13.3 Premium Basis, Experience Modification, and Classification

Premium Basis: Payroll and Classification

Workers compensation premium is built on payroll, not on coverage limits, because the system has no policy limit. The basic formula is:

Premium = (Payroll ÷ 100) × Rate × Experience Modifier

Payroll is divided by 100 because rates are expressed per $100 of payroll. Each type of work carries a classification code (set by NCCI or an independent state bureau) reflecting its hazard: clerical office work has a low rate, while roofing or logging carries a high rate. Assigning the correct class code is critical — misclassification distorts the premium and can trigger audit penalties.

The Premium Audit

Because actual payroll is unknown when the policy is issued, the carrier charges an estimated (deposit) premium at inception based on projected payroll. After the policy expires, the insurer conducts a premium audit to determine actual payroll and class assignments, then issues an additional charge or a return premium.

Key audit rules tested on the exam:

• Overtime pay is generally counted at the straight-time portion only — the premium portion (the extra half) is excluded.
• Payroll for owners, executive officers, and partners may be subject to minimum and maximum payroll limitations.
• Refusing to allow the audit can void the policy or let the carrier estimate payroll at a punitive level.

Experience Rating and the Mod

Larger employers qualify for experience rating, which compares their actual loss history to the expected losses for their class. The result is an experience modification factor (the mod or EMR) applied to the manual premium:

• A mod of 1.00 is average — losses match expectations.
• A mod above 1.00 (a debit) means worse-than-expected losses, raising premium.
• A mod below 1.00 (a credit) means better-than-expected losses, lowering premium.

Frequency of claims affects the mod more than severity, because experience-rating formulas weight the number of losses heavily and cap the impact of any single large loss. Trap: many small claims hurt the mod more than one catastrophic claim.

Worked Mod Example and Rating Plans

Suppose a contractor's manual premium (before the mod) is $80,000 and the firm earned an experience mod of 1.25 from a string of small frequent claims. The modified premium is $80,000 × 1.25 = $100,000 — a $20,000 debit penalty. Had the firm controlled frequency and achieved a 0.85 mod, the premium would be $68,000, a $12,000 credit.

Other rating plans the exam references:

• Retrospective rating — final premium adjusts after the period based on the insured's own actual losses, between a minimum and maximum.
• Premium discount — a volume discount for large policies.
• Schedule rating — credits/debits for specific risk characteristics (safety programs, housekeeping).

Assigned Risk and the State Fund

An employer unable to buy coverage in the voluntary market because of poor experience or a hazardous class is not left uninsured. Coverage is provided through a residual market mechanism:

• An assigned-risk pool (administered by NCCI in many states) distributes hard-to-place employers among carriers.
• Some states operate a competitive state fund that competes with private insurers, while a few run a monopolistic state fund where employers must buy comp from the state (private comp is not sold). In monopolistic-fund states, employers buy a separate stop-gap endorsement on the CGL for employers-liability coverage, because the state fund provides comp only.

Knowing the monopolistic-fund states and the stop-gap concept is a recurring exam item.

Auditable Exposures and Premium Determination

Workers comp is an auditable line: the carrier issues a deposit premium on estimated payroll, then trues it up after the term. The exam expects you to know what counts as payroll and what is excluded. Included: wages, salaries, commissions, bonuses, holiday/vacation pay, and the straight-time portion of overtime. Excluded or limited: the premium (extra) portion of overtime, severance, certain reimbursed expenses, and tips; owners/officers are subject to payroll min/max caps set by the state bureau.

Class codes (NCCI four-digit codes) drive the manual rate, and an employer with multiple operations may carry several codes, each rated on its share of payroll. The governing classification is the highest-payroll non-standard code. Worked example: a firm with $1,000,000 of clerical payroll (low rate) and $500,000 of roofing payroll (high rate) is rated separately by code; misassigning roofing payroll to the clerical code understates premium and triggers an audit charge plus possible penalties. Trap: clerical and outside-sales payroll cannot absorb hazardous fieldwork — each operation keeps its own code.

Dividend Plans, Deductibles, and Self-Insurance

Beyond manual, experience, and retrospective rating, employers manage comp cost through several mechanisms the exam references. Participating (dividend) plans return a portion of premium as a dividend when the insurer's loss experience for the group is favorable — dividends are never guaranteed.

Large-deductible plans let a sizeable employer retain the first dollars of each claim (e.g., $250,000 per claim) in exchange for sharply lower premium, shifting routine losses back to the insured. Qualified self-insurance lets a financially strong employer pay its own claims directly, posting security/bond with the state and often buying excess (specific and aggregate) workers comp above a retention.

Worked example: a large retailer with stable, predictable losses adopts a $500,000 large-deductible plan, paying small claims itself and buying coverage above the deductible; its premium drops, but it now carries the cash-flow and reserving burden of frequent small claims. Trap: dividends are contingent on results and cannot be promised at sale — guaranteeing a dividend is an unfair trade practice.