Workers' Compensation: The Big Picture

Workers' compensation (WC) costs are driven by three environmental factors: 1) size of the payroll, 2) nature of the business, and 3) the firm's WC history. WC premiums are variable costs based on a percentage of payroll. The WC insurance policy will disclose the percentage as a cost per $100 of payroll. The percentage (referred to as a rate) is based on the nature of a business and is set by a state rate-setting bureau. As employees' activities pose greater risks of injuries, rates increase. Like automobile insurance, companies suffering numerous WC injuries pay higher premiums. A surcharge or discount known as an experience modifier, or "mod" may be assessed and is identified in the policy as a decimal. A mod of 1.2 increases rates by 20%.

When WC is purchased, an estimated premium is paid based on an estimated payroll. When the policy lapses the actual premium is determined based on the actual payroll. Insurance carriers reserve the right to "audit" the accounting records.

WC Classifications and Terminology

States often distinguish the risks of various types of work through a system of classification. Most business have more than one classification of work. WC rates vary widely by classification. The amount of payroll for a specific classification is called an exposure and the classification with the greatest exposure is the governing exposure. Employees engaged in miscellaneous functions (i.e., maintenance personnel and night watchmen) are included in the governing exposure. This is true even if a specific classification describes the activities of miscellaneous employees. General inclusions are always included in the governing classification. Conversely, general exclusions are always rated separately.

In addition, standard exceptions are rated separately unless the description of the classification states otherwise. The only standard exceptions are--

1. Clerical office employees, and

2. Outside salespersons.

NPD is an abbreviation for "no payroll division." If a classification is described as NPD, all employees are to be included in that classification except for general and standard exceptions. For example, a receptionist in a medical office takes the patient's blood pressure and temperature. Physicians is an NPD classification; the receptionist is included in this classification. The only possible exception to the above would involve a situation in which an activity unrelated is conducted at a location away from the medical office. N.O.C. is an abbreviation for "not otherwise classified."

Adapting to the Environment: A Micro Look

While insureds cannot change the environment, they can navigate around premium pitfalls and take advantage of cost-saving opportunities. The following are possible cost-reducing opportunities.

Partners and Officers. Usually a business owner does not intend to insure him or herself for workers' compensation. Nevertheless insurance carriers assume partners or corporate officers are insured. Policies should be endorsed to exclude partners or officers. Although partners do not technically take salaries, without endorsement partners are covered. The cost varies by state, but can be based on share of profits with an assumed minimum.

The insurance carrier will usually use the higher figure unless the firm makes an effort to disclose share in profits. Similarly, corporate officers will be insured unless they are specifically excluded by an endorsement; this endorsement names all excluded officers. To save premium for a closely-held corporation, the policy should be endorsed and the stockholders named as officers in the corporate charter or by- laws.

Overtime Remuneration. When overtime is incurred, the extra amounts paid beyond regular wages are excluded from exposure. Insureds often feel bonuses or shift differentials should be excluded--that is untrue. Most insurance carriers are reluctant to reduce exposures for overtime unless excellent records are kept; they need assurance that overtime is not fictitious. Individual earnings records should track overtime from time tickets. Also, overtime premiums must be summarized by exposure on a monthly or quarterly basis. It is the insured's responsibility to present the carrier with a convenient method of verifying overtime. The carrier need not--and indeed may refuse to--reconstruct poor records.

Severance pay. Most payroll systems do not track severance pay. This is unfortunate. Severance pay is not be included in exposures so long as amounts paid for severance can be verified. Sums such as accrued vacation, sick pay, and bonuses paid at the time of termination are included in exposures.

Employment Contributory Payments. Contributory payments made by the firm in connection with group insurance, stock purchase plans, qualified retirement plans, stock options, and deferred compensation plans are not included in premium determination. Insureds suffering classifications with high rates should be made aware that substituting fringe benefits for salaries can save considerable insurance costs while fostering employee loyalty.

Salary reduction and Cafeteria Benefit Plans. The amount by which an employee's salary is reduced to fund the welfare or fringe benefit portion of a cafeteria plan qualified under IRC Sec. 125 is not included in the basis of premium determination. Salary reductions to fund pensions or deferred compensation plans are included. In short, while employer contributions are excluded from payroll, employee contributions are included with the exception of a qualified cafeteria plan.

TABLE1

LAZYGAL'SDEPARTMENTALIZEDPAYROLL

1992

GrossOvertimeSeverance

DepartmentSalariesPremiumPay

Office$450,000$10,000$3,000

Salespersons350,000--2,500

RetailStores220,0008,0001,500

Delivery150,0007,0002,000

Assembly550,00012,0004,000

Upholstery300,00011,0002,200

Shipping60,0001,000--

Maintenance25,000500--

Division of employee's payroll. Individual earning records must track time spent for each classification if an employee does tasks fitting several classifications. Without this record, the carrier will charge the employee for the costliest classification, although relatively little time may have been spent doing that type of work. Premiums can be TABULAR DATA OMITTED saved by summarizing the employee's earnings per classification for the policy period.

Independent Contractors. The insured may frequently use independent contractors. If contractors have no WC insurance and the firm directs their activities, then the carrier will treat contractors as de facto employees. Amounts paid to contractors (with possible reductions for cost of materials supplied by contractors) will be considered payroll. To avoid this nasty situation, proofs of insurance (often called certificates of insurance) should be secured from independent contractors. If the contractor is self-employed, uninsured, and is not under close supervision, carriers will accept a contractor's license number as evidence that the contractor is indeed independent and not to be charged as an employee. Carriers are highly sensitive to this area.

Miscellaneous. Tips are not chargeable. They should be recorded in the payroll register and on individual earning records. Auto allowances are chargeable unless they reimburse the employee for actual expenses. A flat periodic allowance is treated as payroll. The values of meals and lodging are not chargeable unless provided expressly in lieu of wages. For sole proprietors, employed relatives residing in the owners' household are excluded from coverage and are not included in exposure.

WC Premium Determination Illustrated

LaZy Gal Furniture Company is a Boston manufacturer of reclining chairs selling to both wholesale and retail customers. LaZy Gal employs five outside salespersons to secure wholesale orders, and goods are shipped FOB shipping point. Retail operations are conducted through three stores with delivery accomplished by six employees.

TABLE3

CALCULATIONOFWCPREMIUM1992

CodeNo.ClassificationExposureRatePremium

8810ClericalOffice$389,000.37$1,439.30

8752Salespersons299,500.752,246.25

8044FurnitureStores351,5007.3125,694.65

2881FurnitureAssembling569,50010.9662,417.20

9522Upholstering286,8004.8813,995.84

105,793.24

Mod.94

1992WCPremium$99,445.65

Iftheofficersareexcludedsavingswouldamountto:

|($52,000x.37)+($52,000x.75)+($52,000x

10.96).94=$5,904.70

Three officers are Sarah Smith (president in charge of office staff), Karen Kraft (VP in charge of manufacturing) and Laurie Long (managing wholesale operations in the field) each of whom is paid $100,000.

The WC policy is for the 1992 calendar year. Because of LaZy Gal's favorable claim history, an experience mod of .94 is applied to the premium. A departmentalized payroll summary for 1992 is shown in Table 1.

The exposures for LaZy Gal's relevant classifications are determined in the Table 2. The calculation of WC premium for LaZy Gal is shown in Table 3.

Commercial General Liability Insurance: The Big Picture

Less understood than WC, commercial general liability insurance (CGL) insures the firm from damages and claims caused to third parties other than employees, arising out of the conduct of business. In determining auditable exposures, there is good and bad news. The good news is that states have no regulatory power in establishing rules and rates. The bad news is that the policy holder may not necessarily be able to refer to a manual for guidance in all situations. Insurance carriers may have their own rules, classifications and rates. In fact, a single carrier may have different rules and rates for different insureds. Whatever the specifics, like WC, the CGL policy will disclose auditable exposures and rates. Sometimes the specifics are extremely simple. For instance, large companies often have "excess liability" coverage provided by "umbrella policies." Should a claim exceed the primary insurance company's limit of liability, the umbrella policy protects the insured for the excess amount. In most cases, umbrella policy premiums are simply based on gross sales.

Fortunately, the vast majority of insureds is covered for CGL by companies that issue insurance in accordance with provisions found in a "Commercial Manual" issued by the Insurance Services Office, Inc. The CGL Manual contains rules and describes classifications which are assigned a five-digit code number. The three most important auditable exposures covered in the GCL manual are discussed below.

Premises/Operations Liability. This coverage provides protection from exposures arising from the ownership, maintenance, or use of property and from operations in progress. Premises coverage protects LaZy Gal should a customer be injured in the retail store. Similarly, a contractor is protected if a pedestrian sustains injury near a construction site.

The premium for this coverage is usually driven by payroll but may be based on sales. When differing segregated operations are conducted, the insured's exposure may consist of more than one classification. Payroll records must track each employee's activities to prevent that employee's entire remuneration from being assigned to the costliest classification. Payroll includes gross pay, commissions, bonuses, sick pay and vacation pay. Payroll does not include:

1. Standard Exceptions. Clerical and salespersons are not to be included unless the policy specifically states otherwise.

2. Drivers Pay. Liability arising from acts committed by drivers are insured by automobile policies.

3. Overtime. The extra pay for overtime is excluded from payroll provided that payroll records track overtime.

4. Miscellaneous. Other excludable items included severance pay, tips, payments for group insurance or pension plans, and special rewards for employee's inventions or discoveries.

Corporate officers engaged in activities related to premises/operations are charged premium based on an implied "salary" of $26,000 per year. It is necessary to remove these officers' gross pay from exposures and add back $26,000. When engaged in premises operations activities, sole proprietors and partners are also accorded $26,000 in assumed payroll.

Products/Completed operations Liability. This coverage provides protection from claims arising from the products hazard or completed operations hazard. Should a customer be injured as a result of a defective recliner, Lazy Gal is protected from ensuing claims. Similarly, after construction is completed, a contractor is insured for claims resulting from injuries sustained due to faulty construction.

Premiums for this coverage are usually driven by sales. Insurers treat sales synonymously with cash receipts (cash sales plus collections of accounts receivable). Rates are stated per $1,000 of sales and may constitute as much as 4% of revenue. Accounting methods employed to record sales may inadvertently increase the cost of premiums. Naturally, sales include the gross amount charged by the client for products distributed and or operations performed. Sales also include transactions resulting in bad debts. Several reductions are possible, none of which may be taken unless sales are recorded net of these items. These cost reducers include:

* Trade or Cash Discounts.

* Freight Allowance to Customers.

* Sales tax.

* Sales Returns and Allowances.

* Finance Charges.

Sales for consigned goods are included in exposure. If consignment transactions represent a material amount the following alternatives may be considered:

a. Establish a separate entity to handle consignments.

b. Charge the consigner for additional premium incurred.

Companies are well advised to established an accounting system that can summarize sales net of these cost reducers.