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Special to Houston Business Journal…

To Control Costs, Risk, Businesses Benefit from Insurance Audits

Wednesday, October 13, 2005

By Harold Meyer, CIC, and Stephen B. Smith, CPCU

With today’s insurance costs, it is extremely important for businesses to practice sound insurance and risk management techniques. Insurance has just two functions: the pricing of risk and the control of risk. To assure a business is both efficient and effective in managing its risk, an insurance audit can help achieve accurate risk pricing while providing the know-how to control risk through effective business planning.

In businesses statewide, the overall cost of insurance continues to be a major expense, and Workers’ compensation is usually the most costly coverage purchased. So how can a business control workers’ compensation costs internally if they choose to remain in the workers’ compensation system?

One way to begin the process of controlling insurance costs involves applying audit procedures to the computations of insurance premiums and experience modifiers. An experience modifier is a formula created using a number of prior years’ insurance policy data, then applying that formula to determine premium cost. The accuracy of this data is key.

An insurance audit begins with a search for mistakes that may cause premium to skyrocket. Although the insurance industry should be given full credit for good intentions in correctly rating, classifying and applying the formulas and rules involved, it is not at all uncommon for honest errors to creep into the process. Too frequently, usually because of time constraints for these processes, an insurance company’s internal auditor, agent, employee, or underwriter may not detect errors in a policy’s coverage and premiums.

Unfortunately, the average commercial insurance buyer is not sufficiently well informed to be able to monitor this process and catch the errors. One case in point: In auditing workers’ compensation policies for a client for the years 2000 through 2004, we discovered that, in one of the policies, the carrier cancelled our client’s policy in the middle of the insurance year. That cancellation forced the business to seek an alternative carrier. The alternate carrier issued a new policy, but two things happened to adversely affect the outcome: they used incorrect rates and did not apply the outstanding “credit” experience modifier the client had earned. That occurred because the anniversary ‘rate date’ of the experience modifier controls the policy terms, and, since the rate date was in the prior year, it was only after our audit investigation that we were able to have the carrier change the policy rates and apply the credit modifier. Because of the audit process, what began as a descent into insurance difficulties ended instead with a sizeable refund of premium.

As readers may be quickly discerning, the costliest mistakes often occur during the calculation of an experience modifier. The National Council on Compensation Insurance (NCCI) calculates an experience modifier based on information provided by the insurance companies. NCCI formulates the modifier by weighing a host of variables, such as the amount of a business’s payroll and their history of incurred claims. The insurance carrier applies this modifier in calculating premium on the workers compensation coverage, thereby making this experience modifier an extremely critical part of cost containment.

Here’s how it works. Typically, the carrier determines the gross insurance premium for a specific period of time. Then, that amount is multiplied by the experience modifier to arrive at the actual premium cost appearing on a company’s bill. An insured company that has had a high quantity of previous claims will earn a debit experience modifier, which can significantly raise their final premiums. Conversely, those with favorable experience may enjoy a credit on their final premiums. Consequently, the critical elements are accuracy of the data reported and the proper calculation and application of that data.

But the worries don’t end there. Buyers have yet another challenge if their experience modifiers are incorrect:  just who will write their insurance? Insurance companies want to insure clients that have limited prior losses. If a client cannot find a premier carrier to underwrite his insurance due to an unfavorable experience modifier, then that business must turn to carriers applying rate surcharges (formerly, these may have been referred to as ‘non-standard’). This marketplace does not represent a move toward lower premiums.

For these reasons, it is essential that business owners check the accuracy of their losses reported by the insurance company to the NCCI. During an audit, it is not unusual to discover that many loss amounts were incorrect. Incorrect loss amounts could have forced a company that should have been able to purchase coverage at preferred pricing to purchase more expensive insurance. In many cases, this extra expense would have been unnecessary if the losses had been reported accurately.

And there’s more. Other types of errors can often show up in experience modifiers. The experience modifier is generally computed using three years of insurance policy data. Many times, an entire policy year of data will have been omitted from the calculation, or in some cases, estimated results were used rather than actual results. These errors will cause a modifier to be wrong and could possibly cost a business many thousands of dollars.

The good news is that these problems can be corrected. Uncovering problems can be as simple as performing an audit and thoroughly examining and correcting calculation errors agents could have overlooked when the insurance company computed previous premiums.  By undertaking a focused premium and experience audit, a business can benefit from expert knowledge of the various ratings, premium computations, and state rules and thereby determine if their premiums have been calculated accurately. The audit results can correct common errors, consequently returning thousands of premium dollars to clients.

In a local Houston-area case, the client, a manufacturing concern, had already disputed the audit on their own and recovered $17,684. We convinced him to let us take another look at the last two audits and determined if an improper classification code was used in determining the premium. After securing agreement with our findings from the Classification Specialist at the Texas Department of Insurance we disputed the carrier’s audit for the past two years and successfully recovered an additional $45,000.

Since the expected losses of the new, less expensive classification code caused the Experience Modifier to increase, it becomes necessary to make the calculation before a final decision is made. In this case, the higher modifier was more than offset by the savings. In addition, the client received the benefit of the new classification in all future policies. This is not to say that these modifier changes are always to the benefit of the policyholder. A modifier can also skyrocket. The key is to have the real numbers. No outside auditor guarantees a refund, but without an outside audit, there is less chance of uncovering the errors that, when corrected, can benefit a company greatly.

In summary, a careful review and audit of the data used in the procurement of commercial insurance, combined with professional, appropriate risk control policies and procedures, can provide significant management control over the cost of a necessary business insurance program.

Harold Meyer, Certified Insurance Counselor, is Vice President of Wm. Rigg Co. and has nearly 25 years experience in the property and casualty industry, especially chemical, manufacturing, transportation, petrochemical, and utility contractor areas. Mr. Meyer holds the professional designation of Certified Insurance Counselor.

President of Wm. Rigg Co, with offices in three Texas cities, Stephen B. Smith provides leadership to all operations of the 110-year-old agency. Mr. Smith is nationally recognized for his knowledge and proficiency in industry risk management consulting. Mr. Smith is a Chartered Property Casualty Underwriter (CPCU)