The States Where Level Funded Thrives and the States That Regulate It Out of Existence

LFP-07.02 | Sharp Analysis | Series 07: The Geography of Level Funded

State regulatory treatment is the threshold variable for level funded viability. Where a state treats level funded as self-funded under ERISA preemption, the product has full plan design flexibility, no premium tax on the claims fund, and no state-mandated benefit requirements beyond federal law. Where a state regulates it as fully insured, or prohibits the stop loss insurance that makes it financially viable, the product either cannot operate at all or loses the economic advantages that give employers a reason to choose it over conventional small group coverage.

The regulatory patchwork is the single largest geographic variable in the series because it determines whether the product can exist before any other question is asked. Network density, stop loss carrier appetite, marketplace quality, and broker expertise are consequential only in states where the regulatory environment permits the arrangement to function as intended. In states that prohibit or heavily constrain level funded for small groups, the infrastructure analysis is irrelevant.

The Regulatory Spectrum

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State approaches to level funded fall along a spectrum with three recognizable positions, though the middle contains significant variation by state.

At one end, the majority of states treat level funded plans as self-funded ERISA plans and do not impose additional requirements that affect the plan itself. Texas, Florida, Ohio, Indiana, Tennessee, Georgia, Arizona, North Carolina, and most of the Southeast, Southwest, and Midwest operate on this basis. The state insurance department recognizes that ERISA Section 514 preempts state regulation of the employee benefit plan. The stop loss policy that protects the employer is subject to state insurance regulation, including carrier licensing and policy form filing. But the plan document, benefit design, contribution structure, and surplus mechanics are not regulated as insurance. Community rating does not apply. State-mandated benefits do not apply to the plan. The claims fund contribution is not subject to premium tax.

The NAIC Stop Loss Insurance Model Act, adopted by the NAIC in 1995, provides a framework that states can use to regulate the stop loss component without touching the plan itself. The model establishes minimum specific attachment points of $20,000 and aggregate requirements scaled to group size and expected claims. Minnesota, Montana, and Florida have adopted attachment point requirements broadly consistent with the model. These requirements affect level funded economics at the margins, particularly for very small groups where low attachment points would otherwise transfer most claims risk to the carrier and blur the self-funded character of the arrangement. But they do not prohibit level funded or eliminate its structural advantages for groups with adequate size and health profiles.

In the middle range, several states have addressed level funded through regulatory guidance or statutory provisions that add compliance requirements without reclassifying the product. Some states have issued insurance department bulletins confirming that level funded plans structured as self-funded ERISA plans are not subject to small group market rules. Others have established attachment point floors that affect product economics without prohibiting the arrangement. California’s regulatory treatment is complex and has been the subject of ongoing guidance: the state has not explicitly prohibited level funded but has taken enforcement positions through the Department of Managed Health Care and Department of Insurance that create uncertainty around specific plan designs, particularly those where the stop loss carrier also administers the plan or where the TPA is affiliated with the carrier.

At the other end, a small number of states have effectively eliminated level funded for small groups through either stop loss prohibition or regulatory reclassification. New York presents the clearest example. New York Insurance Law Sections 3231 and 4317 prohibit the sale of stop loss insurance to employers with 50 or fewer employees. The prohibition is explicit in the statute: insurers may not provide stop loss, catastrophic, or reinsurance coverage to small groups that, if they purchased insurance, would be subject to the state’s community rating requirements. The practical effect is categorical: level funded for small groups does not exist in New York. An employer with 40 employees headquartered in Manhattan has no path to a self-funded arrangement with stop loss protection under New York law. The employer can move to fully insured, restructure through a professional employer organization in another state, or remain uninsured, but the level funded option is closed by statute.

Delaware maintained a similar prohibition until 2018, when the legislature amended the stop loss restriction for small groups. Connecticut, Vermont, and Massachusetts have not enacted explicit prohibitions but operate regulatory environments where the community rating tradition and state-specific insurance requirements make level funded difficult to structure competitively. Massachusetts merges its individual and small group markets under the Health Connector framework, which applies community rating to the combined pool and limits the plan design flexibility that makes level funded attractive.

The Preemption Argument and Its Limits

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The legal foundation of level funded rests on ERISA Section 514’s preemption clause, which supersedes state laws that “relate to” employee benefit plans. Under ERISA Section 3(1), a level funded plan is an employee welfare benefit plan. The employer bears the obligation to pay benefits from the claims fund. The stop loss policy is a separate insurance contract that indemnifies the employer for excess claims. Under this structure, the state can regulate the stop loss policy as an insurance contract, including setting minimum attachment points and requiring carrier licensing, but it cannot regulate the plan itself through mandated benefits, community rating, or premium tax on the claims fund contribution.

The Department of Labor addressed the stop loss question directly in Advisory Opinion 92-24A, confirming that stop loss insurance does not convert a self-funded plan into an insured plan regardless of the attachment point level. The opinion established that the plan’s self-funded character is determined by where the primary obligation to pay benefits lies, not by the existence of excess coverage. The employer who funds a claims account and draws stop loss reimbursement for large claims remains the plan’s primary obligor. The stop loss carrier is an indemnitor to the employer, not an insurer of the employees.

New York’s approach does not directly conflict with this analysis because the state does not attempt to regulate the plan document or benefit design of a self-funded ERISA plan. Instead, it prohibits the insurance transaction that makes the self-funded arrangement financially viable for small employers. A state can regulate insurance. Stop loss insurance is insurance. The state’s prohibition on selling stop loss to small groups is, on its face, a regulation of an insurance transaction rather than a regulation of an ERISA plan. The preemption boundary runs between the plan and the stop loss policy, and New York operates on the insurance side of that boundary.

The 4th Circuit addressed a related issue in American Medical Security, Inc. v. Bartlett (111 F.3d 358, 1997), where Maryland had attempted to classify stop loss policies with low attachment points as health insurance, thereby subjecting them to mandated benefit requirements. The court found the Maryland statute preempted by ERISA to the extent it imposed mandated benefits on the stop loss policy, because those benefit requirements effectively regulated the underlying ERISA plan. Maryland subsequently revised its approach. The case illustrates where the preemption line runs: states can set attachment point minimums, require carrier licensing, and regulate policy form. They cannot impose health insurance benefit mandates on the stop loss policy itself, because that crosses from regulating insurance into regulating the ERISA plan through the insurance savings clause’s back door.

What Reclassification Does to the Economics

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When a state’s regulatory environment effectively reclassifies level funded as fully insured, three economic consequences follow.

Community rating eliminates the primary pricing advantage that drives employer savings. Level funded’s value proposition rests on underwriting: a group with favorable health experience pays rates that reflect that experience rather than being pooled with the broader market. A 20-person employer with a young, low-utilization workforce might save 15% to 25% against fully insured community-rated pricing when an underwriter can price to the group’s actual risk. Under community rating, that group is rated on demographic factors and geographic area, not health status. The pricing advantage disappears. The employer who would have saved $40,000 annually with level funded underwriting saves nothing under community rating, and the self-funding structure adds administrative burden without delivering the cost reduction that justified it.

State-mandated benefits add costs the plan cannot avoid. Self-funded ERISA plans are not subject to state mandated benefit requirements under ERISA’s deemer clause. An employer in Texas can design a plan that excludes coverage categories the state mandates for fully insured plans, or can include them at the employer’s discretion. In states that treat level funded as fully insured, those mandates apply. The cost of state-specific mandate packages varies, but research by the Council for Affordable Health Insurance has documented aggregate mandate costs that add materially to premiums for fully insured small group coverage. The MEPS data shows that average family premiums in New Jersey, Massachusetts, and New York, all high-mandate states, ran approximately $26,000 to $27,000 in 2023, compared to the national average of approximately $23,938 and averages in lower-mandate southern states of $21,000 to $22,000. The mandate contribution is one component of that variation, not the whole explanation, but it is real and measurable.

Premium tax applies to insurance premiums. The stop loss premium component of a level funded arrangement is insurance and is subject to premium tax in virtually all states, whether or not the state treats the arrangement as self-funded. State premium tax rates for health insurance range from approximately 1% to 4% depending on the state. In states that reclassify level funded as fully insured, premium tax applies to the entire contribution, not just the stop loss component. The stop loss premium in a typical small group level funded arrangement represents 30% to 50% of the total monthly contribution. Applying premium tax to 100% of the contribution rather than that fraction adds a measurable and recurring cost.

The Regulatory Trajectory

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The states most likely to change their regulatory treatment in the near term are those with active state-based marketplace programs, community rating traditions, and legislative environments attentive to ACA risk pool stability.

The risk segmentation concern that drives regulatory interest is real, though its magnitude in the small group market is contested. Linda Blumberg’s widely cited 2016 Urban Institute simulation found that if low-attachment-point stop loss policies are freely available to small groups, fully insured small group premiums could increase by up to 25% as healthier groups exit the community-rated pool. The simulation involved specific structural assumptions about employer behavior and stop loss availability. The observed effect in actual markets has been smaller, but the directional argument remains the basis for regulatory action in several states. Regulators in states with community-rated small group markets see level funded adoption by low-risk groups as a mechanism that concentrates higher-risk employers in the remaining fully insured pool and drives up premiums for those who cannot underwrite out.

Colorado, Oregon, Washington, and New Mexico have had active legislative discussions about restricting or reclassifying level funded for small employers. Oregon’s insurance division has issued guidance that limits certain stop loss arrangements and requires disclosure of level funded plan structures. Colorado maintains an active small group regulatory framework that requires stop loss carriers to file policy forms for regulatory review, which creates an oversight mechanism even without explicit attachment point floors. None of these states has moved to the explicit small-group stop loss prohibition that New York has maintained since the ACA’s small group market expansion in 2016, but the regulatory direction is toward increased scrutiny rather than away from it.

The countervailing argument, pressed by SIIA and employer advocacy organizations, emphasizes that level funded serves employers who would otherwise be entirely uninsured rather than serving as an exit ramp from community-rated pools. The employer with 12 employees who could not afford any fully insured coverage before level funded became available is not a risk pool defector; the employer is a new covered group. That argument has some empirical support in markets where level funded growth has been accompanied by new insurance adoption rather than substitution. Whether regulators in high-scrutiny states accept that framing depends on political context and the specific market data available in each state.

For TPAs and brokers operating nationally, the regulatory trajectory requires ongoing state-by-state monitoring. A product that is fully viable in Indiana today may face new attachment point minimums in a neighboring state next year, or a stop loss form requirement in a third state that adds compliance cost. Geographic expansion requires regulatory due diligence that cannot be satisfied by a one-time analysis. States are not static on this question.