Audit Rules and Guidelines – Part II

Part I of this two-part audit rules and guidelines article presented the section of the work comp policy making the audit possible. It also presented what remuneration was included and what was excluded for premium audit purposes.

Part II details the governing classification and single enterprise rules (including exceptions) and ends with the ABCs of premium audits (which can be applied to any premium audit).

Governing Classification and the Single Enterprise Rule

Once final payrolls are calculated, a “Governing Classification” is assigned to the employer. The governing classification is generally based on the class code generating the largest payroll; rarely the highest rated code is used as the governing class (usually only used in construction-related operations if used at all). All employee payrolls, with certain exclusions and exceptions expounded upon in upcoming paragraphs, are assigned to the governing classification.

The governing classification is intended to represent the exposure created by the overall operational business, not the exposure of each individual employee. Applying the single enterprise rule, the governing classification is designed to anticipate all the normal activities conducted by a particular operation or business. For example, a steel fabrication plant may have employees that rivet, others that bend and shape the steel, others that paint the finished product and still others that add braces and brackets. Even though there are different exposures presented by each of these operations, all payroll is assigned to the same class code – the one that represents the overall exposure.

Further, there are some activities a business conducts that appear to be so unrelated to the primary operations as to require or allow separate classification be assigned. However, NCCI considers some of these activities to be an integral part of the business’ operations thus the payroll of the individuals engaged in these activities is included in the governing classification. Known as “General Inclusions” these included activities are:

  • Employees that work in a restaurant, cafeteria or commissary run by the business for use by the employees (this does not apply to such establishments at construction sites);
  • Employees manufacturing containers such as boxes, bags, can or cartons for the employer’s use in shipping its own products;
  • Staff working in hospitals or medical facilities operated by the employer for use by the employees;
  • Maintenance or repair shop employees; and
  • Printing or lithography employees engaged in printing for the employer’s own products.

Payroll for any employee engaged in the above activities is assigned to the governing classification.

Exceptions to the Governing Classification Rules

There are four exceptions to the governing classification and single enterprise rules. These are:

  • The “Standard Exception” classifications;
  • The “Interchange of Labor” rules;
  • The “General Exclusion” classes; and
  • Employers eligible for classification under the “Multiple Enterprise” rule.
‘Standard Exception’ Classifications

Some duties/activities are so common to most business and may be so far outside the operational activities of the entity that employees engaged in these positions are considered exceptions to the governing classification rules. Payroll for these “standard exception” classes of employees is subtracted from the governing classification and assigned to the applicable standard exception code and rated separately from the governing class. The standard exception classes include:

  • Clerical Employees- Class Code 8810;
  • Clerical Telecommuter – Class Code 8871;
  • Drafting Employees – Class Code 8810;
  • Salespersons – Class Code 8742; and
  • Drivers – Class Code 7380.

For a particular employee or group of employees to qualify for assignment into one of the standard exception classifications, he/she must be physically separated from the operative hazards of the business by means of walls, floors, partitions or counters. Such separation requirement does not negate the assignment of an employee to a standard exception class if he is only entering the area of operation to conduct duties consistent with his class code; such as a clerical employee entering the operations area to deliver paychecks.

Standard exception classifications are not necessarily limited to these five class codes; some states utilize state-specific class codes that are also eligible for assignment as a standard exception. For example, Texas allows certain employees to be assigned to “Executive Officers NOC” (class code 8809) and the payroll for these employees is pulled out of the governing classification and rated as a standard exception.

Employees falling into a standard exception classification may not always be eligible for “standard exception” separation. Attention must be given to the governing classification description; at times, the governing classification may state “…&…” or “…including….” If such wording appears, the payroll for the standard exception employee is included in the governing classification. The reason for such inclusion, the analogy of that particular operation requires the presence of the standard exception employees to accomplish the goals of such business. A few examples of this include (not an exhaustive list):

  • Farm: Nursery Employees & Drivers (Class Code 0005);
  • Chemical manufacturing NOC – all operations & Drivers (Class Code 4829);
  • Carpet, rug or upholstery cleaning & Drivers (Class Code 2585);
  • Physicians & Clerical (Class Code 8832);
  • Photographer – All employees & Clerical, Salespersons and Drivers (Class Code 4361); and
  • School: Professional Employees & Clerical (Class Code 8868).
Interchange of Labor

A second exception to the governing classification rule is the “interchange of labor” rule. The applicability of this rule varies by state; some states only allow its use in the construction, erection or stevedoring classes of business while other states permit the interchange of labor rule to apply to any type of business operation.

Interchange of labor rules allow a single employee’s payroll to be split between or among several class codes that may be present within the operations. The advantage to the employer (premium payer) of such allowance is an ultimately lower premium. Without the interchange of labor rule, the employee’s entire payroll would be assigned to the governing (likely highest rate) classification. With the interchange of labor rule in effect, the employer is charged based on the employee’s actual exposure to injury.

For instance, an employee in the construction industry who does framing work (5645) and hardwood floor installation (5437) can see his payroll divided between these different operations and realize a reduction in premium provided the following specific provisions are met:

  • All classifications used for an employee are appropriate to the job performed;
  • Payroll records exist that allocate the employee’s wages between/among the different classes. This requires an actual, dollar amount payroll split, a percentage of payroll is not allowed;
  • The division of payroll is not available with any of the standard exception classifications (with the possible exception of the driver code); and
  • The operations/activities are not conducted on the same job site.

Continuing the above example using assigned risk rates of $25 for code 5645 and $14 for code 5437, an employee earning an annual payroll of $30,000 will cost the employer $7,500 if there is no interchange of labor. If, however, all the interchange of labor guidelines are met, and the employee’s payroll is split as follows: $20,000 for framing and $10,000 for hardwood floor installation; the employee will only cost $6,400 in workers’ compensation premium (ignoring expense constants, modification factors and debits or credits).

The interchange of labor rule is great for the employer due to the premium savings and is fair for the insurance carrier because exposures differ based on activity. When the employee is on scaffolding he is more like to suffer a severe injury than when installing flooring.

Employers and their agents must understand and take advantage of the interchange of labor rules allowed in each state. Large payrolls can greatly benefit from such splits thus agents should encourage detailed payroll records be kept and the audits should be checked closely.

General Exclusion Classifications

Some operational activities do not fit into the analogous assignment of the governing classification due to the unexpected existence of such an operation as part of a particular business. It is not reasonable to expect the hardware store code (8010) to pick up the exposure created by an onsite sawmill operation (2710) for example.

Such operations are known as “general exclusion” classes. General exclusion classes are listed separately on the workers’ compensation policy and a separate rate (based on the class code) is charged for the employees within these classes of operations.

General exclusion classes are the opposite of “standard exception” classes. General exclusion classes are completely unexpected and not considered part of the analogy of the governing classification of an operation requiring separation to allow the insurer to garner the, usually, higher premium for the increased exposure. Conversely, standard exceptions represent operations common to most business and are of such minimal hazard that the insured should not be punished by having the payroll for these classes included in the governing classification, but should rather enjoy a lower premium for the reduced exposure.

Operations and activities falling within the general exclusion classification are:

  • Employees working in aircraft operations;
  • Employees performing new construction or alterations;
  • Stevedoring employees;
  • Sawmill operation employees; and
  • Employees working in an employer-owned daycare.
Multiple Enterprise Rule

The single enterprise rule requires that all activities usual and customary to a particular operation be assigned to one “governing” class code (with the exceptions described above). However, a particular entity may conduct additional operations not usual or customary to such an enterprise; such disparate activities may allow the insured to qualify for the separation of payroll into multiple classifications under the “multiple enterprise rule.”

A secondary operation producing a basic premium equal to or higher than the governing class code (the “governing class code” is the code generating the highest payroll) premium automatically qualifies for separation under the multiple enterprise rule with the only requirement being segregation of payrolls.

If, however, the basic premium generated by the secondary operation is less than the governing class code basic premium, four tests must be satisfied before the insured can make use of the multiple enterprise rule. These are:

  1. The operation is not commonly found within the operation of the subject insured’s business;
  2. The operation could each exist as a separate entity;
  3. Financial records are kept separately for each operation; and
  4. The operations are physically separated by means of a partition, wall or placement in a separate building.

Such separation of payrolls may benefit the insured employer by a reduction in premium if the secondary enterprise carries a lower rate per $100 of payroll. Additionally, employers that qualify for separation of payrolls under the multiple enterprise rule may also be able to benefit from the application of the interchange of labor rule as presented above and based on the state.

ABCs of Premium Audits

There are specific guidelines that agents and the employer should apply to every audit. These are the “ABCs” of premium audits.

A: Always be there. A representative from the company familiar with the financial records and the operations should be present at every audit. The auditor will likely have questions and unless someone is available to answer these questions and explain the financial documents, the auditor will have to make some potentially costly assumptions and/or mistakes. This duty should not be delegated to any member of the staff not intimately familiar with the business and its finances.

B: Be prepared. The auditor needs all the necessary financial records to conduct the audit and will likely ask for a tour of the facility. Prepare a place for the auditor to work and help them complete their job as quickly as possible. Have ready or available:

  • Payroll records: Payroll journal and summary; 941s; state unemployment reports; an explanation and break out of overtime payments; and the general ledger.
  • Employee records: Include a detailed description of job duties; the number of employees; employee hire and fire dates; and class code splits if applicable.
  • Cash disbursements: Cost of and payments to subcontractors; cost of materials; and the cost of any casual labor hired.
  • Certificates of Insurance: Make sure to supply current certificates of insurance covering the entire period of the audit or the entire period of time the contractor has worked for the insured. If the sub’s policy renews in the middle of the audit period, a new certificate should be requested covering the remainder of the insured’s policy period.
  • OCIP projects: If the insured has been a part of any wrap-up, the auditor needs this information in order to remove the payroll from the calculation.

C: Copy of the auditor’s work papers. Don’t let the auditor leave without getting a copy of the audit work papers. This allows the insured and the agent to review the audit and confirm that there are no errors BEFORE the audit is processed and billed (fixing it “after-the-fact” is more difficult).

D: Don’t volunteer more information than asked. The auditor will ask questions, this is expected. Insureds should be advised to only answer the questions asked and not lead the auditor down a path that may be detrimental to the insured.

E: Exceptions to the single entity rule. The exceptions listed above should be capitalized on by the insured. Audits should, at the very minimum, contain at least one standard exception code. If the insured is eligible for any of the other payroll splits described above, those codes should also be included.

Knowing the rules and exceptions, giving the auditors everything they need to complete the audit quickly and following the above rules increases the chances of a correct and favorable audit.

Workers’ Compensation Series

This is the tenth in a series of articles on workers’ compensation. The series is taken from the book, “The Insurance Professionals’ Practical Guide to Workers’ Compensation: From History through Audit.” The articles in this series are:

  • Workers’ Compensation History: The Great Tradeoff
  • Benefits Provided Under Workers’ Compensation Laws
  • Second Injury Funds: Are They Still Necessary or Just a Drain On the System?
  • Employees Exempt from Workers’ Compensation
  • Nonemployee ‘Employees:’ The Borrowed Servant Doctrine
  • Work Comp for PEOs and Their Client/ Employers
  • Combinability of Insureds
  • Audit Rules and Guidelines
  • Audit Problems Leading to Additional Premiums

About Christopher J. Boggs

Boggs, CPCU, ARM, ALCM, LPCS, AAI, APA, CWCA, CRIS, AINS, is a veteran insurance educator. He is Executive Director, Big I Virtual University of the Independent Insurance Agents and Brokers of America. He can be reached at chris.boggs@iiaba.net. More from Christopher J. Boggs

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