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Employers generally realize that the initial premium they pay for Workers Compensation insurance isn't the final premium for that coverage-Workers Comp is normally subject to an audit after the policy ends, to adjust premium charges based on actual payroll amounts. When the policy starts, after all, payroll amounts can only be estimated for the coming year. So it's routine for employers of any size to undergo a Workers Compensation premium audit, and to receive an audit statement that often seeks some additional premium.

But in what I term "Shock Audits", the employer receives a bill for additional premium far in excess of what had been reasonably expected based on the initial policy. Sometimes, these audits are so extreme they can imperil the continued existence of the employer.

In the most extreme Shock Audit I've seen so far, an Illinois employer purchased Workers Compensation insurance at what is known as Minimum Premium-essentially the lowest premium for Workers Comp allowed under the rules, which in the case was just over a thousand dollars. The initial estimated premium was so low because the employer had only a few actual employees-that is, workers whose earnings were reported on Form W-2. But as the employer disclosed on the initial application, they also used the services of a number of independent contractors. The employer thought, though, that such independent contractors were excluded from Workers Compensation. The employer was wrong. But the insurer didn't pick up on this until several years after the policy, and the next year's renewal policy, had ended. Then the insurer noticed the independent contractors, revised several years' worth of audits, and billed the employer for something more than $3,000,000.00 in additional premiums. And when the employer couldn't pay this Shock Audit, the insurance company filed suit.

Fortunately, I was able to assist this employer to successfully resist this Shock Audit, and ultimately the insurance company lost in its attempt to obtain this additional premium. But even though this case may be the most extreme Shock Audit I've seen so far, it is far from the only instance. In fact, it's a rare month when I am not approached by some employer, in some part of the U.S., with a Workers Comp audit that is threatening the economic well-being of the company.

Here then are the 5 most common causes of these Shock Audits, based on my experience as a consultant and expert witness over the past thirty years.

1. Unanticipated Additional Remuneration

Almost all employers understand that Workers Compensation insurance premium are based on payroll. Except that's not quite exactly right-premiums are based on "remuneration", which includes payroll, but can also include other things-like payments to independent contractors, which tripped up the employer I mentioned earlier. Remuneration can also include things like per diem expense reimbursements, which has tripped up some other employers.

Expense reimbursements are normally excluded from remuneration for Workers Comp purposes, if there are receipts kept. But some employers provide a per diem reimbursement for food and lodging that doesn't require such receipts. And that's where things can get tricky, because the manual rules about per diems hasn't been adjusted for inflation in quite a while, and so it has a daily limit of just $30. That doesn't go very far in 2015, so if an employer pays a more realistic per diem of $100 per day, the amount over the $30 limit can and will be added to payroll amounts used to compute WC premiums.

Similarly, vacation and holiday pay gets picked up for WC premium, even though the workers aren't actually exposed to the workplace on their vacation. Bonuses and commissions also get included in remuneration, with only relatively rare and narrow exceptions made. Employers who don't understand these rules can get ambushed with a Shock Audit after the policy has ended.

2. Classification Changes

The rate that gets applied to remuneration, in the calculation of Workers Comp insurance premium, varies depending on the kind of work done--but only to a certain extent. WC insurance uses a classification system that assigns different rates to different kinds of work. But there are only a limited number of classifications available (in most states, between 500 and 600--but significantly fewer in Pennsylvania and Delaware) so it isn't always easy to find an exact fit. The definitions of classifications can also vary from one state to another, even though the classification code number and name are the same. And there are some complicated rules that govern assignment of classifications that aren't always easy to understand--such as that most businesses get to break out their clerical workers into a cheap classification, but not all.

When a Workers Comp policy starts, classifications are estimated, and the fine print of the policy allows the insurer to make changes when the audit is performed. There are some limits that apply to changes to more expensive classifications, but these limits can vary from state to state and don't apply to all types of employers. Plus, insurers have figured out some clever ways to get around some of these limitations. And premium auditors are trained to focus carefully on any potential classification errors and to correct them at the time of the audit, without giving much consideration to how unexpected and painful the result may be for the employer.

Such was the case for a client based in Alaska, where their insurer and NCCI (the rating bureau for many states) had decided to change their classification code based on a judgement call about proper classification. The manual rules weren't clear-cut and in the judgement of the insurer many of this company's workers weren't eligible for the inexpensive clerical code (where they had been assigned historically) but instead in a classification with a rate roughly three times higher. This abrupt increase in Workers Comp insurance costs posed a serious financial hardship for the employer. Fortunately, we were able to get this classification change reversed, by working with the appeal board in Alaska, and ultimately a much less expensive classification was approved, one that was slightly more expensive than the clerical code but much less than the classification imposed by their insuance company.

3. Payroll Allocations

Even if an insurer doesn't add a more expensive classification at the time of the audit, significantly changing how total payroll is allocated among the classifications originally used on the policy can produce a Shock Audit that ranks as an Extinction Level Event for an employer. So, for example, if the policy classified a large group of workers as clerical (at a cheap rate) and then, at the audit, moved a lot of that payroll out of clerical to whatever more expensive class applied to other workers at the company, the resulting additional premium charge can be a killer. Payroll for an individual worker can't be divided between the clerical class and other classifications--it's all or nothing--so even if some workers do very little that doesn't fit within the clerical definition, it doesn't matter. So if these workers spend 4% of their time doing something that isn't strictly clerical--all of their payroll can get moved to the more expensive classification.

A couple of states limit the ability of insurers to make such drastic changes in payroll allocation at the time of the audit, and in those states I have been able to help employers fight drastic payroll allocation changes. In one instance, a fitness club saw their reservations people moved from clerical to the health club class, with a significant premium increase. Because the change had only been made after the audit, I was able to get these changes reversed in three states that had specific rules and regulations limiting the ability of insurers to make such changes late in the policy term.

I once saw an insurer insist, with a straight face, that because the treasurer of the company had to leave her office at the end of the day and walk past the machines on her way out the door, that meant her payroll belonged in the machine shop classification, not the clerical class. We were able to help that employer fight that change, but it's an example of the kind of thing that can cause mega-voltage Shock Audits.

4. Experience Modifiers

Experience Modification factors are computed by rating bureaus, based on past claim and payroll data reported for a particular employer by their past WC insurers. So a 1.25 modifier essentially produces a 25% surcharge, while a .75 modifier would result in a 25% discount. These modifiers are normally calculated for employers on an annual basis, to coincide with policy renewal, and use (usually) three years worth of prior policies claim and payroll data.

Most (but not all) states put limits on the ability of insurers to increase experience modifiers late in the term of the policy, or after the policy has ended and been audited. But there are exceptions to this, and sometimes insurers will retroactively apply much higher experience modifiers on the audit than were originally on the policy. This is sometimes accomplished by getting it ruled that the employer was technically "combinable" with some other company, for purposes of experience rating. These experience mod increases can produce huge increases in audited premium.

In a recent case, the insurer used experience modifiers of one company to calculate premiums for another company, claiming there was sufficient common management and other commonalities to justify this action, which resulted in the experience modifier being retroactively increased from 1.00 to 1.97.--resulting in a classic Shock Audit for several million dollars of additional premium and a lawsuit.

Again, I was able to help this employer successfully dispute this Shock Audit, as these the insurer had actually erred in applying the rules regarding experience modifiers and certain state-specific insurance regulations that applied.

5. Large Deductible & Other Loss Sensitive Policies

For larger employers, insurers have increasingly been offering Large Deductible policies--that is, policies where the employer is responsible for reimbursing the insurer for all claims under a certain set deductible limit, such as $250,000 or $500,000. Of course, it's never as straightforward as just reimbursing for what the insurer has paid out--these plans typically add on a number of claims handling charges and other fees that can be difficult to truly understand or anticipate by most employers, and they often require reimbursements not just for amounts paid out but also for amounts reserved but not yet paid out by the insurer.

These Large Deductible policies often get turned into policies that technically resemble Retrospective Rating policies) a different, older type of Loss Sensitive policy that adjust charges based on losses) by means of "side agreements" that can be difficult for employers to truly understand at the time coverage is being agreed to. The bottom line is that employers often receive truly astonishing bills for additional premium charges a year or two or three after a Large Deductible policy has ended, based on the incurred losses from that past policy. Large Deductible policies can be the gift that keeps on giving--giving headaches, that is, for employers--long after the policy has ended.

Such was the case for a high profile client a few years back---an NFL team that had been sued by their Workers Compensation insurer for several million dollars in additional premiums under a Large Deductible policy. The particular insurance policy in question had been made into a convoluted and complicated program where the team was responsible for reimbursing the insurer for claims and various and sundry fees and charges after the policies had ended.

Except, it turned out, that the team didn't owe those premiums. In fact, the insurer owed the team back several million dollars, because of various technical errors and insufficiencies in the fine print of these insurance programs. And ultimately, the case was settled along those lines-with a substantial return of premium back to the team.

These kinds of insurance policies are often unwieldly and complicated in the extreme-so complicated, in fact, that even large and sophisticated insurance buyers can't really anticipate or project what their ultimate insurance costs will be. And so these kinds of policies often produce audit billings that cause an employer's hair to stand on end, just prior to being pulled out in frustration and anguish.

The good news, such as it is, is that we have been able to help a great many employers over the years, from all over the United States, who were on the receiving end of such Shock Audits. We can't help everyone, of course. But in a surprising number of cases, we have found that these Shock Audits contain errors that can be reversed, producing a result that can be much less...well, shocking.

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Edward J. Priz, CPCU, APA, has worked full-time in the Insurance Industry since 1976. In 1982, he also began consulting on Workers Compensation insurance issues, and in 1987 established his own consulting firm to specialize in this field, as Advanced Insurance Management. Mr. Priz holds the professional designation Chartered Property Casualty Underwriter (CPCU) from the American Institute of Property and Liability Underwriters, as well as the designation Associate in Premium Auditing, from the Insurance Institute of America.

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