HD19 - The Taxation of Insurance

  • Published: 1987
  • Author: Secretary of Finance
  • Enabling Authority: House Joint Resolution 155 (Regular Session, 1986)

Executive Summary:
Overview and Purpose of this Report

House Joint Resolution 155, passed by the 1986 session of the General Assembly, requested the Secretary of finance to continue the study of the taxation of insurance companies in Virginia conducted pursuant to House Joint Resolution 311 of 1985. This continued study was necessary to respond to several issues that could not be resolved during the 1985 study, and to make specific recommendations for correcting inequities in the current tax treatment of insurance companies.

BC/BS plans are exempted from the gross premium tax because they offer a program of insurance that no other health insurance companies offer. This program--known as the "open enrollment" program--provides health insurance coverage to any Virginia citizen who applies for it regardless of health history, employment status, occupation, or geographical location.

The open enrollment program comprises a small proportion of the Blues' total book of business. In recent years, questions have been raised regarding the equity of providing an exemption from tax on all the Blues' premiums rather than just that unique portion known as open enrollment. In 1985, the HJR 311 study of the Taxation of Insurance Companies in Virginia found that the majority of the Blues' business is very similar to that offered by commercial companies, and that preferential tax treatment for that portion of the business should be reconsidered. However, due to limited information on the extent of participation within BC/BS' open enrollment program, a final recommendation could not be made regarding the preferential tax treatment.

The objectives of this study are:

1. To present documentation of the numbers and character1stics of high risk or uninsurable individuals whose health insurance could be jeopardized if prepaid health care plans such as Blue Cross/Blue Shield (BC/BS) or health maintenance organizations (HMOs) are subject to taxation;

2. To identify the legal and regulatory requirements, if any, needed to protect health insurance subscribers or policyholders if changes to current tax laws are recommended;

3. To evaluate Virginia's policy of exempting certain types of insurance from taxation in light of federal reform actions to eliminate the tax-exempt status of these organizations;

4. To document the views of the Attorney General regarding Virginia's authority to tax self-insured groups under federal law; and

5. To propose specific revisions of the tax structure to rectify inequities in the current tax treatment of insurance companies.

Current Premium Taxation in Virginia

The gross premiums tax that Virg1nia levies on the insurance industry generated $131.2 million in fiscal year 1986, making it the fifth largest source of revenue in the Commonwealth's General Fund. Although the characteristics of the insurance industry have changed dramatically over the years, the rate structure has not changed from the original form adopted by The General Assembly in 1914. HJR 311, passed by the 1985 General Assembly, requested the Secretary of Finance to study the taxation of insurance companies in Virginia.

Findings of HJR 311 study: The HJR 311 study concluded that Virginia's tax structure for insurance companies involves rates that are higher than most states. These comparatively high rates were viewed by industry representatives as one reason why the domestic insurance industry is relatively small in Virginia. Among domestic insurers, the highest relative tax burden is on property and casualty companies, mutual assessment fire companies, and the worker's compensation self-insured groups. Additionally, the study found that Virginia has a more complex, multi-tiered tax structure than most other states, and that there is little justification for the variation in amounts or application of annual license fees.

Tax-Exempt status of Pre-Paid Health Plans and HMOs: Unlike commercial insurance companies, which pay a 2.75% tax on gross premiums, pre-paid health plans such as Be/BS and HMOs are exempt from the premium tax. The current tax-exempt status of these groups was a major issue discussed in the 1985 study. Be/BS plans maintain that they should retain their tax-exempt status because they provide a significant social benefit that other commercial insurers do not. Specifically, this benefit is the plans' open enrollment policy, whereby persons applying for individual or small group health insurance cannot be denied coverage for health reasons, and once enrolled cannot lose coverage due to high utilization of medical services. Certain other groups, deemed ineligible for coverage by some commercial carriers due to the occupational or industrial classification of the group, also benefit from the Blues· open enrollment program.

The Blues also state that, in addition to open enrollment, BC/BS plans provide other community services that further justify this tax-exemption. These community services include: sponsoring public education programs, developing health care cost containment programs, assisting localities in the planning of health care facilities and contributing cash and in-kind services to various community projects.

Although HMOs are exempt from the gross premiums tax, for-profit HMOs are subject to a corporate income tax. The corporate income tax imposes a lesser tax burden than would be the case if HMOs were subject to the gross premiums tax. HMO officials contend that the current tax treatment is appropriate for HMOs because they are health care providers, not insurers. HMO proponents also cite the General Assembly's decision to impose a corporate rather than a premium tax on for-profit HMOs as one way of allowing HMOs to establish themselves during their first years of operation in Virginia.

Commercial insurers in Virginia view the premium tax-exemption now enjoyed by BC/BS and HMOs as a d1stlnct competitive advantage. These insurers contend that the activities of BC/BS plans and HMOs have become so like those of commercial insurers that tax-exemption is no longer appropriate.

BC/BS Health Plans in Virginia

In calendar year 1985, BC/BS plans collected $1.2 billion in total health insurance premiums from Virginia subscribers. Section 38.2-4226 of the Code of Virginia exempts BC/BS from the 2.75% premium tax that other insurers pay on their gross accident and sickness premium income. This exemption totalled approximately $33 million in 1985.

Currently there are two BC/BS plans operating in Virginia: BC/BS of Virginia (based in Richmond) and Blue Cross/Blue Shield of the National Capital Area (BCBSNCA, based in Washington, D.C.). Until March 1986, when it merged with BC/BS of Virginia, BC/BS of Southwestern Virginia operated as a third plan. Since the merger, BC/BS of Virginia now operates with two major divisions, Richmond and Roanoke. Figure 1 displays the percentage of subscribers (or contracts) insured under the various types of coverage offered by BC/BS.

The average total enrollment for BC/BS plans in 1985 was about 1.1 million subscribers. A total of 36,248 subscribers (individual and small group) were covered under BC/BS' open enrollment program in 1985. As seen in Figure 1, these subscribers make up about 3.2% of all BC/BS subscribers. Unlike commercial carriers, BC/BS plans also provide non-group, Medicare-extended coverage to disabled persons under age 65. A total of 6,934 such contracts (.6% of all contracts) were in-force during 1985. Through open enrollment, the Blues also provide coverage to certain groups that are deemed ineligible for coverage by most commercial carriers.

The bulk of the Blues' business (nearly 70 percent) is derived from larger group contracts and Medicare-extended coverage to persons over 65. Industry experts state that the Blues' larger group policies, Medicare-extended policies (persons over age 65) and underwritten (individual and small group) policies are similar in most respects to policies offered by commercial carriers.

Reassessing the Tax-Exempt status of BC/BS Plans

The study team analyzed the medical characteristics and insurability of both individual and small group open enrollment subscribers. The analysis of these groups was agreed to during the planning stage of the study by both BC/BS and the commercial companies which participated in the analysis of claims information. After the study team had completed its analysis of this portion of the Blues' business, BC/BS of Virginia and BCBSNCA identified, following their review of the exposure draft, additional categories of business which they wanted to have included in the scope of the open enrollment program.

The additional categories of business identified by the Blues include members of professional and trade associations (71,130 contracts), certain community-rated groups (ineligible groups: 29,112 contracts; community-rated groups of 2-9 employees: 16,000 contracts) and disabled Medicare-extended subscribers under age 65 (6,934 contracts). Due to the late submission of this information, the study team had limited time to analyze the characteristics of these subscribers. However, the team was able to collect sufficient information to develop general conclusions regarding the insurability of these categories of the Blues' business.

Characteristics of Open Enrollment Subscribers: A telephone survey of BC/BS individual open enrollment subscribers revealed that the primary reasons for participating in BC/BS plans are that subscribers simply converted from BC/BS group coverage (41%) or selected the coverage because they believed the benefits were better than other companies (20%).

The survey of individual subscribers also indicated that 61 percent of the open enrollment subscribers surveyed reported having a high risk condition. However, it cannot and should not be assumed that all of these subscribers would be unable to obtain commercial insurance. For instance, high blood pressure was defined for the purposes of this study to be a "high risk" condition. Because high blood pressure alone does not incur high benefit costs, persons applying to commercial companies with only this condition will likely face less difficulty obtaining insurance.

This finding was corroborated by the survey of commercial insurance companies. This survey demonstrates that comprehensive health insurance is available, although at a higher premium, to most persons with selected high risk medical conditions, particularly persons with only high blood pressure. Only those persons with the most serious medical conditions (alcoholism/drug abuse, stroke/paralysis), those with the more advanced stages of a disease, those with more than one high risk condition and those who have recently been treated for a high risk condition would likely be unable to obtain comprehensive insurance.

At the same time, it is important to note that open enrollment does offer comprehensive health insurance to some persons who, in all likelihood, would not be able to purchase similar coverage from commercial insurers. The underwriting practices of most commercial carriers often exclude high risk conditions from coverage or deny coverage altogether to most persons with serious medical problems. This finding is substantiated by a greater percentage of BC/BS open enrollment contracts with high risk claims, a larger percentage of the Blues' total benefits being paid for high risk claims, a higher average claim liability for open enrollment contracts, and the responses of commercial companies regarding their underwriting practices.

Conclusions Regarding Open Enrollment: The total number of open enrollment contracts in 1985, both individual and small group (2-10 subscribers), was 36,248, or 3.2% of all BC/BS contracts. Medicare-extended subscribers, who are under 65 and disabled, account for .6% of all BC/BS contracts. An additional 29,112 contracts, or 2.6% of the Blues' total contracts, are subscribers who are employed in groups (2-49 employees) the Blues contend are ineligible for coverage from most commercial companies because of the high risk nature of the group. Therefore, even without any analysis of the medical characteristics and insurability of these persons, this segment of the open enrollment program applies to a maximum of about 6.5% of the Blues' total business. These contracts provide the primary basis for justifying the Blues' total tax-exemption, estimated at $33 million in 1985.

The study team concludes that the medical characteristics and insurability of the individual open enrollment population can best be defined in a four-tiered description:

1. Approximately 39 percent of individual open enrollment subscribers, who reported no high risk conditions, would have little, if any, difficulty obtaining insurance from commercial carriers.

2. Those persons with only high blood pressure, about 10 percent of open enrollment subscribers, would likely have to pay additional premiums, but would be able to obtain health insurance from other insurers.

3. An unknown percentage of open enrollment subscribers who reported having other high risk medical conditions would likely have difficulty getting coverage; and if coverage was available, the person would likely pay higher premiums. Whether a commercial carrier would offer coverage to these persons would depend on the seriousness of the condition, and the time between the treatment or diagnosis of the condition and the time of application.

4. The remaining open enrollment subscribers, who have the most serious conditions or who have more than one high risk condition, would not be able to get insurance from any carrier other than BC/BS.

The team further concludes that although some groups are declared ineligible by most commercial carriers, very few groups are totally excluded from coverage by all companies. Due to the varying underwriting practices of commercial companies, the broad categories of groups identified by the Blues as being ineligible, and the difficulty in conducting a comprehensive search of BC/BS's computer files, the team was unable to identify a specific number of subscribers that would not be able to get coverage from other insurers. However, the team does conclude that the number of subscribers employed by these groups who cannot get commercial insurance is substantially less than the number reported by BC/BS (29,112).

The study team does not agree that every subscriber in each of the additional categories of business, identified by the Blues during their review of the exposure draft, is "at-risk" or is a direct beneficiary of the open enrollment program. However, if one were to assume that every subscriber in all of the categories identified by the plans is truly "at-risk" or benefits direct·)y from the open enrollment program, these subscribers would still make up only about 14% of the Blues' total contracts (see Table 11-1). The study team concludes the actual number of BC/BS subscribers that are "at-risk" is substantially less than the number reported by BC/BS.

Based on the analysis presented in this report, open enrollment and the related social benefits cited by BC/BS do not appear to be adequate justification for the Blues' total tax-exemption, estimated at $33 million in 1985. At the same time, some preferential tax treatment is justified because some persons and groups currently enrolled in BC/BS plans will find it difficult or impossible to obtain affordable coverage from commercial insurers and because of any underwriting losses which can result from insuring these enrollees.

Regulatory Mechanisms Available to Protect Uninsurable Persons

The Blues have maintained that, if subject to the gross premiums tax, they would possibly reduce or eliminate open enrollment. Under current Virginia law, BC/BS can elect to eliminate its open enrollment program, as long as BC/BS provides 12 months notice to the state Corporation Commission. If BC/BS did curtail or eliminate open enrollment, selected persons with high risk medical conditions would not be able to purchase comprehensive health insurance. Without insurance, some of these persons would likely be unable to pay their health care costs. As a result, hospital bad debt would increase and be passed on to other consumers or the Commonwealth through increased costs.

The study team examined several regulatory mechanisms as possible means for protecting health insurance subscribers whose coverage may be affected if changes in the current tax laws, or the Blues of their own volition, alter the availability of open enrollment. Among the alternatives examined by the team were: establishing a health insurance risk pool, offering tax credits or deductions to any insurer offering open enrollment, and taxing BC/BS at a reduced rate as an incentive for the Blues to continue open enrollment.

Health Insurance Risk Pools: Health insurance risk pools have been established in ten states to address the problem of uninsurable persons. Risk pools are currently operating in six states. Four additional states expect to implement risk pools in 1987. These mechanisms provide comprehensive hospital and medical coverage for persons who are unable to obtain adequate standard health insurance in the private market, due to uninsurable physical or mental conditions. Risk pool subscribers generally pay between 125 percent to 160 percent of the premiums charged to healthy individuals.

The costs of operating a risk pool that are not recovered through premiums paid by persons insured under the plan are proportionately assessed to all insurance companies operating in the state. Most states subsidize the cost of operating a risk pool by providing tax credits equal to the assessment paid by each company.

If a risk pool does become necessary in Virginia to insure high risk persons, Title 38.2 of the Code would have to be amended. Additionally, a number of important issues would have to be resolved, including: the organization of the pool, funding sources, eligibility requirements, benefit levels, premiums, the extent of state regulation, and the type of state subsidy (if any) for the pool. The sec estimates that approximately one year would be needed to implement a health insurance risk pool in the Commonwealth.

Open Enrollment Criteria: The establishment of open enrollment criteria (e.g., year-round open enrollment, community-rated pricing, etc.) that, if met, would qualify any insurer for special tax rates, credits or deductions would "level the playing field", in that all insurers would have an opportunity to earn preferential tax treatment. Depending on the requirements that are established, this approach would likely require extensive monitoring by the Bureau of Insurance to ensure that companies seeking special tax treatment are indeed earning it.

This approach has not been implemented in any state. Furthermore, although the 1986 federal tax reform law established criteria for special tax treatment at the federal level, it appears that only existing BC/BS plans will qualify for this special tax treatment. If implemented in Virginia, this alternative would likely require that a risk pool be established as a safety net for uninsurable persons in the event no insurer chooses to offer open enrollment. Also, as recognized at the federal level, the financial impact of this option in terms of possible lost premium tax revenue is unknown.

Preferential Tax Treatment for BC/5S Plans: The analysis of BC/BS' open enrollment program and other community services, presented in Chapter II of this report, indicates a total tax-exemption for the Blues is not justified. However, the availability of insurance to high risk individuals and certain groups through open enrollment does warrant preferential tax treatment because no other insurer offers such a program. Based on the analysis presented in this report, the most practical and efficient mechanism for protecting uninsurable individuals would be for the Commonwealth to provide BC/BS a partial tax-exemption as an incentive for continuing open enrollment.

A change in tax status, phased in over time, would help offset the cost of insuring high risk enrollees, and, at the same time, would remedy the current inequity in the tax treatment of BC/BS and commercial insurers.

Regulation and Taxation of HMOs and Self-Insured Groups

Industry experts report that the traditional form of health insurance, in which patients are cared for by physicians of their choice and insurance companies reimburse the patient or provider on a fee-for-service basis, is disappearing. The establishment and rapid growth of health maintenance organizations (HMOs) and preferred provider organizations (PPOs) is quickly reshaping the health care delivery and health insurance industries. Industry experts predict even greater growth in both HMOs and PPOs into the 1990s.

In addition to the dramatic changes seen in the health care delivery and health insurance industries, there has been substantial growth in the numbers of companies, corporations and other groups that are turning to self-insurance as a means of reducing the cost of employee benefit plans. Self-insurance is effecting change not only in the provision of health insurance benefit plans, but also in workers· compensation benefits, property and casualty insurance and liability insurance.

There are no definitive statistics on the amount of premium tax revenue that is no longer collected since the advent of HMOs and self-insurance. However, there is little doubt that as these entities continue to grow, the Commonwealth will experience a commensurate reduction in revenues that otherwise would have been generated through taxing premiums associated with traditional 'forms of insurance.

Taxation of HMOs in Virginia: The Bureau of Insurance reports a total of 18 HMOs licensed in Virginia. Four HMOs are currently operating on a non-profit basis and therefore are 'tax-exempt. The other 14 HMOs are for-profit and are subject to a six percent corporate income tax. The current approach to regulation and taxation of HMOs in Virginia is largely the result of the 1979 Commission to study the Containment of Health Care Costs (also known as the "Willey Commission"). The Commission concluded that encouraging the development of HMOs would inject competition into the health care system, and, in turn, would he19 combat escalating health care costs. The Willey Commission recommended that HMOs be regulated and taxed differently than BC/BS plans and that legislation specifically applicable to HMOs be adopted to encourage their development.

The 1980 General Assembly's decision to impose a corporate rather than a premium tax on for-profit HMOs was one way of recognizing HMOs as health care providers rather than insurers. It also acknowledged the vulnerability of this young industry and attempted to inject competition into the health care system. No HMO has been licensed under the current HMO legislation more than five years, although four were doing business before 1980 under prior Code provisions. The small market share held by HMOs is evidenced by the fact that 11 HMOs reported subscriber income of less than $5 million in 1985; seven had income of less than $500,000. BC/BS plans' enrollment was eight times greater than the total 1985 HMO enrollment; 1985 subscriber income for the Blues was 11 times greater than HMO subscriber income.

Reassessing the Tax Status of HMOs: The study team's reassessment of the tax status of HMOs indicates that the distinction between health care provider and insurer still exists with respect to the five Staff and Group model HMOs operating in the Commonwealth. These types of organizations employ or contract directly with a group of physicians to provide health care for their membership. Moreover, physicians who contract with these HMOs typically deliver most covered services at facilities owned by the HMO. As such, the corporate income tax appears to be the appropriate form of taxation.

The 13 Independent Practice Association (IPA) model HMOs, on the other hand, function similarly to BC/BS plans in that they contract with a large number of physicians who practice in their own offices and generally treat a greater percentage of patients who are not affiliated with the HMO. However, as with Group and Staff model HMOs, IPA physicians assume risk through the prospective method of payment. Because IPA model HMOs are new and have a very small market share of the Virginia health care market, the imposition of a premium tax us not warranted at this time.

Self-Insurance: In recent years, significant numbers of employers have moved to replace traditional insurance coverage with self-insurance or self-funded plans in an effort to control costs. These arrangements have opened new business opportunities for insurance companies and independent management firms. By altering the distribution and assumption of risks, self-insurance plans also have important implications for state tax and regulatory policy.

The types of self-insurance plans can generally be grouped into three classes. The first is where the self-insured assumes all risks but contracts with other entities for administrative services such as claims handling and data processing. A second category of self-insurance is characterized by a sharing of risks between the self-insured party and an insurance company. The final type of self-insurance consists of plans which are totally self-funded and self-administered. Employee benefit plans provided by several large employers or unions fall into this class.

There is little data to accurately measure the volume of self-insurance. The major reason for this is that self-insurance plans are not subject to annual reporting requirements because they are not regulated by state insurance departments, like other forms of insurance. Moreover, the principal sources of information which are available do not cover all aspects of the self-insurance market.

Regulating and Taxing Self-Insured Groups: Current tax provisions for self-insurance seem to be based on the assumption that self-insurance is equivalent to no insurance. This is grounded in the fact that self-insurance does not involve an insurance contract. The arguments for placing a premium tax on these plans, however, are strong since these plans divert income away from insurance companies which would otherwise be included in the premium tax base.

Because of the disparity in tax treatment between insurers and self-insurers, the study team requested the Attorney General's Office to review whether or not Virginia had the authority to impose a premium tax on self-insurance plans. This review indicated that self-insurance associated with employee benefit plans was exempt from state taxation under the provisions of the Employee Retirement Income Security Act of 1974. The Attorney General's Office did indicate, however, that other forms of self-insurance could be taxed. The merits of taking this action are difficult to assess because of the present lack of data on the size and scope of these plans. Clearly, more research is needed in the area of property and casualty self-insurance before 'current tax policy is changed.

Due to the continued growth of both HMOs and self-insurance, the Commonwealth will likely have to reevaluate its current tax policy regarding HMOs and self-insurance within the next few years. Furthermore, the ability of Be/BS plans and other insurance companies to change their operation and products in such a way that premium taxes can be substantially reduced, or avoided altogether, will also be a critical issue that the General Assembly will likely have to address in the upcoming years.

Recommendations

This study and the one conducted pursuant to HJR 311 of 1985 have identified a number of inequities in the manner by which insurance companies are taxed in Virginia. This report provides recommendations and alternatives for addressing these inequities. Three types of recommendations are presented. They include actions to redesign the tax structure, the tax base, and the administration of premium taxes and regulatory assessments.

Recommendations For Tax structure Changes

Recommendation 1: The current premium tax rate imposed on property and casualty and accident and sickness insurance should be reduced to be more in line with the tax rate applied to life insurance.

Recommendation 2: The current tax-exemption provided prepaid health and Blue Cross/Blue Shield plans should be repealed. Instead, consideration should be given to the following:

* As long as an open enrollment program with the current features is maintained by the Blues, tax their entire premium income at a rate which is lower than that applied to commercial accident and sickness insurance;

* Tax BC/BS plans at the same rate as commercial accident and sickness insurance, but exempt a certain percentage or certain types of subscriber income from taxation; or

* Tax the premium income of all insurers (commercial and BC/BS plans) the same, but provide tax credits or reduced rates for that portion of any company's business that is derived from an open enrollment program.

Recommendation 3: The General Assembly should direct the Bureau of Insurance to prepare contingency plans for implementing a health insurance risk pool in Virginia.

Recommendation 4: The General Assembly should recommend an appropriate change to the federal charter of Blue Cross/Blue Shield of the National Capital Area (BCBSNCA) to allow that corporation to be subject to Virginia premium taxation.

Recommendation 5: If Recommendation 2 is adopted, the annual license fee which is imposed on prepaid health plans should be repealed.

Recommendation 6: The tax status of HMOs should not be altered at this time. However, the General Assembly should closely monitor the growth and internal operations of HMOs to determine if changes in taxation are warranted in the future.

Recommendations For Tax Base Adjustments

Recommendation 7: The members of both the Virginia Property and Casualty Insurance Guaranty Association and the Virginia life, Accident and Sickness Insurance Guaranty Association should be allowed to deduct guaranty association assessments from premium taxes, but the amount of this deduction during anyone year should be limited to a specified amount of premium income.

Recommendation 8: The premium income received by cooperative non-profit life benefit companies from policies not requiring legal reserves should be taxed at the rate presently imposed on these companies.

Recommendations for Administrative Reform

Recommendation 9: The General Assembly should direct the Bureau of Insurance to analyze and document those occupational classes or industries that are generally "red-lined" or deemed ineligible from obtaining health insurance from commercial carriers.

Recommendation 10: The premium tax return presently submitted by insurance companies should be modified to accurately account for amounts claimed for allowable deductions.

Recommendation 11: Fraternal benefit societies should be assessed for the cost of regulation.

Recommendation 12: The General Assembly should monitor the evolving changes within the insurance industry at frequent intervals to ensure tax equity among competing forms of insurance and to assess the revenue impact associated with these changes.