Seyfarth Synopsis: Fresh on the heels of the IRS Chief Counsel Memorandum on wellness and indemnity products, discussed in our prior post here, the agencies have weighed in with more formal and more expansive guidance throwing more cold water on the tax treatment of these types of products, that the Administration has dubbed “junk insurance”.
On July 7th, the Treasury Department, Department of Labor, and Health and Human Services (the “agencies”) issued proposed rules impacting “junk insurance”. The guidance proposes (i) changes to what qualifies as short-term, limited-duration insurance, (ii) amendments to the requirements for independent, non-coordinated coverage, and fixed indemnity insurance to be considered an “excepted benefit”, and (iii) clarifications of the tax treatment of fixed amount benefit payments under employment-based accident and health plans. The IRS also asks for comments on coverage limited to specified diseases or illnesses that qualifies as excepted benefits and on level-funded plan arrangements.
The agencies’ goal in the new guidance is to better distinguish what they term “comprehensive coverage” from these types of programs, and to make it easier for consumers to understand the risks they are assuming by enrolling in these products. Comprehensive coverage provides certain consumer protections (e.g., prohibiting pre-existing condition exclusions, lifetime and annual limits, and health status discrimination, requiring coverage for preventive care with no cost sharing), which the so-called “junk coverage” does not. By clarifying the limitations of these types of coverage and the corresponding tax treatment, the agencies hope to make it harder to market these types of policies as comprehensive healthcare coverage or as a valid tax-avoidance arrangement.
A quick tutorial on the types of coverage being addressed is probably warranted.
- Short-Term, Limited-Duration Insurance (STLDI). These policies are designed to fill temporary gaps in medical coverage that may occur, for example, when an individual is changing jobs. STLDI is not considered individual insurance coverage and is therefore not subject to the market consumer protections that would apply to comprehensive coverage. Current regulations limit the maximum duration for such policies to a 12 month term, or 36 months total when taking into account renewals.
- Independent, Non-Coordinated Coverage. While providing longer-term coverage than STLDI, this coverage is a type of “excepted benefit” that is not subject to the consumer protections and comprehensive coverage requirements. These products provide coverage for specific diseases or illnesses, e.g., a cancer diagnosis, as well as hospital indemnity or other fixed indemnity insurance. As implied by the name, these benefits do not coordinate with any comprehensive medical coverage and are not based on the actual costs of medical services. Instead, they pay a fixed amount upon an event or diagnosis, and are designed to provide income replacement benefits. While these excepted benefits are not subject to the consumer protection requirements, they are nevertheless treated as “accident or health insurance” under the Internal Revenue Code.
- Level-Funded Plan Arrangements. This is a self-funded health plan arrangement under which the sponsor makes “level” monthly payments to a service provider in an amount intended to cover estimated claims costs, administrative costs, and stop-loss premiums. Because the monthly payment amount is designed to cover the health plan’s maximum benefit liability (taking into account stop-loss coverage), the sponsor’s payment experience is more akin to a fully-insured plan than a self-funded plan. These products are often marketed to smaller employers who are attempting to avoid the consumer protections associated with the small group insurance market (because the level-funded plans are billed as “self-funded”, they are exempt from those market requirements).
The proposed regulations would make two notable changes to STLDI insurance:
- Shorter Coverage Window. With respect to STLDI, the agencies propose to reduce the current 12-month maximum term (with renewals/extensions no longer than 36 months in total duration) to a maximum 3-month contract term with a 4-month maximum total duration taking into account renewals. For this purpose, “renewals” include any new policy issued by same carrier to policy holder within 12 month period beginning with original effective date. The 3-month maximum dovetails with the maximum permitted waiting period allowed for group health plans. For longer gaps, the regulators reason that the individual can rely on COBRA or federal marketplace coverage.
- New Notice Requirement. The proposed regulations would also require a new (enhanced) notice requirement to ensure consumer awareness. That notice would also have to be included in marketing materials for the product (not just the policy itself).
The proposal would be applicable to new policies sold or issued 75 days after publication of the final regulations.
Independent, Non-Coordinated Excepted Benefits Coverage
The proposed regulations attempt to align the conditions for fixed indemnity policies to qualify as excepted benefits in the individual and group marketplaces. Specifically, under the proposed rules:
- No Per Service Payments. A fixed indemnity policy may only pay out on a per-period basis (and would remove the option to provide payments on a per-service basis). The guidance reiterates that the exception for these types of policies is premised on the condition that it is structured as an income replacement (not medical reimbursement) benefit. The regulations make clear that policies could still include “per-service” payments, but that any such policy would no longer qualify as an excepted benefit.
- Fixed Payment. To qualify as an excepted benefit, payments under the policy must be “fixed”, meaning the policies pay the same amount per setting, regardless of the underlying services received, the severity of the illness, or any other characteristic of the treatment.
- No Direct-to-Provider Payments. While the regulators did not propose a specific rule change, they expressed their opinion that fixed indemnity policies that pay a provider directly likely do not qualify as an excepted benefit. This is because these policies are often structured in a way to reimburse medical expenses specifically or to coordinate with other forms of health insurance. Reiterating that these are intended to be income replacement (not medical reimbursement) benefits, the regulators indicated they would closely examine such “direct-to-provider” payment policies for enforcement action.
- No Coordination. The agencies propose prohibiting even informal coordination with other policies or benefits. The regulators give the example of a fixed indemnity policy offered alongside a “minimum essential coverage” option (sometimes referred to as a skinny plan, or MEC plan), which excludes everything other than preventive care. Even though there is no “formal” coordination between the two policies, the agencies propose treating this as impermissible coordination, meaning the fixed indemnity policy would lose its status as an excepted benefit.
- Notice Requirement. Similar to the STLDI requirement, the agencies also propose a robust consumer notice as well. The notice would apply in the group and individual market and would need to be included not only in policies, but also in marketing materials. The regulations suggest this obligation would extend to enrollment materials, meaning employers offering such policies would likely need to add this disclaimer (prominently, on the first page) in their open enrollment guides.
While the agencies did not propose changes to specified disease types of policies, they have asked for comments on whether and how the fixed indemnity product changes will impact these plans.
The proposed rules (if finalized) would apply for new policies sold or issued on or after the effective date of the final rules, with respect to plan years beginning on or after the effective date of the final rules. The rules would apply to existing policies (those sold/issued prior to the effective date of the final rules) beginning with plan years on or after January 1, 2027 (except the notice requirements would go into effect for plan years beginning after the effective date of the final rules).
Level-Funded Plan Arrangements
The agencies have expressed concern as to status of level-funded arrangements as self-funded plans, which are out of the reach of state insurance regulation. Although, stop loss insurance coverage is wrapped into the policies, such insurance is not subject to federal consumer protections or many state consumer protections for that matter. The agencies are concerned that these arrangements could result in the employer being on the hook for claims required by federal law but not applicable to the stop-loss carrier. Further, it could result in adverse selection in state small group market pools. Finally, the agencies are concerned these arrangements potentially create multiple employer welfare arrangements (MEWAs) if the plan sponsor contributions aren’t properly segregated.
Tax Treatment of Payments from Fixed/Hospital Indemnity Products
The IRS and Treasury clarified the tax treatment of amounts that are paid under “accident or health insurance” without regard to the amount of actual medical expenses incurred, and where the premiums are paid on a pre-tax basis. Internal Revenue Code Sections 104 and 105 are two of the most opaque tax sections and are only to be read by the strong-of-heart. The arcane nature of these provisions have allowed for the marketing of certain products (typically labeled as fixed or hospital indemnity products) with promises of generous benefits coupled with the avoidance of income and FICA taxes to boot. The tax agencies are aware of these products that purport to exclude benefits from income and employment taxes, even though they are paid unrelated to actual expenses. Surprise: They don’t like them! So, clarification of the tax treatment is welcome here.
The tax agencies explained that Section 104 addresses payments and benefits under accident and health plans where the premiums are paid on an after-tax basis. In this case, amounts paid from such an accident and health plan can be excluded from tax under Section 104(a)(3). So, this would apply where employees pay for the cost of coverage after-tax and not via the employer’s cafeteria plan (and where the employer otherwise provides no premium subsidy).
On the other hand, Section 105 addresses the situation where premiums are paid on a pre-tax basis. In order for the payments from an accident and health plan to be excluded from gross income under Section 105(b):
- the premiums for the coverage must be made on a pre-tax basis (i.e., under the employer’s cafeteria plan); and
- the benefit payments from the plan must be for reimbursement of substantiated medical expenses as defined in Internal Revenue Code Section 213(d). (The tax agencies are taking comments on whether the substantiation could be provided after the fact.)
Because fixed indemnity policies rarely (if ever) substantiate actual medical expenses prior to paying claims, these new regulations would significantly change the taxation of benefits – not just for the new class of “FICA Avoidance” wellness programs, but for traditional fixed indemnity/hospital indemnity products as well.
The proposed regulations would take effect the later of the date of publication of final regulations or January 1, 2024. Of note, this is more definitive and likely earlier than the effective date of the rest of the proposed regulations, indicating that the tax agencies are committed to effecting this change sooner rather than later.
The breadth of these regulations suggest they have the potential to impact all employers who have (or are considering) sponsoring or offering any form of indemnity product to their workforce. In many instances, these regulations will require employers to act immediately to address the rules prior to their next renewal. We will watch for the release of final regulations and provide an update on any future changes or developments in this space.