13.3 Premium Basis, Experience Modification, and Classification
Key Takeaways
- Premium = (Payroll / 100) x manual rate per NCCI class code; payroll is the exposure base and the rate varies sharply by job hazard
- Coverage is written on ESTIMATED payroll and reconciled by a year-end PREMIUM AUDIT; additional or return premium follows the audited exposure
- The experience modification factor (mod) compares an employer's actual losses to expected losses for its class: a mod above 1.00 is a debit (surcharge), below 1.00 is a credit
- Experience rating uses three years of data (excluding the most recent year) and weights claim FREQUENCY more heavily than severity, so many small claims hurt the mod more than one large one
- Standard premium x experience mod, then schedule/premium-discount/expense modifications, produce the final premium; minimum premium and the expense constant also apply
The Premium Formula
Workers' comp is rated on payroll, the exposure base. Each job type carries an NCCI classification code with a manual rate per $100 of payroll.
Formula: Manual Premium = (Payroll / 100) x Manual Rate
Worked Example: A clerical class (code 8810) rate is $0.30 per $100, and a roofing class (code 5551) rate is $25.00 per $100.
| Class | Payroll | Rate per $100 | Premium |
|---|---|---|---|
| Clerical (8810) | $400,000 | $0.30 | $400,000/100 x 0.30 = $1,200 |
| Roofing (5551) | $400,000 | $25.00 | $400,000/100 x 25 = $100,000 |
The enormous spread shows why misclassification is the costliest premium error; assigning a roofer to a clerical code grossly understates the exposure. The governing classification is generally the highest-rated class describing the business operation, with standard exceptions (clerical, outside sales, drivers) rated separately.
Estimated Payroll and the Premium Audit
Because final payroll is unknown at inception, the policy is bound on estimated annual payroll that produces a deposit (estimated) premium. At expiration, the insurer conducts a premium audit of actual payroll records and issues:
- Additional premium if actual payroll exceeded the estimate, or
- Return premium if it fell short.
The basis of premium is remuneration: wages, salaries, commissions, bonuses, and most overtime (at straight-time value, with the premium portion of overtime excluded). Severance pay, certain reimbursed expenses, and tips in some states are excluded. Refusing the audit can let the insurer estimate payroll and bill the maximum.
Experience Modification (the Mod)
The experience modification factor adjusts the manual premium up or down based on how the employer's actual losses compare with the expected losses for its classification and size.
| Mod Value | Meaning | Effect on Premium |
|---|---|---|
| Above 1.00 | Worse-than-average losses | Debit / surcharge |
| Exactly 1.00 | Average for the class | Neutral |
| Below 1.00 | Better-than-average losses | Credit / discount |
Key design points the exam tests:
- Experience rating uses three years of loss and payroll data, excluding the most recent (immature) policy year.
- It weights frequency over severity through primary/excess loss splits, so many small claims raise the mod more than a single large one.
- A new or small employer below the eligibility premium threshold is not experience-rated and runs at a 1.00 mod.
Putting It Together: Standard and Final Premium
The order of operations matters:
- Manual premium = sum of (payroll/100 x rate) across all class codes.
- Standard premium = manual premium x experience mod.
- Final premium = standard premium adjusted by schedule rating (debits/credits for risk characteristics), premium discount (volume scale), and the expense constant; subject to a minimum premium.
Worked Example — applying the mod:
- Manual premium = $50,000
- Experience mod = 1.20 (poor history)
- Standard premium = $50,000 x 1.20 = $60,000
If safety improvements later drove the mod to 0.85, the same manual premium would yield $50,000 x 0.85 = $42,500 — a $17,500 swing on identical payroll, the direct dollar incentive for loss prevention.
A contractor has $600,000 of payroll in a class rated $8.00 per $100 and an experience modification factor of 1.25. Ignoring other adjustments, what is the standard premium?
Two employers in the same class have identical total incurred losses. Employer A had one large claim; Employer B had many small claims. Under NCCI experience rating, which employer is likely to have the HIGHER experience mod, and why?
Classification Codes and the Governing Class
Premium starts with classification: each job is assigned an NCCI (or state) class code with a manual rate per $100 of payroll reflecting that work's hazard. A business may have several classes (e.g., clerical, sales, manufacturing); standard exception classes like clerical office and outside sales are rated separately at lower rates. The governing classification is the highest-payroll non-standard-exception class describing the business. Misclassification is a major audit issue — assigning roofing payroll to a clerical code understates premium and triggers audit corrections and possible penalties.
The Experience Modification Factor in Depth
The experience modification (mod) compares an employer's actual losses to the expected losses for its class and size over a three-year window (excluding the most recent year). A mod of 1.00 is average; below 1.00 (credit) lowers premium, above 1.00 (debit) raises it. The formula weights frequency more heavily than severity, so many small claims hurt the mod more than one large claim of equal total dollars. This rewards safety programs that reduce accident frequency. Worked: a $100,000 manual premium with a 0.85 mod yields $85,000 before scheduled/expense modifications.
Premium Audit and Estimated Payroll
Workers comp premium is auditable: it is initially based on estimated payroll, then adjusted at year-end by a physical or voluntary audit of actual payroll by class. If actual payroll exceeded the estimate, the insured owes additional premium; if it was lower, a return premium is due. Overtime is generally counted at straight-time wages for premium. The exam links this to classification — an audit reassigns misclassified payroll to the correct, often higher-rated class, producing additional premium plus the mod and any schedule-rating adjustments.
Schedule Rating, Premium Discount, and the Final Premium Walk-Through
After the manual premium and experience mod, larger accounts may receive schedule rating credits/debits for safety features and premium discount for size (economies of scale on expenses). The build is: payroll/100 × manual rate = manual premium; × experience mod = modified premium; × schedule mod, then apply premium discount and the expense constant and minimum premium. Worked: $600,000 payroll in an $8.00 class = $48,000 manual; × 0.90 mod = $43,200; a 5% schedule credit nets $41,040 before discount. Knowing the order — classification, mod, schedule, discount — is the tested skill.