United States: HRAs And COBRA: Developing A New Strategy For Compliance

By Paul M. Hamburger P and Charles K. "Chip" Ker III

Many employers have established health reimbursement arrangements (HRAs) under which specified dollar amounts are available to employees in order to reimburse them for unpaid medical expenses. Typically, HRAs are established in conjunction with changes to the employer’s traditional indemnity plan where deductibles and co-payment amounts are increased significantly. The primary guidance on HRAs is included in IRS Notice 2002-45 and IRS Revenue Ruling 2002-41. According to the notice, an HRA is an arrangement that is paid for solely by the employer and not provided pursuant to a salary reduction election or otherwise (directly or indirectly) under a cafeteria plan; reimburses the employee for medical care expenses incurred by the employee, the employee’s spouse and tax code dependents; and provides reimbursements up to a maximum dollar amount for a coverage period.

Depending on the terms of the HRA, and as is the case with many HRAs, any unused portion of the maximum dollar amount at the end of a coverage period may be carried forward to increase the maximum reimbursement amount in subsequent coverage periods. Coverage and reimbursements of medical care expenses of an employee and the employee’s spouse and dependents under an HRA are generally not taxable, just like other employer-provided group health plan coverage.

A typical HRA plan design would provide regular monthly credits to employees’ accounts to be used for medical care and a carryover of any unused portion from year to year. The employer may also put a cap on the total amount of the carryover.

Under COBRA, qualified beneficiaries have a right to continue coverage that is identical to the coverage provided to similarly situated individuals with respect to whom a qualifying event has not occurred. In addition, COBRA requires that each qualified beneficiary be provided with a separate and independent right to elect COBRA coverage.

Because they are group health plans, HRAs are subject to COBRA. However, existing COBRA regulations and IRS rulings have not provided definitive guidance on the application of COBRA to HRAs. One rule seems to have been well-accepted in the field, though: COBRA results in a duplication of coverage when it is applied to HRAs. In this case, a qualified beneficiary has the right to continue coverage under the full amount of the remaining account balance at the time of a qualifying event; and if there are multiple qualified beneficiaries, each qualified beneficiary would have a separate right to continue HRA coverage separately from each other qualified beneficiary. This leads to a "mushrooming" effect whereby a single HRA could spin off into multiple HRAs increasing the employer’s liability accordingly.

The traditional approach to COBRA for HRAs is not compelled by the statute. A more logical approach can be developed based on the differences between indemnity-type group health plans and HRA coverage.

Defined Benefit vs. Defined Contribution Group Health Plans A traditional group health plan is a defined benefit plan. Each participant or beneficiary is entitled to coverage based on the specific terms and conditions in the plan and the nature of covered or uncovered expenses. Subject to annual and/or lifetime maximum coverage limits, if they exist, each member of a participant’s family has an unconditional right to coverage under the plan usually equal to a certain percentage of the usual, customary and reasonable (UCR) fee for a service, regardless of the expenses incurred by other family members. That is, if an employee incurs a $1,000 expense, that $1,000 expense does not automatically reduce the availability of coverage for each member of the employee’s family. Employers’ expectations in setting up a traditional defined benefit health plan (and the employees’ coverage expectations in such a plan) are that each member of the family could be reimbursed for the full amount of covered expenses.

By contrast, an HRA is a defined contribution plan. Each year, a participant’s family as a whole is entitled to coverage that is based solely on the amount in an account under the plan. Each family member has a conditional right to coverage under the plan. That is, if there is $6,000 in an account at a particular point in time, the participant’s right to that $6,000 of reimbursement is conditionally available as long as no other member of his or her family had any other expenses. The plan’s obligation is not defined by the nature of the expense (e.g., whether it equals or exceeds UCR, whether it is experimental, whether it was incurred at time of war, etc.). Rather, as long as the expense qualifies as a medical expense, it is reimbursable under the plan up to the account limit, subject to utilization by other family members. The employers’ and employees’ expectations under such arrangements are that employees have this conditional right to expense reimbursement.

An alternative approach to integrating COBRA and HRA coverage should satisfy two fundamental principles.

First, HRA COBRA coverage should consist not only of an amount of coverage identical to that in effect before the qualifying event but also of a type of coverage (conditional defined contribution) identical to that in effect before the qualifying event.

If there is going to be separate and independent HRA COBRA coverage available to qualified beneficiaries, the HRA COBRA coverage should provide for separate coverage rights for each covered unit, based on an equitable partitioning of the existing HRA coverage in effect at the time of the qualifying event. In designing a new COBRA approach to HRA coverage, there are two components of that coverage at the qualifying event. One component of the package is the existence of an account balance from which all family members may draw. Another component of the package is the existence of a right to ongoing credits. Of course, each family member’s right to this account balance (and ongoing credits) is conditional on the future (unknown) expenses of the other family members.

Based on these two key principles, a reasonable interpretation of the statute would be to ensure that a family’s conditional right to an HRA account balance and ongoing credits prior to a qualifying event is continued, but not expanded, for each qualified beneficiary after a qualifying event. Thus, the minimum COBRA requirement would be based on the first principle described above and would simply allow qualified beneficiaries the right to continue to participate in the conditional HRA coverage that is established by reference to the covered employee immediately prior to the qualifying event.

Under this approach, qualified beneficiaries would simply pay a COBRA premium for the right to continue to participate in the employee’s HRA account. The key point, however, is that there would be only one COBRA/HRA account from which all qualified beneficiaries would derive their coverage.

In many situations, however, the continued availability of this purely conditional right may not be desirable from a policy standpoint. For example, if a covered employee and spouse divorce, it is likely that the employee would not want a former spouse to continue to have the ability to deplete the availability of all coverage for the covered employee.

To accommodate this possibility, the second principle described above could be applied to provide qualified beneficiaries with a separate and unconditional right to share in an equitable partition of the pre-qualifying event HRA account balance. The division of the HRA balance could be accomplished through agreement of the parties, perhaps with a regulatory default division based on the number of individuals in each covered unit before and after the qualifying event. A similar equitable partitioning could then be applied to any future ongoing credits under the HRA. This equitable partition would apply for the duration of the COBRA period and could be adjusted as qualified beneficiaries fail to pay the applicable premium or otherwise terminate COBRA coverage.

The key advantage of this modified approach to integrating COBRA and HRAs is that it is consistent with employers’ and employees’ expectations in these programs. Also, this approach avoids the "windfall" created for qualified beneficiaries under the current COBRA rules. By adopting this approach to COBRA and HRAs, the government would remove a significant obstacle to the creation and growth of defined contribution group health plans.

MWE lawyers met with and made a proposal based on the aforementioned principles to the Internal Revenue Service and the U.S. Department of the Treasury. The government agencies have reviewed the MWE proposal and it is under active consideration.

Before implementing HRA coverage, employers should carefully consider how to apply COBRA's requirements to HRA coverage and how the plan documentation should be drafted to address these issues.