California Mandates Pay or Play Health Coverage

On October 5, 2003, Governor Davis signed Senate Bill 2, the “Health Insurance Act of 2003” (“SB2”). This new law creates a purchasing pool to provide health care coverage “for all working Californians and their families that is not tied to employment with an individual employer.” The law requires employers either to contribute to the pool or to provide health benefits at prescribed coverage and cost levels for their employees and, if applicable, employees’ dependents. SB2 will apply to large employers effective January 1, 2006, and to medium employers effective January 1, 2007. There is, however, a significant issue as to whether this new state law is preempted by federal law under the Employee Retirement Income Security Act of 1974 (“ERISA”).

Creation of the State Health Purchasing Program

SB2 creates the State Health Purchasing Program (“Program”), a purchasing pool providing health care coverage for eligible employees and their dependents (if applicable). This Program will be administered by the Managed Risk Medical Insurance Board (“Board”). The Board will “have authority and fiduciary responsibility for the administration of the Program, including sole and exclusive fiduciary responsibility over the assets of the fund.” The Board will be responsible for determining the fee to be paid by employers and for establishing the required deductibles and coinsurance or copayment levels for specific benefits, including total annual out-of-pocket costs. The Board will also negotiate contracts with health care service plans and health insurers that choose to participate.

Covered Employers

SB2 applies to California employers who are either “large employers” or “medium employers” within the meaning of the law. A large employer is defined as a “public or private entity employing for wages or salary 200 or more persons to work in this state.” A medium employer is one which employs at least 20 but no more than 199 persons to work in California. Employers with from 20 to 49 employees, however, will not be required to comply with SB2 unless and until a tax credit of at least 20% of the net cost to the employer of the fee owed is enacted. Small employers who employ at least 2 but no more than 19 persons to work in California are not required under current law to comply with SB2.

It is important to note that, when determining the number of employed persons, the term “employer” includes all of the members of a controlled group of corporations as defined in Section 1563(a) of the Internal Revenue Code (“Code”), with the modification that the phrase “more than 50%” is to be substituted for the phrase “at least 80%” wherever it appears in that Code section.

Employer Fees and Reporting Requirements

All large and medium California employers will be required to provide information regarding eligible employees and dependents to the Board. All large and medium California employers, subject to the potential credit discussed below, will have to pay into a state fund so that coverage may be provided by the new state Program. The employer fee will be based on the cost of coverage for all eligible employees and dependents (if applicable), and other allocation factors to be determined by the Board. Large employers bear an additional cost under SB2 because their fees are based on the cost of coverage for all of their eligible employees and their eligible employees’ eligible dependents, while the fees for medium employers are based on the cost of coverage for their eligible employees only.

Employer Provided Health Care Coverage

In lieu of paying the fee, an employer can voluntarily provide health coverage to its eligible employees and their dependents (if applicable) that conforms to the minimum requirements set forth in the Knox-Keene Health Care Service Plan Act of 1975, as amended. If an employer voluntarily provides the specified level of benefits, and provides proof thereof to the Employment Development Department, the employer will receive a credit against the fee. To qualify for the credit, employer provided coverage must also conform to the required deductibles and coinsurance or copayment levels for specific benefits, including the total annual out-of-pocket costs, established by the Board. Furthermore, an employee cannot be required to pay any out-of-pocket costs other than copayments, coinsurance, and deductibles in amounts greater than the levels established by the Board.

Collective Bargaining Agreements

The minimum coverage requirements of SB2 will not supplant any greater benefits provided pursuant to a collective bargaining agreement as the law states that it “shall not be construed to diminish any protection already provided pursuant to collective bargaining agreements or employer-sponsored plans that are more favorable to the employees than the health care coverage required by this part.”

Eligibility for Health Care Coverage

Employees who have worked for the employer for three months and who work at least 100 hours per month will be eligible for this mandated health coverage. For purposes of SB2, an employee includes sole proprietors or partners of a partnership who are actively engaged in the business at least 100 hours per month. An employee’s dependents, if they are eligible for coverage, include the employee’s spouse, domestic partner and minor children (under age 18), and an employee’s child 18 years of age and over who is dependent on the employee. However, to the extent a dependent has coverage through his or her own employer, or is otherwise enrolled in the Program, the employee’s employer does not have to provide coverage for such dependent. SB2 does not define domestic partner. Presumably it is intended to mean a domestic partner as defined in California Family Code section 297, but this will need to be clarified through regulations.

Coverage under the Program will be coordinated with coverage available under other public programs including the Medi-Cal Program and the Healthy Families Program.

Employee Contributions

Employee contributions toward the Program, which employers will be required to collect from employees, may generally not exceed 20% of the employer fee. However, a medium employer may require an employee to contribute more than 20% if both of the following apply:

  • The coverage provided by the employer includes coverage for dependents; and
  • The employer contributes an amount that exceeds 80% of the cost of the coverage for an individual employee.

This exception creates an incentive for medium employers to provide coverage to dependents, by allowing the employer to require employees to pay more than 20% of the employer fee for dependents.

In no case, however, may an employee with family coverage whose wages are less than 200% of the federal poverty guidelines for a family of three, be required to contribute more than 5% of his or her wages.

Penalties for Non-Payment

The Employment Development Department will be responsible for collecting the employer fees and employee contributions, which will be deposited in the State Health Purchasing Fund. A penalty of 200% of the amount of any fee that would otherwise have been paid by the employer will be assessed in the event the employer does not timely pay the required fee, including employee contributions.

SB2 prohibits an employer from designating an employee as an independent contractor or temporary employee, reducing an employee’s hours of work, or terminating and rehiring an employee to avoid the employer’s obligations under the law, on behalf of that employee. Any employer who does so will be subject to a penalty of 200% of the amount of any fee that would have otherwise been paid by the employer, including fees for the period that the employee and dependents (if applicable) would have received coverage but for the employer’s conduct.

ERISA Preemption

ERISA section 514 provides, with certain exceptions, that state laws that “relate to any employee benefit plan” subject to ERISA are superseded by federal law. SB2 states: “Existing law requires health care service plans and health insurers to comply with various requirements relating to health care coverage for small employers.” SB2 further states: “This bill would extend the application of these requirements to health care coverage provided directly by employers under the bill, and would impose various other requirements.”

Although positioned as a fee payable by employers, SB2 specifically references employer sponsored health care plans as well as ERISA plans and is, therefore, subject to ERISA preemption. SB2 would avoid ERISA preemption, however, if it constitutes a state law regulating insurance. The Supreme Court in Kentucky Association of Health Plans, Inc. v. Miller, 123 S. Ct. 1471 (2003), recently announced a new test for determining whether a state law is saved from ERISA preemption by virtue of being a valid regulation of insurance. To survive ERISA preemption, the state law must meet both of the following requirements:

  • It must be specifically directed toward entities engaged in insurance; and
  • It must substantially affect the risk pooling arrangement between the insurer and the insured.

SB2 most likely will be found to be preempted by ERISA because it does not appear to meet either of these requirements. The new law is directed at employers, not insurance companies, and it does not appear on its face to have any direct impact on the risk pooling arrangement between insurers and insureds. Furthermore, ERISA provides that employee benefit plans are deemed not to be insurance companies. Thus, with respect to health plans that are self-funded by employers, SB2 would seem to be clearly preempted by ERISA as it mandates the level of benefits to be provided and imposes maximum deductibles and coinsurance or copayment levels for specific benefits, including total annual out-of-pocket costs. In addition, to the extent that other states pass similar legislation, multi-state employers would have to comply with up to 50 different administrative schemes if SB2 and any other similar state laws are not held to be preempted. One of the core purposes behind the ERISA preemption provision is to avoid such a patchwork of inconsistent regulation and administration of employee benefit plans.

Fee vs. Tax

In addition to ERISA preemption issues, SB2 may be found to be an illegally enacted tax even though it is positioned on its face as a “fee.” Under Article 13A of the California Constitution, which was implemented following the passage of Proposition 13, any changes in state taxes enacted for the purpose of increasing revenue must be passed by a two-thirds vote of both houses of the Legislature. It is our understanding that SB 2 did not have the required two-thirds vote necessary for the imposition of a new tax. Thus, the charge imposed on employers by SB2 must be found to be a fee and not a tax in order to be valid.


It is likely that SB2 will be challenged on both the issues of whether it is a fee or a tax and whether it is preempted by ERISA. It will certainly be interesting to follow the life of SB2 as it makes its way through the legal system. Ideally, these issues will be resolved well before the January 1, 2006 effective date of the new law.