer than 15 percent of HMO plans.
The major problem with a self-funded medical expense plan is not the
prediction of claims frequency but rather the prediction of the average severity
of claims. Although infrequent, claims of $500,000, $1,000,000, or more do
occasionally occur. Most small- and medium-sized employers are unwilling to
assume the risk that they might have to pay such a large claim. Only employers
with several thousand employees are large enough to anticipate that such
claims will regularly occur and to have the resources necessary to pay any
unexpectedly large claims. This does not mean that smaller employers cannot
self-fund medical benefits. To avoid the uncertainty of catastrophic claims,
these employers often self-fund basic medical expense benefits and insure
major medical expense benefits or self-fund their entire coverage but purchase
stop-loss protection. Many employers that self-fund, regardless of size, also
purchase at least some administrative services.
It is not unusual to use self-funding and self-administration in other types
of benefit plans, such as those providing coverage for dental care, vision care,
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 prescription drugs, or legal expenses. Initially, it may be difficult to predict the
extent to which these plans will be utilized. However, once the plans have
“matured,” the level of claims tends to be fairly stable. Furthermore, these
plans are commonly subject to maximums so that the employer has little or no
risk of catastrophic claims. Although larger employers may be able to
economically administer the plans themselves, smaller employers commonly
purchase administrative services.

Self-Funding with Stop-Loss Coverage and/or ASO Arrangements

Two of the problems associated with self-funding and self-administration
are the risk of catastrophic claims and the employer’s inability to provide
administrative services in a cost-effective manner. For each of these problems,
however, solutions have evolved—namely stop-loss coverage and administra-
tive-services-only (ASO) contracts—that still allow an employer to use
elements of self-funding. Although an ASO contract and stop-loss coverage
can be provided separately, they are commonly written together. In fact, most
insurance companies require an employer with stop-loss coverage to have a
self-funded plan administered under an ASO arrangement, either by the
insurance company or by a third-party administrator.
Until recently, stop-loss coverage and ASO contracts were generally
provided by insurance companies and were available only to employers with
at least several hundred employees. However, these arrangements are
increasingly becoming available to small employers, and in many cases the
administrative services are purchased from third-party administrators who
operate independently from insurance companies.

Stop-Loss Coverage
aggregate stop-loss Aggregate stop-loss coverage is one form of protection for employers
coverage against an unexpectedly high level of claims. If total claims exceed a
specified dollar limit, the insurance company assumes the financial
responsibility for those claims that are over the limit, subject to the maximum
reimbursement specified in the contract. The limit is usually applied on an
annual basis and is expressed as some percentage of expected claims
(typically between 115 percent and 135 percent). The employer is
responsible for the paying of all claims to employees, including any
payments that are received from the insurance company under the stop-loss
coverage. In fact, because the insurance company has no responsibility to the
employees, no reserve for claims must be established.
Aggregate stop-loss coverage results in (1) an improved cash flow for the
employer and (2) a minimization of premium taxes because they must be
paid only on the stop-loss coverage. However, these advantages are partially

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 (and perhaps totally) offset by the cost of the coverage. In addition, many
insurance companies insist that the employer purchase other insurance
coverages or administrative services to obtain aggregate stop-loss coverage.
Stop-loss plans may also be written on a “specific” basis, similar to the
specific stop-loss way an insured plan with a deductible is written. In fact, this specific stop-
coverage loss coverage (most commonly used with medical expense plans) is
sometimes referred to as a big-deductible plan or as shared funding. The
deductible amount may vary from $1,000 to $250,000 but is most commonly
in the range of $10,000 to $20,000. It is usually applied on an annual basis
and pertains to each person insured under the contract. Although stop-loss
coverage was once written primarily for large employers, more recently it has
also been written for employers with as few as 25 employees. These plans
have particular appeal for small employers who have had better-than-average
claims experience but who are too small to qualify for experience rating and
the accompanying premium savings.
The deductible specified in the stop-loss coverage is the amount the
employer must assume before the stop-loss carrier is responsible for claims
and is different from the deductible that an employee must satisfy under the
medical expense plan. For example, employees may be given a medical
expense plan that has a $200 annual deductible and an 80 percent
coinsurance provision. If stop-loss coverage with a $5,000 stop-loss limit has
been purchased, an employee assumes the first $200 in annual medical
expenses, and the plan will then pay 80 percent of any additional expenses
until it has paid a total of $5,000. At that time, the stop-loss carrier
reimburses the plan for any additional amounts that the plan must pay to the
employee. The stop-loss carrier has no responsibility to pay the employer’s
share of claims under any circumstances, and most insurance companies
require that employees be made aware of this fact.
Misunderstandings often arise over two variations in specific stop-loss
contracts. Most contracts settle claims on a paid basis, which means that only
those claims paid during the stop-loss period under a benefit plan are taken
into consideration in determining the liability of the stop-loss carrier. Some
stop-loss contracts, however, settle claims on an incurred basis. In these
cases, the stop-loss carrier’s liability is determined on the basis of the date a
loss took place rather than when the benefit plan actually made payment. For
example, assume an employee was hospitalized last December, but the claim
was not paid until this year. This is an incurred claim for last year but a paid
claim for this year.
A second variation affects an employer’s cash flow. Assume an employer
has a medical expense plan with a $20,000 stop-loss limit and that an
employee has a claim of $38,000. If the stop-loss contract is written on a
reimbursement basis, the employer’s plan must pay the $38,000 claim before
the plan’s administrator can submit an $18,000 claim to the stop-loss carrier.
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 If the stop-loss contract is written on an advance-funding basis, the
employer’s plan does not actually have to pay the employee before seeking
reimbursement.
Most insurance companies that provide stop-loss coverage for medical
expense plans also agree to provide a conversion contract to employees
whose coverage terminates. However, the employer must pay an additional
monthly charge to have this benefit for employees.

ASO Contracts
ASO contract Under an ASO contract, the employer purchases specific administrative
services from an insurance company or from an independent third-party
administrator. These services usually include the administration of claims,
but they may also include a broad array of other services, such as COBRA
administration, prescription drug cards, employee communications, and
government reporting. In effect, the employer has the option to purchase
services for those administrative functions that can be handled more cost
effectively by another party. It should also be noted that an employer may
purchase different administrative services from more than one source. In
addition, third-party administrators often subcontract some of the services
they provide employers to other administrators that provide specialized
services, such as case management and hospital audits.
Under ASO contracts, the administration of claims is performed in much
the same way as it is under a minimum-premium plan; that is, the
administrator has the authority to pay claims from a bank account that
belongs to the employer or from segregated funds in the administrator’s
hands. However, the administrator is not responsible for paying claims from
its own assets if the employer’s account is insufficient.
In addition to listing the services that are provided, an ASO contract also
stipulates the administrator’s authority and responsibility, the length of the
contract, the provisions for terminating and amending the contract, and the
manner in which disputes between the employer and the administrator are
settled. The charges for the services provided under the contract may be
stated in one or some combination of the following ways:
• a percentage of the amount of claims paid
• a flat amount per processed claim
• a flat charge per employee
• a flat charge for the employer

Payments for ASO contracts are regarded as fees for services performed,
and they are therefore not subject to state premium taxes. However, one
similarity to a traditional insurance arrangement may be present: The

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 administrator may agree to continue paying any unsettled claims after the
contract’s termination but only with funds provided by the employer.

Funding through a 501(c)(9) Trust

Sec. 501(c)(9) of the Internal Revenue Code provides for the
establishment of voluntary employees’ beneficiary associations (commonly
501(c)(9) trust called 501(c)(9) trusts or VEBAs), which are funding vehicles for the
employee benefits that are offered to members. The trusts have been allowed
for many years, but until the passage of the 1969 Tax Reform Act, they were
primarily used by negotiated trusteeships and association groups. The
liberalized tax treatment of the funds accumulated by these trusts resulted in
their increased use by employers as a method of self-funding employee
benefit plans. However, the Tax Reform Act of 1984 imposed more
restrictive provisions on 501(c)(9) trusts, and their use has diminished
somewhat, particularly by smaller employers who previously had overfunded
their trusts primarily as a method to shelter income from taxation.

Advantages
The use of a 501(c)(9) trust offers the employer some advantages over a
benefit plan that is self-funded from current revenue. Contributions can be
made to the trust and can be deducted for federal income tax purposes at that
time, just as if the trust were an insurance company. Appreciation in the
value of the trust assets or investment income earned on the trust assets is
also free of taxation. The trust is best suited for an employer who wishes to
establish either a fund for claims that have been incurred but not paid or a
fund for possible claims fluctuations. If the employer does not use a
501(c)(9) trust in establishing these funds, contributions cannot be deducted
by the employer for federal income tax purposes until they are paid in the
form of benefits to employees. In addition, earnings on the funds are subject
to taxation.
The Internal Revenue Code requires that certain fiduciary standards be
maintained regarding the investment of the trust assets. The employer,
however, does have some latitude and does have the potential for earning a
return on the trust assets that is higher than what is earned on the reserves
held by insurance companies. A 501(c)(9) trust also lends itself to use by a
contributory self-funded plan because ERISA requires that, under a self-
funded benefit plan, a trust must be established to hold employees’
contributions until they are used to pay benefits.
There is also flexibility regarding contributions to the trust. Although the
Internal Revenue Service does not permit a tax deduction for “overfunding” a
trust, there is no requirement that the trust must maintain enough assets to

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 pay claims that have been incurred but not yet paid. Consequently, an
employer can “underfund” the trust in bad times and make up for this
underfunding in good times with larger-than-normal contributions. However,
any underfunding must be shown as a contingent liability on the employer’s
balance sheet.

Disadvantages
A 501(c)(9) also has its drawbacks. The cost of establishing and
maintaining the trust may be prohibitive, especially for small employers. In
addition, the employer must be concerned about the administrative aspects of
the plan and the fact that claims might deplete the trust’s assets. However, as
long as the trust is properly funded, ASO contracts and stop-loss coverage
can be purchased.

Requirements for Establishment

To qualify under Sec. 501(c)(9), a trust must meet certain requirements⎯
some of which may hinder its establishment⎯including the following:

• Membership in the trust must be objectively restricted to those

persons who share a common employment-related bond. Internal
Revenue Service regulations interpret this broadly to include active
employees and their dependents, surviving dependents, and
employees who are retired, laid off, or disabled. Except for plans
maintained pursuant to collective-bargaining agreements, benefits
must be provided under a classification of employees that the IRS
does not find to be discriminatory in favor of highly compensated
individuals. It is permissible for life insurance, disability, severance
pay, and supplemental unemployment compensation benefits to be
based on a uniform percentage of compensation. In addition, the
following persons may be excluded in determining whether the
discrimination rule has been satisfied: (1) employees who have not
completed 3 years of service, (2) employees under age 21, (3)
seasonal or less-than-half-time employees, and (4) employees
covered by a collective-bargaining agreement if the class of benefits
was subject to good-faith bargaining.
• With two exceptions, membership in the trust must be voluntary on the
part of employees. Members can be required to participate (1) as a
result of collective bargaining or (2) when participation is not
detrimental to them. In general, participation is not regarded as
detrimental if the employee is not required to make any contributions.

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 • The trust must provide only eligible benefits. The list of eligible cover-
ages is broad enough that a trust can provide benefits because of death,
medical expenses, disability, and unemployment. Retirement benefits,
deferred compensation, and group property and liability insurance
cannot be provided.
• The sole purpose of the trust must be to provide benefits to its mem-
bers or their beneficiaries. Trust assets can be used to pay the adminis-
trative expenses of the trust, but they cannot revert to the employer. If
the trust is terminated, any assets that remain after all existing liabil-
ities have been satisfied must either be used to provide other benefits
or be distributed to members of the trust.
• The trust must be controlled by (1) its membership, (2) independent
trustees (such as a bank), or (3) trustees or other fiduciaries, at least
some of whom are designated by or on behalf of the members. Indepen-
dent trustees selected by the employer control most 501(c)(9) trusts.

Limitation on Contributions
The contributions to a 501(c)(9) trust (except collectively bargained
plans for which Treasury regulations prescribe separate rules) are limited to
the sum of (1) the qualified direct cost of the benefits provided for the
taxable year and (2) any permissible additions to a reserve (called a qualified
asset account). The qualified direct cost of benefits is the amount that would
have been deductible for the year if the employer had paid benefits from
current revenue.
The permissible additions may be made only for disability, medical,
supplemental unemployment, severance pay, and life insurance benefits. In
general, the amount of the permissible additions includes (1) any sums that
are reasonably and actuarially necessary to pay claims that have been
incurred but remain unpaid at the close of the tax year and (2) any
administration costs with respect to these claims. If medical or life insurance
benefits are provided to retirees, deductions are also allowed for funding
these benefits on a level basis over the working lives of the covered
employees. However, for retirees’ medical benefits, current medical costs
must be used rather than costs based on projected inflation. In addition, a
separate account must be established for postretirement benefits provided to
key employees. Contributions to these accounts are treated as annual
additions for purposes of applying the limitations that exist for contributions
and benefits under qualified retirement plans.
The amount of certain benefits for which deductions are allowed is
limited. Life insurance benefits for retired employees cannot exceed amounts
that are tax free under Sec. 79. Annual disability benefits cannot exceed the
lesser of (1) 75 percent of a disabled person’s average compensation for the
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 highest 3 years or (2) $175,000. Supplemental unemployment compensation
benefits and severance benefits cannot exceed 75 percent of average benefits
paid plus administrative costs during any 2 of the immediately preceding 7
years. In determining this limit, annual benefits in excess of $66,000 cannot
be taken into account. (The $175,000 and $66,000 amounts are for 2006 and
subject to periodic indexing.)
In general, it is required that the amount of any permissible additions be
actuarially certified, although deductible contributions can be made to reserves
without such certification as long as certain specified limits on the size of the
reserve are not exceeded. The specified limits for supplemental unemployment
compensation benefits and severance benefits are the same as the amounts
previously mentioned. For short-term disability benefits, the limit is equal to
17.5 percent of benefit costs (other than insurance premiums for the current
year), plus administrative costs for the previous year. For medical benefits, the
limit is 35 percent. The Internal Revenue Code provides that the limits for life
insurance benefits and long-term disability income benefits will be those
prescribed by regulations. However, no regulations have been issued.
Employer deductions cannot exceed the limits as previously described.
However, any excess contributions may be deducted in future years to the
extent that contributions for those years are below the permissible limits.
There are several potential adverse tax consequences if a 501(c)(9) trust
does not meet prescribed standards. If reserves are above permitted levels,
additional contributions to the reserves are not deductible and earnings on the
excess reserves are subject to tax as unrelated business income. (This effec-
tively negates any possible advantage of using a 501(c)(9) trust to prefund
postretirement medical benefits.) In addition, an excise tax is imposed on
employers maintaining a trust that provides disqualified benefits. The tax is
equal to 100 percent of the disqualified benefits, which include (1) medical and
life insurance benefits provided to key employees outside the separate accounts
that must be established, (2) discriminatory medical or life insurance benefits
for retirees, and (3) any portion of the trust’s assets that revert to the employer.

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