Legal Analysis of Premium Refunds, Credits, or Dividends on Experience-Rated Insurance Contracts

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1 U.S. Department of Labor Office of the Solicitor Washington, D.C MEMORANDUM FOR FROM: SUBJECT: CHARLES LERNER Director of Enforcement, PWBA RISA D. SANDLER Counsel for Fiduciary Litigation, PBSD Legal Analysis of Premium Refunds, Credits, or Dividends on Experience-Rated Insurance Contracts This memorandum analyzes whether experience rating dividends, refunds, and credits attributable to employee contributions should be treated as plan assets. It also presents several examples to assist you in determining the extent to which such dividends, refunds, and credits are attributable to employee contributions. As you know, PBSD has on several occasions examined the proper disposition under ERISA of premium refunds, credits, or dividends paid by insurers as a result of favorable claims experience on experience-rated insurance policies providing welfare benefits. In addressing this issue, we have followed the legal analysis articulated in a March 22, 1983 litigation memorandum regarding the Kaiser Steel Group Insurance Plan (PWBP Case No (49)). The Kaiser Steel analysis was applied most recently in a September 23, 1991 litigation memorandum concerning the Amoco Corporation Group Life Insurance Plan (PWBA Case No (48)). Recently, however, questions were raised concerning certain aspects of the Kaiser Steel analysis in connection with PWBA's investigation of the Group Life Insurance Plan for Employees of Conoco, Inc. (PWBA Case No (48)). In light of those questions, we have decided to reevaluate the legal analysis applied in Kaiser Steel and its progeny. For the reasons explained below, we believe that experience rating dividends, refunds, and credits should be treated as plan assets to the extent that they are attributable to employee contributions. In general, determining the extent to which any particular dividend, refund, or credit is attributable to employee contributions will require careful analysis of the language of the documents and instruments governing the plan. Depending on the terms of the plan in question, a particular refund, credit, or dividend may be attributable to employee contributions, employerpaid premiums, or both. But regardless of what the plan documents say, ERISA

2 403(c)(1) prohibits any distribution to the sponsoring employer of experience rating refunds, credits, or dividends in excess of the total premiums paid out of the employer's own assets. THE KAISER STEEL ANALYSIS We began in Kaiser Steel with the observation that insurance premiums could not be characterized as plan assets once they had been paid to and commingled with the assets of the insurer. Consistent with ERISA 401(b)(2) and the then proposed plan asset regulation, we indicated that the only asset owned by the plan in such a case would be a contractual right to receive the benefits promised in the contract of insurance. We recognized in Kaiser Steel that neither ERISA 401(b)(2) nor the proposed regulation addressed specifically the legal status of dividends, refunds, or credits paid by insurers as a result of favorable claims experience. Nevertheless, we declined to treat any such dividends, refunds, or credits as plan assets because we could find no statutory basis for arguing that all dividends, refunds, and credits were plan assets. Furthermore, treating all such dividends, refunds, or credits as plan assets would be inconsistent, we explained, with an Advisory Opinion issued to the Northwestern National Life Insurance Company on May 16, 1977 (WSB File #77-35), which adopted the view that an employer's premium remittance to an insurer is not a plan asset: [It is our opinion that in those cases where an employer makes premium payments for a health insurance policy for its employees solely with employer contributions from the general assets of the employer, the premium payments by the employer would not be considered plan assets.] Nor could we find any statutory basis for a rule that invariably would require allocating all such dividends, refunds, or credits between the employer and the employees in amounts directly proportional to their original contributions. Despite our conclusion that experience rating dividends, refunds, and credits were not plan assets, we determined in Kaiser Steel that, because ERISA 404(a)(1)(A) would preclude employers from operating plans for their own financial enrichment, an employer could not receive experience rating dividends, refunds, or credits in excess of its total contribution. In addition, we determined that ERISA 404(a)(1)(D) would require that any such payment to an employer be consistent with the terms of the plan and the disclosures made to participants. Thus, the analysis we articulated in Kaiser Steel required a case by case examination of the facts in light of ERISA 404(a)(1)(A) and (D) to determine whether dividends, refunds, or credits could be paid to an employer.

3 RECONSIDERATION OF THE KAISER STEEL ANALYSIS Our conclusion in Kaiser Steel that experience rating dividends, refunds, and credits are not plan assets was based largely on the May 16, 1977 Advisory Opinion issued to the NorthWestern National Life Insurance Company (WSB File #77-35), which adopted the view that an employer's premium remittance to an insurer is not a plan asset. But out analysis in Kaiser Steel and the May 16, 1977 Advisory Opinion on which it relied did not answer the question whether employee contributions toward the payment of insurance premiums are plan assets. The Department of Labor has since promulgated 29 C.F.R , which provides that employee contributions become plan assets as of the earliest date on which they can reasonably be segregated from the employer's general assets:... the assets of the plan include amounts (other than union dues) that a participant or beneficiary pays to an employer, or amounts that a participant has withheld from his wages by an employer, for contribution to the plan as of the earliest date on which such contributions can reasonably be segregated from the employer's general assets, not to exceed 90 days from the date on which such amounts are received by the employer (in case of amounts that a participant or beneficiary pays to an employer) or the date on which such amounts would otherwise have been payable to the participant in cash (in the case of amounts withheld by an employer from a participant's wages). This regulation does not address specifically whether plan assets include experience rating dividends, refunds, or credits to the extent that they are attributable to employee contributions. But it certainly raises the question whether employee contributions can forever lose their original character as plan assets simply because they are paid to and commingled with the general assets of an insurer. Nothing in ERISA 401(b)(2) or the plan asset regulation, 29 C.F.R , requires such an anomalous result. In our analysis of Kaiser Steel, we indicated that treating all experience rating dividends, refunds, and credits as plan assets would be inconsistent with the Advisory Opinion issued to Northwestern National Life Insurance Company. By the same token, we believe that treating experience rating dividends, refunds, or credits attributable to employee contributions as anything other than plan assets would be inconsistent with 29 C.F.R Accordingly, we now conclude that premium refunds, credits, or dividends paid by an insurer as a result of favorable claims experience on insurance policies providing welfare benefits should be treated as plan assets to the extent that they are attributable to employee contributions. Our conclusion in Kaiser Steel that

4 experience rating dividends, refunds, and credits are not plan assets should therefore be limited to that portion of any dividend, refund, or credit which is properly attributable to premiums paid by the employer out of its own general assets. As explained below, determining the extent to which any particular dividend, refund, or credit is attributable to employee contributions will require careful analysis of the language of the documents and instruments governing the plan. At a minimum, however, ERISA 403(c)(1) will prohibit any distribution to the sponsoring employer of experience rating dividends, refunds, or credits in excess of the total premiums paid by the employer out of its own general assets. 1 DETERMINING THE EXTENT TO WHICH EXPERIENCE RATING DIVIDENDS, REFUNDS, OR CREDITS ARE ATTRIBUTABLE TO EMPLOYEE CONTRIBUTIONS In an experience-rated insurance contract, the rates charged by the insurer are based on the loss experience of the insured over a period of time. The initial premium charged by the insurer is essentially an estimate of what it will cost to pay claims and expenses in the future. The insurer determines the actual cost of the policy at the end of the year when it performs a final accounting of the experience under the policy. If the estimated cost exceeds the actual cost at the end of the year, the insurer may issue a dividend, refund, or credit to cover all or part of the overpayment. Likewise, if the actual cost at the end of the year exceeds the estimated cost, the insured may be required to make up the shortfall either by paying an additional premium at the end of that year or by paying higher premiums in subsequent years. Given the nature of experience-rated insurance contracts, we believe that dividends, refunds, or credits paid as a result of favorable claims experience should be viewed as adjustments from the estimated to the actual cost of the insurance coverage provided under the policy. Whether a dividend, refund, or credit paid as a result of favorable claims experience on a particular policy is properly attributable to 1 We note that, unlike ERISA 404(a), claims alleging violations of ERISA 403(c)(1) do not require proof that the defendant acted as a fiduciary with respect to the disposition of a particular dividend, refund, or credit. Treating experience rating dividends, refunds, or credits attributable to employee contributions as plan assets will make any person who exercises any discretionary authority or control over the disposition of such dividends, refunds, or credits, a de facto fiduciary. Thus, any disposition that violates ERISA 403(c)(1) may also give rise to fiduciary breach claims under ERISA 404(a).

5 employee contributions cannot be determined without knowing how much the employees are required to contribute toward the actual cost of that policy, as well as how much they in fact contributed toward the estimated cost of the policy. Because ERISA does not require employers to allocate the actual cost of experience-rated insurance contracts between themselves and their employees in any particular manner, any analysis of whether a specific dividend, refund, or credit is properly attributable to employee contributions should focus on the manner in which the documents and instruments governing the plan allocate responsibility for payment of the actual cost of the policy between the employer and its employees. In theory, we can envision at lest five different ways in which the documents and instruments governing a plan might allocate the responsibility for payment of the actual cost of the insurance coverage provided under the policy: 1. The plan may provide that the employer will pay the entire cost of the insurance coverage; 2. The plan may provide that the employees will pay the entire cost of the insurance coverage; 3. The plan may provide that the employer and its employees will each be responsible for paying a fixed percentage of the cost of the insurance coverage; 4. The plan may provide that the employer will be responsible for paying a fixed amount of the cost of the insurance coverage, and that the employees will be responsible for paying any cost in addition to that amount; or 5. The plan may provide that the employees will be responsible for paying a fixed amount of the cost of the insurance coverage, and that the employer will be responsible for paying any cost in addition to that amount. We will examine each of these scenarios in turn. (1) Plans providing that the employer will pay the entire cost of the insurance coverage In the case of a plan which requires the employer to pay the entire cost of an experience-rated group insurance policy, the employer often pays all of the initial premium for the policy. In that situation, any dividends, refunds, or credits paid as a result of favorable claims experience would not be treated as plan assets.

6 Consequently, the employer would be entitled to keep the full amount of any such dividend, refund, or credit. (2) Plans providing that the employees will pay the entire cost of the insurance coverage In the case of a plan which requires the employees to pay the entire cost of an experience-rated group insurance policy, the employees often pay all of the initial premium for the policy. In that situation, any dividends, refunds, or credits paid as a result of favorable claims experience would be treated as plan assets. Consequently, the full amount of any such dividend, refund, or credit would have to be held in trust for the exclusive benefit of the employees. (3) Plans providing that the employer and its employees will each be responsible for paying a fixed percentage of the cost of the insurance coverage In the case of a plan which requires the employer and its employees each to pay a fixed percentage of the cost of an experience-rated insurance policy, any dividends, refunds, or credits paid as a result of favorable claims experience would have to be allocated between the employer and the plan in such a way that the employer and its employees would each be left paying the full amount of the actual cost for which they were ultimately responsible. If the percentage of the initial premium paid by the employees equalled the percentage of the actual premium for which they were ultimately responsible, any experience rating dividend, refund, or credit would have to be allocated to the plan in direct proportion to the employer's and employees' original contribution. EXAMPLE NO. 1: Assume that employer X purchases an experience-rated group insurance contract that provides welfare benefits to its employees. The plan document provides that the employer will be responsible for paying 60% of the total cost of the coverage provided under the policy, with the employees being responsible for paying the remaining 40%. Assume further that the employer pays an initial premium of $55,000 for that coverage, while the employees pay an initial premium of $40,000. The insurer performs a final accounting at the end of the year, determines that the actual cost of the benefits provided under the policy was $85,000, and declares a $10,000 dividend. Because the plan document required the employer to pay only $51,000 ($85,000 x 60%), and the employer actually paid $55,000, the employer would be entitled to keep $4,000 ($55,000 - $51,000) of the $10,000 dividend. The remaining $6,000 of the $10,000 dividend would be attributable to employee contributions and would have to be treated as a plan asset.

7 EXAMPLE NO. 2: Assume that employer X purchases an experience-rated group insurance contract that provides welfare benefits to its employees. The plan document provides that the employer will be responsible for paying 60% of the total cost of the coverage provided under the policy, with the employees being responsible for paying the remaining 40%. Assume further that the insurer charges an initial premium of $100,000 for all of the coverage provided under the policy, $60,000 of which is paid by the employer, and $40,000 of which is paid by the employees. Under these circumstances, 40% of any dividend, refund, or credit paid as a result of favorable claims experience would have to be treated as a plan asset. (4) Plans providing that the employer will be responsible for paying a fixed amount of the cost of the insurance coverage, with the employees being responsible for paying any cost in addition to that amount In the case of a plan which requires the employer to pay a fixed amount of the cost of an experience-rated insurance policy, with the employees being responsible for paying any cost in addition to that amount, any dividends, refunds, or credits paid as a result of favorable claims experience would have to be allocated between the employer and the plan in such a way that leaves the employer paying no more and no less than the full amount of the actual cost for which it was ultimately responsible. In this situation, experience-rating dividends, refunds, or credits would be treated as plan assets unless they exceeded the total amount of the initial premium paid by the employees. EXAMPLE: Assume that employer X purchases an experience-rated group insurance contract that provides welfare benefits to 200 of its employees. The plan document provides that the employer will be responsible for paying $20 per month for each employee covered under the policy, or $240 per year for each covered employee, and that the employees themselves will be responsible for paying any cost in addition to that amount. Assume further that the insurer charges an initial annual premium of $85,000 for all of the coverage provided under the policy, $48,000 ($240 x 200) of which is paid by the employer, and the remaining $37,000 of which is paid by the employees. The insurer performs a final accounting at the end of the year, determines that the actual cost of providing the benefits guaranteed under the policy was $80,000, and declares a $5,000 dividend. Because the plan document provided that the employees themselves would have to pay only the amount by which the actual cost of the policy exceeded $48,000, which in this case meant $32,000 ($80,000 - $48,000), the entire $5,000 dividend would be attributable to employee contributions and would have to be treated as a plan asset.

8 (5) Plans providing that the employees will be responsible for paying a fixed amount of the cost of the insurance coverage, with the employer being responsible for paying any cost in addition to that amount In the case of a plan which requires the employees to pay a fixed amount of the cost of an experience-rated insurance policy, with the employer being responsible for paying any cost in addition to that amount, any dividends, refunds, or credits paid as a result of favorable claims experience would have to be allocated between the employer and the plan in such a way that leaves the employees paying no more and no less than the full amount of the actual costs for which they were ultimately responsible. Experience-rating dividends, refunds, or credits would not be treated as plan assets unless they exceeded the total amount of the initial premium paid by the employer out of its own general assets. EXAMPLE NO. 1: Assume that employer X purchases an experience-rated group insurance contract that provides welfare benefits to 200 of its employees. The plan document provides that the employees will each be responsible for paying $30 per month for the coverage provided under the policy, or $360 per year, and that the employer will be responsible for paying any cost in addition to that amount. Assume further that the insurer charges an initial annual premium of $90,000 for all of the coverage provided under the policy, $72,000 ($360 x 200) of which is paid by the employees, and the remaining $18,000 of which is paid by the employer. The insurer performs a final accounting at the end of the year, determines that the actual costs of providing the benefits guaranteed under the policy was $80,000, and declares a $10,000 dividend. Because the plan document required the employer to pay only the amount by which the actual cost of the policy exceeded $72,000, which in this case meant $8,000 ($80,000 - $72,000), the employer would be entitled to keep the entire $10,000 dividend ($18,000 - $8,000). EXAMPLE NO. 2: Assume that employer X purchases an experience-rated group insurance contract that provides welfare benefits to 200 of its employees. The plan document provides that the employees will each be responsible for paying $35 per month for the coverage provided under the policy, or $420 per year, and that the employer will be responsible for paying any cost in addition to that amount. Assume further that the insurer charges an initial annual premium of $95,000 for all of the coverage provided under the policy, $84,000 ($420 x 200) of which is paid by the employees, and the remaining $11,000 of which is paid by the employer. The insurer performs a final accounting at the end of the year, determines that the actual cost of providing the benefits guaranteed under the policy was $80,000, and declares a $15,000 dividend. Because the plan required the employer to pay only the amount by which the actual cost of the policy exceeded $84,000, which in this case meant $0, the employer would be entitled to keep $11,000 ($11,000 - $0) of the $15,000 dividend. The remaining $4,000, which is the amount by which the

9 total dividend ($15,000) exceeded the initial premium paid by the employer ($11,000), would be attributable to employee contributions and would have to be treated as a plan asset. We believe that the allocation method described in scenario 5 above is probably more common in practice than either of the allocation methods described in scenarios 3 and 4. That belief is based on our recognition that, unlike scenario 5, either the insurer or the employer in scenarios 3 and 4 above would have the difficult task of having to collect additional premiums from employees at the end of the year in the event of unfavorable claims experience. We have analyzed all five scenarios in this memorandum because each of them are at least theoretically possible and PWBA may encounter any of them at one time or another. CONCLUSION We believe that experience rating dividends, refunds, and credits should be treated as plan assets to the extent that they are attributable to employee contributions. Treating such dividends, refunds, and credits as plan assets has obvious implications for employees, employers, and insurers alike. Any such dividends, refunds, or credits would have to be held in trust for the exclusive benefit of the employees. Furthermore, anyone who exercised any discretionary authority or control with respect to such dividends, refunds, or credits would be an ERISA fiduciary. Because of these implications, we would welcome any comments or suggestions you may have concerning our analysis. H:\5001\1290\LEGAL ANALYSIS - CONTRACTS.DOC