Crain News Service
WASHINGTON -- The Internal Revenue Service is opening the door to a new, tax-favored way for employers to pre-fund retiree health care obligations.
The IRS recently issued a favorable private-letter ruling involving an employer-established voluntary employee beneficiary association's purchase of medical stop-loss insurance from an offshore group captive.
The ruling was obtained by Energy Insurance (Bermuda) Ltd., Hamilton, Bermuda, a separately capitalized subsidiary of Energy Insurance Mutual Ltd., Tampa, Fla. The company was set up in 1992 and designed as a rent-a-captive-style insurer to write a broad range of insurance coverages, reinsurance or nontraditional financial deals for utilities that belong to EIM.
Before the ruling, at least one utility -- Oklahoma Gas & Electric of Oklahoma City -- had been using a VEBA to buy stop-loss coverage from Energy Insurance as a way to pre-fund future retiree health care liabilities.
"This has proved to be a very cost-effective way to fund retiree health care benefits," said James Hatfield, vice president and treasurer at Oklahoma Gas & Electric, which began using the program in 1995.
While the IRS ruling applies to Energy Insurance and a particular set of facts, legal experts say it could have broad application.
"This should be of interest to any large employer that is funding retiree medical liabilities. We expect lots of companies to be interested" in this approach, said Henry Lawrie, a partner with the Chicago law firm of Gardner, Carton & Douglas.
In its ruling, the IRS said reserves established for stop-loss policies are eligible for the same favorable tax treatment as life insurance reserves to the captive insurer. That means the investment income supporting the reserves is not taxed.
In addition, the IRS ruled the inside buildup in the value of the stop-loss insurance is exempt from the unrelated business income tax generally applied to investment returns of VEBAs used to fund retiree health benefits.
The linkage of a VEBA, stop-loss insurance and an offshore captive insurer, experts said, avoids many of the problems employers face when they want to fund their retiree health care obligations in advance. Advance funding reduces liabilities employers have to report on their financial statements under Financial Accounting Standard 106 and also helps to ensure enough money is available to pay claims.
While employers are looking to pre-fund retiree health care liabilities, there are significant obstacles to doing so in tax- or cost-effective ways.
For example, a 1984 law limits the tax-effective use of a VEBA alone to fund in advance retiree health care benefits. Among other things, the law bars employers from taking into account anticipated increases in health costs in making tax-deductible contributions to VEBAs. Investment income earned on VEBA assets used to fund retiree health care liabilities is subject to the unrelated business income tax. This reduces the amount available to pay for benefits.
To avoid these problems, VEBAs can purchase life insurance products -- known as trust-owned life insurance -- from commercial insurers. Under such policies, the inside buildup of value is not taxed. While the VEBA owns the policies, individual employees are named as the insured. When those employees die, the VEBA collects the insurance proceeds and uses them to pay for retiree health care costs.
Alternatively, employers can purchase corporate-owned life insurance policies from commercial insurers. Similar to trust-owned policies, COLI policies, which name individual employees as the insured but are owned by the employer, allow the tax-free buildup of investment income earned on premiums paid by the employer. When employees die, the proceeds are used to pay for retiree health care claims. If certain rules are followed, money also can be borrowed tax-free from the policies.
The Clinton administration, however, has proposed ending some tax advantages of COLI policies.
In addition, in many states employers must disclose to employees that while they are named on life insurance policies, they will not receive the benefits. That can create an employee relations problem.
The purchase of stop-loss coverage to fund future retiree health care costs by an employer-established VEBA from an offshore captive can be even more financially attractive and avoid the disclosure problem, said Chris George, a consultant in the Wellesley Hills, Mass., office of Watson Wyatt Worldwide, which has been working with Oklahoma Gas & Electric and other large employers to fund benefit obligations through offshore captives.
"You get much greater cost efficiency. There are fewer frictional costs," Mr. George said.
For example, by buying coverage from offshore captives, companies can avoid state premium taxes, which commercial insurers must pay. In addition, offshore captives generally have lower overhead costs than commercial insurers. And, by buying medical stop-loss insurance from offshore captives, companies avoid employee disclosure requirements.
In addition, an individual employer whose VEBA buys coverage from a group captive probably will have greater control in how premium contributions are invested than it would if it purchased policies from a commercial insurer.
The design of a VEBA stop-loss insurance captive-linked program is simple. Employers make tax-deductible contributions to the VEBA. With those contributions, the VEBA buys stop-loss policies from the group captive. The policies provide coverage for claims that exceed a specified level. To maximize earnings potential of the premium contributions, the policies could cover active employees years away from retirement. That would allow a significant growth of investment income before claims are paid.