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Premium fraud and payroll misclassification have been big topics of discussion in workers compensation, especially after a recent report showed that New York City’s construction industry cost the city and state approximately $500 million. The main reason for this loss was unpaid premiums, in which businesses paid salaries off the books or purposely misclassified employees as independent contractors.

Executive Summary

Flagging workers compensation policies that are above certain premium thresholds for audit may result in wasted energy and expense, according to Valen Analytics CEO Dax Craig, who notes that larger insureds expect and are prepared for physical audits. Here he recommends some basic steps for setting baselines to develop an audit scope and to fine-tune an audit strategy.

Fraud, or “moral hazard,” is one cause of payroll misclassification for which carriers ultimately pay the price. When employers misrepresent the type of work an employee performs or falsely classify employees as independent contractors, it creates revenue and expense implications for carriers reliant on self-reporting.

This issue extends beyond the borders of New York. According to Valen’s data consortium, nearly half of all workers comp policies have some level of misclassified exposure. Not surprisingly, some industries are worse than others. Between 2008 and 2012, construction had the largest percentage of misclassified payroll, totaling $76.8 billion.

Challenges With Identifying Fraud

The N.Y. grand jury recommended a vigorous auditing program to catch those committing fraud. However, large company insureds (e.g., large construction firms) tend to have less exposure to misclassification because they understand they’ll be physically audited more frequently and are therefore prepared. Carriers with sophisticated processes for identifying which policyholders to audit as part of their standard business practice will do a better job at catching or preventing premium fraud.

This also has implications for claims. When an insured has misclassification issues, it’s important to find out why. If there is a moral hazard issue either from the insured or the agent, it can be a trigger to conduct further due diligence. For instance, is an insured paying minor claims out of pocket, which can lead to late reporting and IBNR (incurred but not reported) issues?

Without knowing about the smaller incidents, insurers lose the ability to see the signals to schedule loss control visits that help prevent large losses. One question to ask is whether the experience modification factor on the account is lower than it should be.

The problem is that many carriers focus their audits on policies that are above certain premium levels. By doing so, they spend energy and money auditing policies that turn out to be in compliance while missing the larger (but more fragmented) occurrence of misclassification that exists “below the waterline.”

That begs the question of which policies really need attention. It’s impractical and unprofitable to physically audit every policy, especially small ones.

The crux of the issue is that carriers are constantly dealing with information asymmetry. The insured knows what its payroll is and what its employees are doing. The agent knows more about the insured than the carrier does. But carriers end up having less information at the point of new business.

Establishing a Baseline

Fortunately, there are strategies for carriers to address the information gap and to be equipped to go beyond the traditional business rules (e.g., industry, size of policy) that trigger an audit. To do this, carriers can create a common definition or baseline to determine what impact payroll misclassification is having on their book of business and then pick the best approach to rank their policies and fix their audit program.

To establish a baseline, it is important to understand what an overall portfolio looks like and how much exposure is misclassified. A few basic questions to ask:

  • Is there more or less misclassified exposure compared to last year?
  • Are particular hazard or industry groups performing better or worse than others?
  • What are the other dimensions that could make a difference?

By answering these questions, carriers will be ahead of where many others are today in understanding the scope of the problem and how to improve their bottom lines.

Refining Audit Strategies

Armed with a baseline, carriers can evaluate their current audit strategies.

A simple yet effective method is examining premium size. For instance, carriers can identify the percentage of policies between $5,000 and $15,000 that are getting physical audits. Then, they can compare whether the additional or return premium on those policies is more or less than it is for policies that are over $50,000 in premium.

Once carriers do that, they’ll be able to evaluate data fields for things they believe might be predictive or help in the future.

Another good step is to evaluate audit strategies and business rules. Business rules that guide underwriting decisions, such as targeting specific types of businesses, geographies or premium levels, should be mapped to the carrier’s data warehouse—its policy and claim data—in order to understand how each one of those rules correlates to actual results within the carrier’s own book of business. Carriers should pay particular attention to successfully post-audited values to find out how advantageous particular rules are, whether they are used today or are being considered for future use. Then, they can think through what information they have in their data set to take advantage of the insights they gain.

Being Proactive

In light of recent high-profile workers comp fraud cases, carriers should anticipate an increasing amount of pressure from public officials to closely monitor employers’ practices. Having the right strategies in place has never been more critical to stay organized and ultimately improve a carrier’s bottom line.

By using a combination of approaches, carriers have the opportunity to recognize many forms of fraud and prevent them before they occur.