Many small businesses are run on a tight budget having found a good common ground of revenue generation to incurred expense allowing them to continue in business. Often you’ll find these operations are locally owned, perhaps family owned, who employee local workers and who provide a valuable service to their community. Far too many times it’s these small business owners who suffer due to workers compensation premium errors, audit and classification mistakes. In this blog we will explore the negative effects workers compensation premium errors have on small business and we will discuss what a small business owner can do to protect themselves.
Failure rate of a small business, depending on where you get your data, can range from 50% in the first year to over 66% in years five to ten. Of course different industries have different failure rates. Restaurants, for example, have a typically higher failure rate depending on several factors which include that smaller start-up operations have a higher failure rate than large or even franchised restaurant operations.
Construction is another industry susceptible to a high failure rate. Small contracting operations may find themselves facing business failure due to fluctuations in the economy, changes in financial positions, death of an owner, inability to qualify for bidding new jobs and just about everything else you can think of! Information from the US Census indicates that construction firms with 1 to 4 employees have a much greater failure rate than firms with 20 to 500 employees, which they indicate has the lowest failure rate.
Risk is the greatest challenge to any business owner. It’s also the greatest reason for business failure. Identification and management of risk, in whatever form it takes, is a key factor to the survival of just about any small business.
Let’s identify and discuss a few broad categories of risk, specifically related to workers compensation, that harbor potential harm for a business.
Every state has a workers compensation statute that directs how their state law applies; who the law applies to and what happens when the employer is in non compliance. Non compliance penalties are the enforcement actions of any individual state authority. When a business owner is required to carry workers compensation coverage and does not they will face harsh consequences from the state authority. Here’s a sample list of penalties a state will levy on any employer who is in violation of state workers compensation laws:
- Alabama – Employer is guilty of a misdemeanor and subject of a fine not less than $100 or more than $1,000. Employer is liable for two times the amount of compensation which would have been payable for injury or death to an employee. Also court may impose civil penalties.
- Alaska – A fine of up to $1,000 per employee for each day the employer failed to have coverage. Other penalties may apply.
- Arkansas – Subject to a fine up to $10,000 or be guilty of a Class D felony.
- Arizona – Subject to penalty as stipulated in statute or guilty of a Class 6 felony.
- Illinois – Guilty of a Class A misdemeanor and 12 months in prison. Class 4 felony, 1-3 years in prison and $500 per day with a $10,000 minimum fine. Other penalties may apply.
- Florida – Civil enforcement and cease of operations. Penalty is 2 times amount of premium the employer would have paid. Subject to criminal charges .
- Minnesota – Suffer a fine of up to $1,000 per week per employee during the uninsured period of time. Other penalties and action may apply.
- Missouri – Guilty of a class A misdemeanor and penalty of 3 times the annual premium or up to $50,000 which ever is the greater amount. Additional violations are subject to class E felony. Employer may also be subject to other civil penalties.
The list goes on and on! While these examples represent just a few states, you can be sure that all other states have similar, if not stronger, responses to the uninsured or non-compliant employer.
For many small business owners when starting up their business and having to deal with the day to day issues of doing so, compliance with their states workers compensation act may not even be on their radar. We’ve seen it happen several times, when a business owner fails to secure a workers compensation policy when they are required to in their state. An injury occurs and the next thing you know the business owner is facing fines and potential criminal prosecution for non compliance with their state workers compensation law.
As you can see from the above list, individual state authorities take the lack of compliance very serious! And from a small business owners perspective unexpected fines and prosecution may certainly be something that could lead to potential business failure on their part.
Policy Related Issues.
Policy related issues can be further broken down into specific topics each of which carry potential harm for any business operation. These topics may include but are not limited to:
Classification Codes – Every workers compensation policy identifies a business by assigning a classification code. This code is, at best, a description of the business and is known as the governing classification code. If you are a regular visitor to our website or a regular reader of our blog you will know that we write a great deal about the effects proper classification can have on any business. Remember, class codes carry different rates per 100 of remuneration. It’s these rates and the premium calculation formula that determines the deposit premium that a business pays at the beginning of a workers compensation policy. Rates an insurance company assigns to these codes can vary greatly! For example a clerical class code may carry a rate of .29/100 while a roofing class code may carry a rate of $35/100. As you can see, improper classification may easily lead to an inflated premium a business would pay for their workers compensation policy. This inflated premium may cause undue burden on the financial capacity of the business.
Audit – The audit process is a mandatory process as outlined in any workers compensation policy. Audits are typically conducted at the end of a workers compensation policy period. The primary purpose of an audit is to determine the actual rating exposure (remuneration) and compare the actual exposure with that used when the policy was set up. The policy is then recalculated using the audit generated exposure and the result is then compared with the original policy. Any reduction in premium generated from the audit process is then returned to the business. Any additional premium generated from the audit process is then billed to the business.
While the primary purpose of an audit is that of identifying and reporting rating exposure to the insurance company there are other functions that occur during the audit process. These include the verification of proper classification codes and class code assignment. The process is somewhat simple. The auditor, while conducting the audit, will ask the business detailed questions about their work processes. They will dig into the individual duties of each employee with the purpose of identifying their proper classification. It’s this function that often causes changes in the classification of a business and under certain circumstances re-assignment of employees into different class codes. These changes can lead to significant premium increases.
We’ve worked expert witness cases where the additional premium is in excess of $1,000,000. While these cases are not that common they do occur. At this point I believe you now understand the devastating effect an audit can cause a business. You can certainly argue whether an audit is right or wrong and if faced with a high audit bill I would expect that you would! But what if it’s right? A business surprised with unexpected high audit bills may certainly be staring business failure square in the face.
Experience Modification Rate or EMR – This individual rating modification factor is used to reflect, in the premium rating formula, specific loss experience of an individual business. Development of the EMR for any business is complicated. It pulls together audited remuneration, class codes, incurred losses during the experience period all by location and compiles that data into a formula that ultimately compares the loss results of the business in question with others found within the same industry/occupations. The rating bureau then publishes the EMR and the insurance company then uses it in premium rating for the individual business. An EMR for a specific business may range from .7 to 2.0 or higher!
We’ve seen EMR’s in the 2.9 and 3.0 range. Think about it. The basic premium for your business is $15,000 and your EMR is 2.0 causing your actual premium to be $30,000. All while your competitor down the street has a basic premium of $15,000 and an EMR of .70 causing their actual premium to be $10,500! You’re paying a premium $19,500 more than your competitor! Just because you had workers compensation claims and your competitor did not. Of course it’s much more complicated!
Another just as serious issue concerning the Experience Modification Rate is how this rating factor is now used as a safety indicator for those business operations who bid on providing services, work or jobs for others. If your business bids on government projects or provides some type of construction services for larger construction firms you will be required to provide your EMR in the bid qualification phase. These organizations will have set minimum acceptable EMR rates and I’ll tell you that if your EMR is over 1.0 or if you have a deteriorating EMR (it’s getting worse over time) your ability to bid and secure bid work will be non-existent. Our consulting firm often works on cases where an employer, who had previously done bid work, is now not allowed to bid projects because their EMR has moved over a 1.0.
Think about it. You’re a contractor who has service contracts with large industrial or manufacturing operations that generate $5,000,000 in annual work for your business. This year your EMR came in at 1.10 and you are no longer allowed on the job site and you lose $5,000,000 in annual work. Could your business now be facing a financial catastrophe and possible business failure?
Subcontractor (Statutory Employee) Issues – Some of the largest additional premium audits we’ve ever seen are caused when the business uses uninsured subcontractors and has not planned or does not understand the workers compensation premium consequences. Most states allow that when one contractor hires another contractor to perform work on its behalf and the hired party has no workers compensation policy in place then the injured worker employed by the hired party may look to the hiring contractor for coverage for their injury. It’s here that the hiring contractors workers compensation insurance company will respond just like that injured worker was one of their own employees. And when this happens, the insurance company will pick up all of the rating exposure of the uninsured contractor and charge it to the hiring contractors policy. Sorry about that! I know it can be confusing and that’s exactly why this issue causes so much trouble! Let’s look at an example.
Lets say my company clears utility right of ways and has always carried workers compensation insurance on my employees as long as we’ve been in business. I have an opportunity to pick up another contract to do more work but I don’t have the extra crew to do the job. So I ask around and find another business who’s available so I hire them to work as a subcontractor for me on this extra work. Lets say the workers compensation rate for the kind of work we do is $25 per 100. I pay the subcontractor $500,000 to do the work and I make an extra $75,000 of the entire job. I’ve never done this before so I’m not used to the ins and outs of working with subcontractors. Just so happens the one I hired did not have workers compensation insurance. At audit my insurance company picks up the additional $500,000 in sub costs and adds that to my workers compensation policy at a rate of $25 per 100. The additional premium charge is $125,000! And yes, I just lost the $75,000 I thought I would make from this work plus an additional $50,000!
Needless to say, uninsured subcontractor issues can ruin a small business. Not only will there be an adverse effect of additional premium due but what if there were injuries incurred by the uninsured subs workers? Those claims would show up on my EMR potentially ruining my chances at securing future bid work while placing an additional financial burden on my business!
To gain a better understanding of the financial consequences these events cause, you need to know what it takes for a business to generate the additional cash flow, and where the money comes from to pay for these unexpected financial losses.
Consider these scenarios and their financial consequences:
Case 1 – Regulatory Action: Consider a Missouri business that failed to secure proper workers compensation coverage. They incur a state imposed penalty of $50,000. This business operates on a profit margin of 20%. The business would have to generate additional gross revenue of $250,000 to cover the financial loss due to the imposed penalty. Of course this does not consider the potential criminal charges which may be levied on the business owner.
Case 2 – Policy Related Issues – Classification Codes: Consider a business owner has secured a workers compensation policy. The agent mistakenly misclassified the business operation using a class code that carried a rate of $14 per 100 of remuneration. The projected rating payroll for this business was determined to be $200,000. The premium calculated out to be $28,000. In fact the proper class code carried a rate of $8 per 100 of remuneration and the correct premium should have been $16,000. The difference in premium was $12,000. Now consider this business operates on a profit margin of 10%. That means this business would have to generate additional gross revenue of $120,000 just to break even on the mistake this misclassification caused.
Case 3 – Policy Related Issued – Audit: Consider this business completed their workers compensation audit. At the time of the audit the auditor discovered an error in the original classification of the business. The correction entailed moving a great deal of the business rating payroll from a class code that carried a rate of $12 per 100 of remuneration to a code that carried a rate of $37 per 100 of rating payroll. The business also had an anticipated growth in work causing a 40% increase in payroll causing their payroll to increase from $300,000 to $420,000. There were no corrections to the original policy during the policy period that would reflect this increase in payroll or change in classification. The premium increased from $36,000 to $155,400 generating an additional premium charge of $119,400. Now consider this business operates on a profit margin of 10%. That means this business would have to generate additional gross revenue of $1,194,000 to recover from the unexpected additional premium charge at audit.
Case 4 – Experience Modification Rate: Consider the example outlined above where the business provided service to manufacturing and industrial clients. Part of the contract they have with their clients is that they must maintain an EMR or 1.0 or below in order to continue work. Because of a misclassification of the business (wrong class codes) and a few claims, the EMR increased to 1.10. They were ordered off the work sites. The business just lost $5,000,000 in contract work.
Case 5 – Subcontractor Issues: Consider the example provided above where the business hired an uninsured subcontractor to help with a job. To recap, the business paid the subcontractor $500,000 and hoped to make a profit of $75,000 off the work. Unknown to the business the subcontractor did not carry workers compensation insurance. At audit the insurance company picked up the additional $500,000 in uninsured subcontract costs and charged that against the business. The additional premium charge was $125,000. Not only did the business lose the $75,000 they thought they would make on the extra work but at a %20 profit margin they would have to generate an additional $625,000 in gross revenue to offset having to pay the $125,000 additional premium.
How can a business owner avoid or, at a minimum, better manage potentially business ending workers compensation events like these?
Here’s a few points to consider and some tips to help you out:
- Education – The business owner who takes the time to educate themselves about the ins and outs of workers compensation issues will find the little time they dedicate to doing so will pay off in big rewards later. It’s easy for any business owner to learn about work comp. Just google around a little and you’ll find out what I’m talking about. It’s all over the web. Learn the basics. Do not make assumptions! Ask questions and you’ll find there’s a ton of knowledgeable folks out there that want to help!
- Pay Attention To The Details – Workers compensation issues are all about the details! Whether it’s a classification code issue, audit issue or experience rating problem, you’ll find workers compensation issues are driven by the small details. When a business owner fails to pay attention to the details of their audit I’d almost guarantee there’ll be issues. When the business changes or modifies their operations, different, possibly more costly, rates may apply creating increased costs seemingly unknown to the employer. The business owner or employer should always be aware of claims. And when claims drive up the experience mod or EMR the employer should have known what was going to happen well before the resulting effect shows up. Get smart, watch the details!
- Work With Workers Compensation Professionals – Find and work with insurance agents who have a good working knowledge of workers compensation. Agents work hard to keep insurance costs down for their clients but, as you can see, it’s not always about finding the cheapest price. As a matter of fact, we’ve worked many cases where misclassification of a business was driven by the overwhelming desire to pay the cheapest price possible. Work with a professional agent. They will look after your best interest when it comes to providing proper workers compensation coverage.
- COVID-19 Complications of a Pandemic – During this time of so many hardships placed on the shoulders of business owners, business survival cannot be anything but paramount in every employers mind. Be sure that you contact your workers compensation insurance agent and ask about what kind of premium relief may be available for your business. For example many states have approved premium relief if you, as an employer, have provided your employees with paid leave of absence. Make sure you ask about this because you may qualify to have any payroll made to furloughed employees held out of your premium calculations. Most of this is being done at audit but you may need to have a special class code endorsed onto your policy in order to take advantage of this rule. Simply contact your agent and ask if this may apply to your business.
Workers compensation is complicated. Premium generation issues can easily get out of hand leading to costly actions. No business is immune. We’ve given you just a few of the workers compensation risk categories that can lead to catastrophic issues for a business. We’ve identified the significant financial impact these issues can cause on cash flow of a business. We’ve discussed these topics and provided you with a few steps you can take to help protect yourself from financial harm.
The failure of a business is a sad thing. It’s the end of someone’s dream. The sad end result of someone’s hard work, diligence and sacrifice. Don’t let it be because of some workers compensation hidden, unknown or unidentified event!
I hope this post has been helpful! And thanks for reading!