While workers’ compensation requirements can differ between states, many policies include a routine premium audit process. Different from most other lines of commercial insurance (e.g., property coverage)—in which potential exposures can be identified upfront and premium expenses are final—workers’ compensation premiums paid at the beginning of policy periods are provisional amounts.
In other words, these premium expenses are purely estimates based on an organization’s projected payroll and operations for the upcoming policy period. That being said, the purpose of a premium audit is for an insurer to evaluate an organization’s actual payroll and work performed at the conclusion of a policy period to determine whether the initial premium amount was appropriate.
Depending on the results of a premium audit, an organization may either owe additional expenses to their insurer or have funds returned to them. Review this guidance to learn more about premium audits, how to prepare for an audit and next steps following an audit.
Premium Audits Explained
To better understand premium audits, it’s first important to note how workers’ compensation premiums are calculated. An organization’s premium is based primarily on three key elements:
- Employee classification rates—First, employees are assigned class codes based on the work they perform and the perceived level of risk associated with that work. These codes are tied to specific employee classification rates. The higher the rating, the riskier the employee’s job role is. For example, a roofer would receive a greater rating than a carpenter due to the risk of falling from height. Such rates are typically determined by the National Council on Compensation Insurance, but some states utilize different systems.
- Payroll—Next, an organization’s overall payroll must be considered. In the scope of calculating workers’ compensation premiums, for each employee classification rate, an organization pays per every $100 of payroll. Keep in mind that an organization’s classification rates and total payroll are the two elements used to generate its manual premium. This means that the equation for an organization’s manual premium is (employee classification rate(s)) x (payroll/100).
- Experience modification factor—Lastly, an organization’s experience modification factor—also known as the mod factor—is calculated using loss and payroll data from the last three policy years, excluding the most recently completed year. From there, the organization’s actual losses are compared to its expected losses by industry type. A mod factor greater than 1.0 is a debit mod, which means that an organization’s losses are worse than expected—resulting in an elevated premium. A mod factor less than 1.0 is a credit mod, which means an organization’s losses are better than expected—resulting in a discounted premium.
Putting these elements together, the general equation for a workers’ compensation premium is an organization’s manual premium multiplied by its mod factor. However, given that the initial premium payment takes place at the beginning of the policy period, the elements of the manual premium equation are only estimates.
After all, throughout the course of the policy, employees’ job roles or work tasks could change—altering their classification rates. Further, the final payroll amount could end up being different for a number of reasons (e.g., promotions or layoffs). This is why premium audits are necessary.