Understanding the Acquisition, Valuation and Ongoing Management of a Business

Insurance Transaction

September 4, 2014 Introduction by Paul Hughes, CIC

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Introduction

According to Wikipedia, an ecosystem is…”a community of living organisms (plants, animals and microbes) in conjunction with the nonliving components of their environment (things like air, water and mineral soil), interacting as a system.”

The purpose of this article is to provide an overview of the traditional business insurance ecosystem (“BIE”) and the disruption we anticipate on the imminent horizon. Hierarchy and financial cliques have existed in insurance since the sea Captains approached nobility in the London tea houses during the late 1600’s in hopes of finding support for nautical voyages into the new world. Over time, the original process of a Sea Captain (client) going to a broker (usually a mate most adept at business), who goes to a representative of nobility (underwriter), who in turn represents nobility or what was deemed a syndicate (risk-bearer). The lead underwriter would set terms and then other participating underwriters would sign their names under that of the lead and thus the term “underwriter”. This process has been in place for the commercial lines sector of insurance since 1688 in London and in the United States since 1752 based on the formation by Ben Franklin of the country’s first insurance carrier. It is an industry that enjoys great history but due to its lack of creativity and technological advancement, it is an industry prime to be disrupted.

Technology mavens that have challenged and conquered other business sectors such as Yahoo and Amazon sit at the ready to attack. Who will pull it off with credibility first is the only question. The lions are at the gate with multi-billion dollar war chests to fund the next tipping point technology –

“High performance analytics makes it possible to expand analytics into new spaces using more and more data. Master data management is a good place to start. Insurers should build or upgrade their master data management capabilities and position the enterprise to capture, cleanse, organize, and use data to gain new insights. Next, a high performance analytics platform should be considered – with software and hardware solutions that provide the ability to apply Big Data techniques and increase the speed of analytics by orders of magnitude.”1

An even more meaningful commentary from SAS, a technology behemoth on the business analytics front and most pertinent to the existing BIE:

“This shift, fueled by Big Data and high performance analytics, is enabling insurers to select more profitable business, implement more precise pricing, manage the risk portfolio holistically, improve fraud detection, and increase investment returns. High performance analytics is an area where a strong alignment between business and IT can

1 http://www.sas.com/resources/whitepaper/wp_49547.pdf

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create powerful new capabilities within an insurer’s organization – robust capabilities that set the stage for true differentiation. “2

The aforementioned white paper is from 2012 and yet two years later much of the rhetoric has not changed. The same results and lack of data direction exist in the boardrooms of the world’s largest reinsurers, insurers, brokers and intermediaries. Insurance IT departments incapable of meeting the business side needs for actionable business intelligence have flailed at trying to meet the challenge of utilizing internal data in an actionable way. Instead they continue to build, program and implement more on foundational CRM’s that were outdated many years prior. The software companies behind these CRM’s are few and far between and have little motivation to advance technology beyond what is currently in play until someone else challenges their positions at the top. The IT departments of many insurance entities have held the business side hostage to the capabilities of the individuals of that IT department versus the capabilities that exist in the world today to manage risk. 80% of insurance company CEO’s see their legacy systems as their #1 issue.3

Phases of Data Management

Most insurers are lucky to be in phase 1 of data management – proper democratization and storage. Simply put, what do I have, what does it mean and potentially how can it be used? Stage 2 is drawing conclusions from the data and contemplating the credibility and meaningfulness of outcomes. Stage 3 is taking action as a result of actionable business intelligence that has credibility and is meaningful. The proper democratization, understanding and application of “big data” is the major hurdle that has deterred progress within the IT departments of the largest of insurance entities.

Never could the business insurance ecosystem (“BIE”) be monitored at an advanced level of clarity to better predict, perfect and report on future results; yet where it exists the guidance is typically archaic at best with limited functionality of the data reported. In the current BIE, results are not known before business is renewed due to time lag on audited earned premiums, many in the typical transaction such as brokers earn much more then they are worth and hidden cost-drivers that are allocated to files in supposed measures of cost containment act as “silent killers” that can impact results the most, yet are the least understood. Before the managed care

2 Ibid 3http://www.businessinsurance.com/content/dam/oracle/us/en/industries/insurance/Legacy%20Migration%20Infographic.pdf

Democratization   Analysis   Application  

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craze of the early 1990’s, allocated loss adjustment expense (“ALAE”) was never more then 15% of expected losses. Since managed care became all the rage, ALAE as a % of loss has never been less then 25% of loss. Has the extra 10% on the expense side worth the amount towards cost containment? Great question as the writer has never seen empirical evidence to suggest that managed care specifically helps outcomes or reduces overall cost for a policyholder. Too often instead I have seen this as an avenue to cost shift profitability for a carrier form what is tangible in “fixed costs” to what is variable in “loss”. The future empirical evidence one way or another lies in millions of binary lines of data at the ready to be interpreted and acted upon in a more efficient and effective manner.

At present, with the proper democratization and understanding of the “big data” that exists in the legacy systems of insurance entities, we can produce tabular reporting through mediums such as “excel” and “xml” on a static basis. Every time a report is needed it is rerun using new information at some predisposed interval. By creating a vehicle to build an unlimited amount of algorithms using an unlimited amount of data, we can understand past outcomes through algorithms deemed meaningful by the smartest actuarial minds in the world. The vehicle used being a data mart, a technology that can through time can understand results in a sequential fashion so that trend is known in time versus at a specific point in time only. These algorithms created using any data pools available in the vault augmented with any other data pool available and worthwhile to add to the data mart. This business process also allows sequential understanding in time (ie outputs at various month end valuation dates for same inception date). In order to properly understand and more importantly act on the algorithmic output from the data, visualization tools such as Tableau are used to build actionable business intelligence.

Using Data for Actionable Intelligence

Since the new technologies available enable one to measure and track the BIE in the most granular manner with maximized efficiency and clarity, the RiskMD technology allows for the measurement of the effectiveness of the BIE better then any other technology created to date. It allows us to concisely understand the impact of the various organisms (“entities”) within the Business Insurance Ecosystem (“BIE”) 4.

1: a branch of science concerned with the interrelationship of organisms and their environments 2: the totality or pattern of relations between organisms and their environment

The role of the Theoretical Ecologist is in part to understand the rules of an ecosystem so that they made be understood and theoretically applied to other communities of unlike organisms which in are thesis would be known as entities. The ecosystem of an insurance transaction involves insurance entities playing the following roles from the bottom of the food chain to the very top.

4 http://www.merriam-webster.com/dictionary/ecology

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The Hunters

- “Buyer” - Policyholder- “Buyer’s Agent” – Retail Agent/Broker/Consultant- “Seller’s Agent” – Production Underwriter/Managing General Agency- “Risk-Bearer” – Primary Insurance Carrier of Record- “Risk-Bearer’s Agent” – Reinsurance Intermediaries/Consultants- “Risk-Bearer’s Risk Bearer” – Reinsurers/Captives

The Gatherers

- CPA’s- Risk Managers- Third Party Administrators- Redundant Claims Managers- Loss Control/Safety- Risk Management- Redundant Underwriters- Independent Actuarial- Managed Care Networks- Lawyers- Bankers- Case Management- Utilization Review- Surveillance- Wellness

“the hierarchical structure of ecosystems is primarily regulated by a small set of plant, animal, and abiotic processes each operating over different scale ranges. Important changes in ecosystem dynamics can be understood by analyzing a few, typically no more than five, key variables (Walker et al. 2006).

In this interpretation, the scientific focus is on the critical structure and processes of an ecosystem.

“Individual species can be replaced if the critical structure and key processes persist (Walker et al. 1999, Elmqvist et al. 2003, Nyström 2006). In this extended-ecological meaning, resilience is defined as ‘the magnitude of disturbance that can be absorbed before the system changes its structure by changing the variables and processes that control behavior’ (Gunderson and Holling 2002:4) or ‘the capacity of a system to experience shocks while retaining essentially the same function, structure, feedbacks, and therefore identity’ (Walker et al. 2006:2).” 5

5 http://www.ecologyandsociety.org/vol12/iss1/art23/

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The following white paper is an analysis of the existing Business Insurance Ecosystem and the role of a Professional Employer Organization within it. The

following paper will identify, analyze and opine to the model known as coemployment.

Table of Contents

7. The PEO Industry11. PEOs vs. Employee Staff Leasing14. Workers’ Compensation Pricing & Costs (Mod Washing) and State Unemployment

Tax Arbitrage15. PEO Revenue Models18. The PEO Industry and P&C Insurance Underwriting & Production22. Individual Risk Selection and Underwriting25. Conclusion

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The Understanding of The Business Insurance Ecosystem

A Case Study on PEO

The PEO Industry

Chief Economist of the National Council of Compensation Insurance (“NCCI”), Harry Shuford, while presenting a study named “Before You Speculate, Investigate” on the PEO Industry at a WCI Conference related PEOs helping their somewhat historically tarnished reputations of the past as “as easy as getting chewing gum out of one’s hair”. The PEO has historically been viewed as the “cockroach” of the business insurance ecosystem. A non-producing member that often spread disease and hardship without any documented benefit to other members of the community. As a result of the historical “vilification” of the PEO industry, the industry and its members became more resilient. Capabilities in areas such as risk-bearing, underwriting, brokerage and data management went from being areas of external dependence, to part of the PEO value proposition. All of a sudden all of the organisms needed in an insurance transaction are the PEO, its representative to the marketplace and the carrier of record. Efficiencies of scale and efficacies of being a professional buyer of insurance provide PEO with a unique opportunity to fragment the traditional manner in which insurance has been deployed for over 300 years.

Why the PEO Industry? The understanding of any ecosystem is usually understood by understanding the role of the lowest form of life. Interestingly enough in our case example the lowest form of life at the same time creates some of the largest inequities in the normalcy of the BIE. While this “scorned” industry it has been suggested has caused many of the other members of the BIE heartache and pain, there are a select few that understand the huge rewards equated by cutting through speculation into reality. Because hearsay, lack of empirical evidence and overly-dramatized stories involving fraud, deceit and theft have been associated with the PEO model, the PEO valuation within the BIE is slim to none while the knowing few sit on the banks and take in all of the rewards by further perpetuating the “fear factor” associated with the industry class. While seen as a specialty, reality is that the PEO model is an aggregation of that which would be considered “traditional” without the involvement of a PEO.

The following is an excerpt from the Wiki entry on PEO’s

“A professional employer organization (PEO) is a firm that provides a service under which an employer can outsource employee management tasks, such as employee benefits, payroll and workers' compensation, recruiting, risk/safety management, and training and development. The PEO does this by hiring a client company's employees, thus becoming their employer of record for tax purposes and insurance purposes. This practice is known as joint employment or co-employment.”

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As of 2010, there were more than 700 PEOs operating in the United States, covering 2-3 million workers. PEOs operate in all fifty U.S. states.

Business Model In co-employment, the PEO becomes the employer of record for tax purposes, filing paperwork under its own tax identification numbers. The client company continues to direct the employees' day-to-day activities. PEOs charge a service fee for taking over the human resources and payroll functions of the client company: typically, this is from 3 to 15% of total gross payroll. This fee is in addition to the normal employee overhead costs, such as the employer's share of FICA, Medicare, and unemployment insurance withholding. One key service usually provided by a PEO is to secure workers' compensation insurance coverage at a lower cost than client companies can obtain on an individual basis. Essentially, a PEO obtains workers' compensation coverage for its clients by negotiating insurance coverage that covers not just the PEO, but also the client companies. This is allowed because legally the PEO is the co-employer of the workers at the client companies. There have been instances of PEOs using improper means to lower their workers' compensation insurance costs and some principals of PEOs have been found criminally liable for fraud. PEOs can also offer basic levels of background & drug screening.

Use of a PEO saves time and staff that would be used to prepare payroll and administer benefits plans, and may reduce legal liabilities or obligations to employees that it would otherwise have. The client company may also be able to offer a better overall package of benefits, and thus attract more skilled employees. The PEO model is therefore attractive to small and mid-sized businesses and associations, and PEO marketing is typically directed toward this segment.

PEOs can benefit companies differently. For example, a blue-collar organization may see more value in workers' compensation insurance and vice versa. A variation of a PEO model without co-employment is an administrative services organization.

Early History Employee leasing in the United States began in the late 1960s by three businessmen, Eugene Boffa, Louis Calmare, and Joseph Martinez. The concept was popularized by Marvin R. Selter who leased the employees of a doctor's office in Southern California. [8] The Employee Retirement Income Security Act of 1974 (ERISA) contained an exemption for multiple employer welfare arrangements (MEWA), which provided a loophole for employers with leased employees to claim they were exempt from the ERISA requirements. Passage of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) further encouraged employee leasing by providing a tax shelter for employers who contributed a minimum amount to employee plans. More stringent guidelines in the Tax Reform Act of 1986 later eliminated most of the TEFRA incentive, however. By 1985, there were approximately 275 staff leasing companies in the United States.

A new business has also developed recently, in which marketing or brokering company serves to connect businesses with professional employer organizations. Many of these sites receive a

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commission if they arrange a contract between a PEO and a new business client. These sites earn their money by "brokering" for various PEOs and receiving compensation for contracting PEO relationship.

Abuses State Unemployment Tax (SUTA) arbitrage, commonly referred to as "SUTA dumping," occurs when an employer with a high unemployment insurance rate transfers or "dumps" employees to purchased subsidiaries with lower unemployment insurance rates. However in any PEO relationship the client company would take the Professional Employer Organization's SUTA rate by law, in effect many times lowering their SUTA through SUTA Arbitrage, however the only time this wouldn't apply is in client reporting states. Owners of professional employer organizations are in a position to commit fraud by keeping the funds deducted from employee paychecks instead of paying the insurance and government entities for whom the deductions were made. In a case in San Antonio, Texas four executives were convicted of siphoning $133 million from the three PEOs they owned and operated.

Regulation Each state in the U.S. has differing regulations for workers' compensation insurance and state unemployment insurance, so PEOs are typically regulated at the state level.

In 2004, President George W. Bush signed into law the SUTA Dumping Protection Act of 2004, which requires that all 50 states enact anti-SUTA-dumping legislation by 2007. Most states have now done so; however, federal law does not prohibit companies from using a PEO to obtain more favorable SUTA rates.

The staff leasing industry itself has also taken steps to address abuses. It formed its first trade association, the National Staff Leasing Association, in 1985. The association changed its name to the National Association of Professional Employer Organizations in 1994 to reflect the term in current usage.

As part of the industry's efforts to self regulate, an independent accreditation body, Employer Services Assurance Corporation (ESAC), was formed in 1995. ESAC's purpose is to verify PEO compliance with important ethical, financial, and operational standards and to provide financial assurance backing the performance of its accredited PEOs.

PEOs may also undergo a certification process conducted by the independent Certification Institute (CI) formed in 2002. This certification verifies that a PEO's workers' compensation (WC) program is meeting proven insurance industry risk management best practices to reduce work-related accidents and health exposures and control WC insurance losses.

Updated Changes In 1985 there were approximately 275 staff leasing companies in operation. In 2012, according to NAPEO, there are now approximately 700 PEO's operating in all 50 states. They were

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responsible for approximately $81 billion in gross revenue in 2010.

NCCI Impact on PEO's A recent change in 2013 regarding the way companies Experience Modifier is calculated has caused companies with previously good modifiers to get better, while companies whose modifiers had struggled previously have gotten worse. The Experience Rating Plan, as NCCI refers to it, will be undergoing a change that NCCI believes will more accurately reflect individual employers’ claims experience. NCCI, the National Council on Compensation Insurance, sees this as a "Mod Neutral" action since the median average does not change. While some companies get better, some get worse. Overall, however, the "center" stays in essentially the same spot. While this will assist the good companies to improve their position, this will cause the companies in dire straights to get worse. Many of these companies may be forced out of the "standard" market and into secondary markets such as PEO's and other "options of last resort" such as state pools. This may lead to a further increase in the number of PEO's, or it may lead to an increase in state pools, or possibly both.

NCCI views this action as having two primary benefits. The first is that it "tailors the cost prediction and final net premium cost to the individual insured" making the calculation more accurate. The second benefit is that "it provides added incentives for loss reduction."

A few interesting observations can be made from the above excerpt. The article interchanges the terms “staff leasing companies and PEO”. Further the article highlights the dubious reputation of PEO’s and highlights areas of abuse such as workers compensation pricing & costs (Mod Washing), State Unemployment Tax Arbitrage, ERISA obligation avoidance and outright fraud. Almost nowhere in the article are any of the benefits of a PEO mentioned. Chief Economist of the NCCI, Harry Shuford, while presenting a study on the PEO Industry at a WCI Conference related PEOs helping their somewhat historically tarnished reputations of the past as “as easy as getting chewing gum out of one’s hair”. It would be insightful to dig deeper into some areas highlighted in the Wiki article.

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PEO’s vs. Employee Staff Leasing

Employee Staff Leasing variously called Staff Leasing, Temporary Leasing, Staffing, Temp Agencies.. The list goes on. Again, looking at a Wiki article –

“Temporary work or temporary employment refers to a situation where the employee is expected to leave the employer within a certain period of time. Temporary employees are sometimes called "contractual", "seasonal", "interim", "casual staff", "freelance"; or the word may be shortened to "temps." In some instances, temporary professional employees (particularly in the white-collar worker fields, such as law, engineering, and accounting) even refer to themselves as "consultants."

Temporary workers may work full-time or part-time, depending on the individual case. In some instances, temporary workers receive benefits (such as health insurance), but usually benefits are only given to permanent employees. Not all temporary employees find jobs through a temporary employment agency. For example, a person can simply apply at a local park for seasonal jobs.

A temporary work agency, temp agency or temporary staffing firm finds and retains workers. Other companies, in need of short-term workers, contract with the temporary work agency to send temporary workers, or temps, on assignments to work at the other companies. Temporary employees are also used in work that has a cyclical nature, requiring frequent adjustments to staffing levels.

In 2008 there were a total of 13,722 temp agencies and staffing services in the U.S. with revenue of over $7.4 million per firm.

A temporary work agency may be distinct from a recruitment firm, which seeks to place permanent employees, but there is often a large overlap: a permanent employee may start out as a "try-before-you-buy" trial temporary worker.

A temporary work agency may have a standard set of tests to judge the competence of the secretarial or clerical skills of an applicant. An applicant is hired based on their scores on these tests, and is placed into a database. Companies or individuals looking to hire someone temporarily contact the agency and describe the skill set they are seeking. A temporary employee is then found in the database and is contacted to see if they would be interested in taking the assignment.

When a temporary employee agrees to an assignment, they receive instructions pertaining to the job. The agency also provides information on correct work attire, work hours, wages, and whom to report to. If a temporary employee arrives at a job assignment and is asked to perform duties not described when they accepted the job, they may call an agency representative for clarification. If they choose not to continue on the assignment based on these discrepancies, they will most likely lose pay and may undermine chances at other job opportunities. However, some agencies guarantee an employee a certain number of hours pay if, once the temporary employee arrives, there is no work or the work isn't as described. Most agencies do not require an employee to continue work if the discrepancies are enough to make it difficult for the employee to actually do the work.

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It is up to the temporary employee to keep in constant contact with the agency when not currently working on an assignment; by letting the agency know that they are available to work they are given priority over those who may be in the agency database who have not made it clear that they are ready and willing to take an assignment. A temporary work agency employee is the exclusive employee of the agency, not of the company in which they are placed (although subject to legal dispute). The temporary employee is bound by the rules and regulations of their direct employer, even if they contrast with those of the company in which they are placed.

Pros • Easy hire: Those meeting technical requirements for the type of work are often virtually

guaranteed a job without a selection process. In this sense, it could be argued that itwould be easier to find work as a temporary worker. Also, in some cases, agencies willhire temporary workers without submission of a resume or an interview.

• The potential for flexible hours.• There is an opportunity to gain a wealth of experience: companies are all unique, so the

temporary worker will be exposed to a plethora of different situations and officeprocedures.

• There are companies that do not hire internally and use these staffing services only. Theyare a good gateway to get employment with a certain company.

Cons • Lack of control over working hours and the potential for immediate termination for

refusing an assigned schedule.• Positions often are with high turnover rates. Research suggests that plants choose

temporary workers over permanent ones when they expect output to fall, which allowsthem to avoid costs associated with laying off permanent employees.

• Lack of reference as many employers of experienced job positions do not consider workdone for a temporary agency as sufficient on a resume.

• In the United States, the gradual replacement of workers by temporary workers resultedin millions of workers being employed in low-paid temporary jobs.

• Typically, temporary workers earn roughly a third of a permanent counterpart, receivefew or no health benefits and seldom become full-time employees from their temporarypositions.

The easiest way we have found to highlight the difference between a PEO and a Staffing Company is the following example. Think of your own company. You have a fairly static set population of employees right now filling a variety of positions and fulfilling a variety of functions. For various reasons, much of which we will cover later in this memo, you might want to outsource many or most of the HR functions and associated benefits to a PEO. If you do, not much if anything changes in the day-to-day population makeup of your employees, their positions or job functions (other then perhaps a reduced HR department). Now think of a situation wherein you need a special project handled. Perhaps you have a large temporary data entry need from an acquisition. In this instance you would contract with a temporary staffing company to fulfill your short-term need for extra workers. Looking at this comparison from the viewpoint of an insurance underwriter, the PEO allows for a know population of employees,

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their job location and job function. The temporary staffing company enables no such transparency or understanding of the employee exposures. Another distinct difference involves the concept of co-employment. A temporary staffing relationship is different then a PEO relationship in that the staffing relationship is one in which there is a sole employer and the PEO is one in which typically, co-employment exists.

What is Co-Employment? The National Association of Professional Employer Organizations (NAPEO) defines co-employment as the contractual allocation and sharing of employer responsibilities between a PEO and its client. In a co-employment agreement, workers are technically employed by two separate entities: the business owner, or client employer, who controls their daily duties and core job functions; and the PEO, or co-employer, who handles personnel-related functions. Co-employers do not supply a workforce; they supply services and benefits to a client employer and its existing workforce. The client employer maintains control of all business decisions and operations while the co-employer manages employee-related aspects of business operation.

Why Co-Employment is Essential to HR Outsourcing Business owners who align with a PEO in a co-employment relationship transfer a substantial portion of the risk and responsibilities associated with employees to the co-employer. The structure of the relationship allows the PEO to offer better benefits and benefit options, handling of wage and employment tax responsibility, freedom from the responsibility of reporting, collecting and depositing the taxes with state and federal authorities, and assistance with workers’ compensation coverage and claim management.

Common Misconceptions About Co-Employment Relationships

There are a number of misconceptions about co-employment that exist because of pre-conceived notions about outsourcing in general. The most common is the belief that contracting with a PEO will result in a loss of control for the business owner. In reality, the structure of a co-employment relationship allows client owners to retain control over staffing and business decisions, while the PEO assumes certain employer responsibilities and risks. Many business owners also worry that their employees will not embrace the new arrangement, that workers will be considered temporary or non-permanent, or that their existing HR staff will be terminated. Again, these concerns are valid but unwarranted. A co-employment relationship is administrative in nature and is beneficial to employees because it extends a greater depth and breadth of benefits and services than could typically be offered by the client owner alone. There is little, if any, disruption to existing employees when the relationship is established, and at no time is employee “leasing” involved in the agreement. Lastly, co-employers often align with existing HR departments to provide much-needed expertise in areas where they may fall short. The result is a stronger organization, and a better way of doing business. Later in this article we will discuss the implications of this co-employment concept on the structure of a workers compensation insurance policy for both the PEO and the client company.

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Workers’ Compensation Pricing & Costs (Mod Washing) and State Unemployment Tax Arbitrage

These are two of the most well known and often thought of areas of abuse that the PEO industry has facilitated. The following, taken from PEOCompare.com highlights these two areas-

“State by state, regulations for workers’ comp and state unemployment insurance vary considerably. This variance can invite abuse by staff leasing companies, and PEOs (Professional Employer Organizations).

SUTA Dump Explained It has been possible for organizations to 'dump' employees into groups with lower unemployment insurance rates. This is called State Unemployment Tax Arbitrage, or, the 'SUTA Dump'. Employers in states with high unemployment insurance rates have been able to dump their employees into subsidiaries that they owned in states with lower unemployment insurance rates.

Workers Comp Mod Washing Some employers have also tried using the PEO dump, utilizing existing PEOs to evade the higher workers’ compensation premium rates. They reduce their rates by shifting their high incident experience to a PEO with lower incident experience, taking advantage of a loophole created by the nature of the PEO.

Federal Regulation The SUTA Dumping Protection Act of 2004 requires all states to enact anti-dumping legislation. The states have done their part, but the Act never did specifically address the role of PEOs. Seeing the threat to its value-added marketing advantage, the industry devoted to staff leasing took steps to fix things.

Self-Regulation ESAC (Employer Services Assurance Corporation) formed in 1995 to audit the ethics, finances, and standards of operating PEOs. NAPEO (National Association of Professional Employer Organizations) became the industry’s trade association developing standards and codes of ethics for organization behavior. CI (Certification Institute) promotes a certification that the PEOs’ workers’ comp program meets best practices in risk management.

Arbitrage Abuse Sadly, in the past; staff leasing businesses have been set up with fraud in mind. They routinely charged their client employers for insurance payments, but they fraudulently channeled the cash flow without remitting it to the legitimate taxing agencies. With specific reference to the rates for workers’ compensation insurance, they moved the accountability from payrolls with high-risk claims experience to new entities, some of them newly formed PEOs that had no claims history. When things caught up with the PEO, it went out of business. Other employers, wanting to avoid minimum participation rules, move their low paid employees off payroll onto the PEO

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payroll. This move takes those employees out of the count for pension or medical insurance plans that require a minimum participation. In this case, only the remaining high paid staff benefit.

New Direction Today, PEOs have done what they needed to do to honor their obligations in law and ethics. Admittedly, PEOs profit from tax and insurance arbitrage. They maximize the economies of scale to manage costs, mark them up, and bill them to the client company still at a lower cost than they would have paid. Everyone is happy with this value added proposition, so long as some rules are respected.

• Transparent finances allow investigation of all fiduciary functions and responsibilities.• Compliance reports and audits all entities across all states involved.• Vetting of controlling persons assures confidence in their identification, background, and

credibility.• Financial statements are prepared to reveal deep and broad activity, within the PEO and

across all related entities.

PEOs continue to provide comprehensive and integrated services to manage employers’ HR duties and risks. At the same time, they take on much of the labor overhead in time and money, so employers can spend their time on growth and sustainable innovation. Small and mid-sized employers continue to pursue the benefits of co-employment, and they can take comfort in recognizing PEOs with integrity, trust, and liability.

As we will examine below, most PEO’s that are reputable and long-term operators do not use SUTA dumping or Mod washing as a source of revenue generation but rather other legitimate areas of revenue generation. Obviously there are PEO’s who do use these techniques to their benefit, we will discuss later in this article the methods utilized to identify and avoid those PEO’s.

PEO Revenue Models

PEO’s have many and varied areas in which they derive revenues. The most obvious area is to charge a fee. PEO’s charge fees for the services that they provide for such things as payroll processing and administration, benefits administration, compliance advice and human resource services. The list below gives a perspective on the wide breadth of services that PEO’s can supply.

COMPLIANCE

• Age Discrimination in Employment Act (“ADEA”)• Americans with Disabilities Act (“ADA”)• Title VII of the Civil Rights Act of 1964 as amended (Equal Employment Opportunity

laws) (“EEO”)

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• Equal Pay Act (“EPA”)• Consumer Credit Protection Act (“CCPA”)• Fair Credit Reporting Act (“FCRA”)• Consolidated Omnibus Budget Reconciliation Act (“COBRA”)• Employee Retirement Income Security Act (“ERISA”)• Family and Medical Leave Act (“FMLA”)• Genetic Information Nondiscrimination Act (“GINA”)• Patient Protection and Affordable Care Act (“PPACA” or the “Healthcare Reform Act”)• Fair Labor Standards Act (“FLSA”)• Immigration Reform and Control Act (“IRCA”)• Occupational Safety and Health Act (“OSHA”)• Uniform Services Employment and Reemployment Rights Act (“USERRA”)• Worker Adjustment and Retraining Notification Act (“WARN”)• State and local laws and regulations

HUMAN RESOURCE SERVICES

• Employer counseling• Employer assistance with ADA, EEO, wage and hour laws, and other employment

regulations• Hiring and recruitment procedural guidance• Employee training• Performance management• Unemployment claims administration• Compliance and job description audits• Employment verification• Governmental and census reporting• EEOC claims administration• Employment practices liability insurance• Employee assistance program administration• Drug testing assistance and background checks

PAYROLL ADMINISTRATION, TECHNOLOGY AND TAX ADMINISTRATION

• Full payroll processing, including overnight delivery• Web payroll access, including employee self-service• Employee maintenance• Time and attendance system integration• W-2 processing, including electronic distribution• New hire reporting• A full suite of payroll reports including on-line access• Garnishment administration

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• Benefits and deduction processing• Direct deposit processing• Paid time off benefit accruals• Federal, state and local payroll tax filing and remittance

BENEFITS

• Major and mini medical insurance• Group vision and dental insurance• Life insurance• Long and short-term disability insurance• Individual insurance programs• Benefit administration consulting services, including claims dispute assistance• Open enrollment processing• Billing and reconciliation• Administration of 401(k)/retirement options, including coordination of mid-year and

year-end 401(k) compliance testing• Administration of Section 125 Plan• Coordination of employee notifications, annual orientations, enrollments and

terminations• COBRA administration: administer notifications, payments, benefits, regulation

compliance and reporting• Benefits package administration to new hires and on-going employee orientation,

including new hires, terminations and option changes• Coordination of benefits renewals

WORKERS’ COMPENSATION AND RISK MANAGEMENT

• Workers’ compensation insurance options from A-rated workers’ compensation carrierpartners

• Field-based safety services• Loss control safety consulting services, including training materials and inspections, and

field-based assistance• OSHA compliance assistance• Risk analysis and safety recommendations• Review/analysis of claims, losses, reserves and classification codes• Internal employee advocate staff• Administration assistance with drug-free workplace programs• Return-to-work programs

In addition to charging a fee for the types of services listed above, some PEO’s also earn commissions on products that are purchased by both the client company and the employees of those client companies. These product commissions may be from workers compensation

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policies, employee benefit policies, employment practice liability policies and even pet insurance. Another area of revenue generation is the rate arbitrage in areas we discussed above such as Workers Compensation Insurance and State Unemployment Tax. One form of this arbitrage is where a PEO purchases workers compensation policy with a large deductible, thereby lowering the rate it pays for each class code, but charges the client company as if there was a first dollar coverage in place. As long as the PEO can manage the exposure in the deductible layer they can make a profitable return on this arrangement. As you can imagine there is not one standard business model for revenue generation in the PEO industry. Some PEO’s prefer to use the fee for service model as the majority of their revenue generation while others prefer the other areas discussed and yet others prefer some combination thereof.

It is important to point out that like every other industry in business there exists various levels of excellence and integrity among the specific participants. In the PEO industry we segment the industry into 3 classes of participants- The Bad Operators, The Shell Game Operators and The Legitimate Service Providers.

The Bad Operators are no longer prevalent in the industry. It was common for these PEO’s to under report exposures and to misclassify payrolls. They wrote business on a composite rate basis and targeted high hazard accounts.

The Shell Game Operators sole marketing and value proposition is to reduce workers compensation costs for client companies. They used questionable methods to achieve this goal and when their mod factors became onerous they would simply create a new PEO and start over at unity. We call this the mod washing game.

Finally, there exists The Legitimate Service Providers. A real value added provider who markets to businesses with administrative burdens and a need for outsourced HR and risk management support. They target small to medium size companies (10-50 employees). They manage a variety of functions for the client company including workers compensation, allowing the clients to focus on its core business while outsourcing employer related administrative functions. These are our target clients.

The PEO Industry and P&C Insurance Underwriting & Production

In order to bring forth what we believe to be the unique opportunity that the PEO industry presents to the P&C Insurance industry, I think the best place to start is to address the historical concerns that the P&C Insurance Industry has had with the PEO Industry.

The first area of concern is that the PEO model creates a set of unknown and unknowable exposures spanning unknown and unknowable territories. In short there exists a lack of transparency between the carrier, the PEO and the client company. As we discussed above, the PEO model differs from the Temp Staffing model in that they contract with firms and co-employ a stable population of employees. This misconception stems from the confusion between a

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staffing company and a PEO. The next area of concern is the conversion of high mod business to low mod business (Mod Washing). Again we have partially addressed this above but it would be helpful to further explore the issue of Mods in the world of PEO’s. The vast majority of businesses that contract with a PEO are as stand alone businesses not eligible for a mod factor. However when a small business contracts with a PEO they inherit the mod of the PEO. Certainly this “inheritance of the mod” can be a double-edged sword. As we outlined above, in the classic mod washing scenario a PEO who has a lower mod then the client company can pass some of those savings on to the client as an inducement to contract with the PEO. The PEO then rides the lower mod until such time as the inevitable poor loss results catch up to the entire arrangement, closes the PEO and starts over again fresh. We will discuss techniques to avoid becoming involved in such a situation. But what about the more frequent situation wherein the client company has no mod, as they were too small on their own, but inherits the PEO’s mod upon contracting with the PEO. In this instances the PEO must be sure to control their overall mod or else they would end up needing to charge a higher price for the workers compensation coverage then the client company had enjoyed as a stand alone enterprise. In this unfortunate circumstance the PEO either can not offer the client company a compelling overall package of goods and services (remember the exhaustive list of services above included in the fee portion of the PEO charges) due to the higher workers comp costs or subsidize those extra costs by lower their fees. There exists a very powerful incentive for a PEO to control the loss costs of their workers compensation program so as not to suffer an erosion of the mod factors hence making their offerings to clients uncompetitive. PEOs must make informed decisions on the classes of business they write, the jurisdictions they write that business in, and how they price and control the risks they add to their respective WC portfolios. The good PEO’s, what we called above the The Legitimate Service Providers, look at their workers compensation policy(ies) as a stock manager looks at a stock portfolio. There is enough data available between statistical bureaus, insurance carriers, and the actual loss data of the PEO/co-employer/co-employee relationship banks to pick the right client companies in the same manner that an investment fund manager picks the right stocks to get a proper return on investment. Portfolio managers in the investment world analyze the performance of their stocks on a daily basis, yet most in the insurance industry do not provide that type feedback to any of its insureds on anything better than a monthly basis on the overall portfolio. This is an opportunity for statistically driven companies in the PEO space, as there is no employer better equipped to manage its WC investment portfolio than a co-employer with intimate access to the client company's otherwise off-the-radar issues, such as business practices, payroll fluctuations, and sophistication. These are the subjective measures carrier actuaries cannot contemplate in providing estimates of future losses and adequate pricing.

Another area of historical concern to the insurance industry is the credit risks that PEO’s pose when they purchase high deductible policy types. As we discussed above, some PEO’s feel comfortable taking risk on their workers compensation programs as a means of driving revenue. Later in this article we will discuss the risk mitigation methods used to reduce credit risks.

Probably the most important issue that the PEO industry posed to the P&C insurance underwriters was the inability to individually underwrite the client companies of the PEO. Much

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of this confusion stems from the various methods used to construct the actual insurance policy(ies) for the PEO. One of those methods, called the Master Policy, sends shivers up the spine of any self respecting underwriter who needs to the ability to be granular in the underwriting and pricing of services to the actual client companies that make up the portfolio, versus only looking at the aggregate book. The ability to look at the individual client make up of any insured group allows much better decision making on all sides of the table. When a PEO focuses in the same manner as the primary carrier and reinsurance support, it is a telling statement of being a responsible and credible operator. Later in this article we will go into depth on the subject of individual risk underwriting and the methods that enable an underwriter to only insure those individual companies within a PEO whose exposures and unique make up fit their underwriting criteria.

It is necessary to quickly outline the various types of policies and naming conventions used to write the workers compensation exposures for PEO’s. Much of these types of policies and their usage are dictated by State regulation.

Master Policy A Workers' Compensation policy written with the PEO and client companies on a single policy in states that allow a Master policy. This is an arrangement whereby the PEO is issued an insurance company whereby they are the only named insured. Through co-employment, the PEO then extends its policy coverage to those employees payrolled by their client company. Client-based companies that are written on a single policy. With co-employment.

Notes: - A standard WC and employers liability policy written in the name of the PEO covering the workers of multiple client companies and direct workers of the PEO required to be covered pursuant to the WC laws of the state of coverage.

Multiple Coordinated Policies (MCP) Workers Compensation Policy written with the PEO and the client company as named insured. An arrangement under which a separate policy is issued to or on behalf of each client or group of affiliated clients but payment obligations and certain policy communications are coordinated through the PEO”. The MCP takes on various formats on a state-by-state basis. Client-based companies that are written in states that require an individual policy. With co-employment.

Notes: - A form of policy issuance used to provide WC and employers liability insurance for the workers of multiple client companies of a PEO. Policy issuance is as follows:

• The PEO has its own standard policy covering only its direct workers.• Generally, if there are no direct workers, the policy is issued on an “if any basis.• Each client has own standard policy covering its workers in the name and under the FEIN

of each client individually.• Endorsements are used to coordinate coverage between the Client Company and PEO.

Client-Based Policies These are an arrangement whereby the PEO or an agent on its behalf procures an insurance

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policy on behalf of its client company. The client company is the only named insured in this arrangement although the PEO may be involved in the maintenance of the policy and the collection of premiums.

Carve-Out Standard/traditional WC Policy, Guarantee Cost client based policy written stand-alone with co-employment. Issued policy is in client company’s name and an alternative employer endorsement is required to protect against dual coverage issues.

Notes: - Contractors may require client companies to be "named insured" on a WC policy. Certain ineligible exposures will cause client companies to be written outside of the PEO program. To certificate the client company on a Named Insured basis. To eliminate excluded exposures form the Master program.

Admin Services Only (ASO) Pay-As-You-Go Standard/traditional WC Policy, Guarantee Cost – without co-employment.

Notes: - Client-based policies where PEO provides administrative services only. Client company does not want purchasing power from co-employment. PEO only acts as billing agent and provider of employer-related administrative services i.e. HR and Payroll.

Historically, the preferred platform for the PEO industry was the master policy due to its administrative ease of use and control it gave the PEO over the risk management practices of the client company. Because the PEO is the only named insured on this platform, it is able to dictate to its client companies' important cost containment practices such as return to work, loss control compliance and physician channeling. Because the client company has no statutory rights to the insurance policy, non-renewal notices, cancellations and other important regulatory correspondence only went to the PEO. This in itself is of great concern to the insurance regulators countrywide as there have been some unfortunate occurrences of PEO’s continuing to charge client companies for workers’ compensation after the master policy coverage had been terminated. In addition, the NCCI is opposed to the master policy because of the inability for it to break out the individual loss and payroll data for experience modification promulgation purposes. While this is a statutory requirement in some states such as Florida, the reality is that many of the insurance carriers that support the PEO industry do not have the IT legacy systems to support this type of data transmittal. As a result, that which is transmitted to NCCI tends to be manual and sporadic in nature.

The bottom line is that those that oversee the workers’ compensation system are of the opinion that the master policy approach is imperfect. As a result, the NCCI has commenced a crusade to file MCP endorsements state by state. In addition, the National Association of Insurance Commissioners (NAIC), along with many states on their own, is drafting new employee leasing models, most of which include the MCP platform. The MCP platform is already mandatory in the two largest states for insurance (California and New York), and the NCCI in the past year has introduced the platform for adoption in the fourth largest state (Florida). Without a doubt, the

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MCP format brings more of an administrative burden to the PEO, its brokers/agents and the respective carriers that underwrite the business.

Insurance Industry Acceptance: NAPEO and its constituents have made great strides in working with NAIC, NCCI and various state legislators to institute and implement rules surrounding the PEO industry. Most of the outstanding issues that these bodies are concerned with such as “mod washing”, consistency of experience rating, “piggybacking”, and statutory rights of client companies are neutralized by the MCP format.

Individual Risk Selection and Underwriting

The basic fact that must be established at the outset of this section is that it is not only possible to exclude specific client companies from a specific PEO workers compensation program but absolutely vital to do so. As we already discussed, PEO’s must be very diligent to protect the mod factor that is imposed on all of its policies. PEO’s must be the first line underwriters for the client companies that they want to contract and be very selective on how they handle the placement of the workers compensation coverage for these exposures. As a matter of practice most PEO’s maintain a few operating companies so that they can group similar industry profiles together. By this I mean you would not mix a group of accounting firms with a group of waste haulers. Hence the PEO maintains a few different operating companies to keep the mod levels accurate for the type of clients they are contracting with. The ability to write a single client company on a policy type such as a MCP, Carve Out or ASO is critical. Some client companies simply belong in the residual market; some client companies simply belong in specialty markets while others can be written in the more traditional standard carrier markets. As a reminder, if a client company does not have a mod factor, as over 80% of the PEO clients do not, then if they go into a MCP, Carve Out or ASO policy they still do not have a mod factor. However if that same client goes onto a PEO master policy then they are priced with the overall mod of that master policy.

Before we address the unique abilities and philosophy of Risk Transfer, below is an excerpt from one of their publications discussing the concept of individual risk selection in the overall analysis of a PEO program –

Filling the blind spots carriers have when analyzing a PEO's portfolio of workers' compensation exposure warrants a discussion of probabilities and statistics. The PEO industry generally has used statistics—NCCI loss development factors, hazard group indexing, and other data generally available through the various actuarial bureaus—to make informed decisions. The foundation of any risk management program is the organization's ability to benchmark and measure performance against its peers and the overall market. This data is useful in evaluating past results, but its use is limited in predicting future results and go-forward pricing.

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Let us explain. There are three general themes in PEO WC programs overlooked when developing the appropriate initial cost basis and service pricing:

Geography. Very simply, where are carriers making the most money? In the example shown in Table 1, if you are an Illinois domiciled PEO with no geographic dispersion, you can expect most all carriers to know this and consider it in the pricing of your account. While loss ratios contribute greatly to the return on equity calculation, other considerations, such as payment patterns, frequency of excess losses, and investment returns of carriers overall, also contribute to the formula.

Propensity to cause excess losses. (defined here as a loss in excess of $250,000) Fatalities and permanent disabilities cost much more than other injury types; therefore, codes that have a greater frequency of causing those types of losses should be carefully underwritten and your risks should be reflected in your service pricing. While some of these codes are obvious, such as long-haul trucking, mining, and roofing, there are outlier codes that are not contemplated in NCCI's hazard group rating. It is one of the primary functions of the reinsurance market to build predictive models around excess losses. If you analyze NCCI hazard groups A through G, the frequency of excess losses goes up by each hazard grouping, but can vary widely within the same one as well. See Tables 2 and 3.

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Performance results by class code. When PEOs evaluate historical results by geography, they also determine the areas of highest returns within that given jurisdiction and strategically pinpoint areas to pursue growth opportunities. It is very common for carriers to use “territorial multipliers” in states such as California, where results can substantially deviate by class code. Drill further, and reveal which client companies are over achievers and which industry classes provide the best results. Even further down, what types of loss in that given class code can be engineered and targeted? When given the ability to swiftly track their inherent ebb and flow, PEOs can deploy resources much more proactively and effectively than the traditional marketplace. See Table 4.

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Conclusion

A PEO is often mistakenly compared to an insurance company, or managing general agency (MGA). It is true that the sophisticated infrastructure required for PEOs to administer and manage the risk of extended coverages to co-employers makes them somewhat comparable in scope to that of insurance carriers. For example, by our count, four PEOs in Florida would be in the top 10 insurance carriers in the state if ranked by their volume of premiums to carriers. However, PEOs have more contact and capacities at their clients than carriers will ever have. The many touch points of PEOs with clients and their ability to manage risk and to reduce losses can have significant impact.

Moreover, your PEO may have particular experience with specific industries. This ability to identify and manage risk is a major benefit to your clients of your WC services.

Knowing and using the same statistics and actuarial guidance as carriers can only help the PEO further outperform the traditional agency model and maximize its profits. At a bare minimum, doing so will create a relationship alignment with the carriers supporting the industry. Ask your broker, your carrier, or anyone else that can bring you facts to analyze your exposure and help you to price your client companies. Like an insurance carrier, charging the right amount for WC services for the exposure is what every PEO needs to have down to a science for us to "beat the market."

Analogy of insurance agents – have a universe of businesses to insure and the carrier picks which one they want.

Alignment of interests – more aligned then agency partners with outcomes.

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