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Workers' Compensation 101 If you have employees, you need workers' comp insurance. We'll help you wrap your head around what you need to do to ensure your business is covered.

Editor's note: This article was excerpted from Entrepreneur Magazine's Ultimate Guide to Workers' Compensation Insurance.

Almost every business in the United States that has employees has to handle the problem of workers' compensation. Most states (with a few important exceptions) essentially require employers to purchase an insurance policy to handle their statutory obligations to workers who are injured or made ill due to a workplace exposure. Whether your business is small or large, handling the expense and effort of meeting those statutory obligations is an ever-present challenge.

As a consultant to employers on their workers' compensation cost and coverage, I've seen firsthand that the cost of workers' compensation is a universal concern of business owners and managers. Whether working with a small machine shop that employs 30 people or a Fortune 100 corporation that employs thousands across many states, I've found that the details may vary but the concern remains the same: how can the voracious cost of workers' compensation be controlled effectively?

Some researchers have suggested that the earliest roots of workers' compensation can be traced back to the code of Caribbean pirates: those who were injured plying their dangerous trade would be compensated with shares of booty taken by their able-bodied fellow buccaneers. Colorful as that conjecture may be, workers' compensation requirements in the United States began early in the 20th century, back in 1911.

Before then, workers who'd been injured or made ill on the job had to take legal action against their employers, resulting in a system that simultaneously made it difficult for workers to obtain compensation for such injuries and yet exposed employers to potentially devastating financial penalties under the tort system. Beginning in 1911, an historic compromise solution was devised by the various states. Wisconsin was the first, but other states quickly followed, enacting a "no fault" system intended to make sure workers received fair and prompt medical treatment and financial compensation for workplace injuries and illness. This compromise system also established limits on the obligations of employers for these workplace exposures, so that the costs could be made more predictable and affordable.

Today, modern workers' compensation laws provide fairly comprehensive and specific benefits to workers who suffer workplace injury or illness. Benefits include medical expenses, death benefits, lost wages, and vocational rehabilitation. Failure to carry workers' compensation insurance or otherwise meet a state's regulations in this regard can leave an employer exposed not only to paying these benefits out of pocket, but also to paying penalties levied by the states.

But our federal system in the United States means that workers' compensation regulations, for the most part, are the jurisdiction of the individual states. There are some federal workers' compensation statutes, such as for longshoremen and harbor workers, but for most employers, the system of workers' compensation rules and regulations they usually deal with is enacted by the states (along with Washington D.C. and Puerto Rico). This means that workers' compensation in the United States has something of a patchwork quality to it. There are great similarities among the workers' compensation systems enacted by the various jurisdictions, but also important differences.

How States Differ
In most jurisdictions, employers can meet their workers' compensation obligations by purchasing an insurance policy from an insurance company. However, five states and two U.S. territories (North Dakota, Ohio, Puerto Rico, the U.S. Virgin Islands, Washington, West Virginia, or Wyoming) require employers to get coverage exclusively through state-operated funds. If you're an employer doing business in any of these jurisdictions, you need to obtain coverage from the specified government-run fund. These are commonly called monopoly state funds. A business cannot meet its workers' compensation obligations in these jurisdictions with private insurance.

Nevada was a monopoly state until recently, but now it's shifted to a system of private insurance and the former state fund has morphed into a mutual insurance company. Thirteen other states also maintain a state fund, but the state funds compete with private insurance. In these states, an employer has the option (at least theoretically) to use either the state fund or private insurance. Those states that offer employers this option are Arizona, California, Colorado, Idaho, Maryland, Michigan, Minnesota, Montana, New York, Oklahoma, Oregon, Pennsylvania and Utah.

The State-by-State Mosaic
Since workers' compensation is primarily regulated by the individual states (and territories), there is no single cohesive set of rules governing benefits, coverage, or premium computation. Even if you have considerable experience in dealing with one state's workers' compensation system, if your business expands to a different state, you can easily find yourself dealing with very different rules.

The closest thing there is to a uniform set of rules for premium computation are those established by the National Council on Compensation Insurance (NCCI, This organization creates policy forms and writes the rules for premium computation in the majority of states.

NCCI is what used to be called a "rating bureau." Nowadays the organization tends to prefer the term "advisory organization," although a lot of folks still use the older term. NCCI performs a number of important tasks for the workers' compensation system in the states that use NCCI. It gathers the statistical data from insurance companies that is used to develop rates, for instance. It also creates the standardized policy forms that are approved by state insurance regulators. Perhaps most importantly, from the standpoint of those who buy workers' compensation insurance, NCCI writes the manuals that govern how workers' compensation insurance premiums are calculated.

If you have a high tolerance for technical and obtuse language, try reading the fine print of your workers' compensation insurance policy. If you stick with it, you may notice something interesting: the policy itself doesn't really spell out how the premiums for the insurance are calculated. Instead, the policy states that premiums on the policy are just an estimate and that the final actual premiums for the coverage will be calculated in accordance with the insurance company's manuals of rules.

But in practice, insurance companies don't write their own manuals of rules. Instead, they find it more practical to use the manuals developed by rating bureaus like NCCI. (Remember: NCCI isn't the rating bureau in all states. Some states maintain their own independent rating bureaus. These other bureaus also develop manuals that govern premium computation in their particular states.)

Also, even among the various NCCI states there can be important differences. Some states tinker with NCCI rules in various ways, so that in some fundamental rules there can be very important differences even among NCCI states.

So to figure out what rules govern the computation of your workers' compensation insurance premiums, you have to first identify the states and then figure out which rating bureau (and thus which manual of rules) has jurisdiction in those particular states.

Workers' Comp--Who Needs It?
That may be the first important question that a business needs to address, because not every business is required to purchase workers' compensation insurance. Generally speaking, sole proprietors and partnerships aren't required to purchase workers' compensation insurance unless and until they have employees who aren't owners. Most states will allow sole proprietors and partners to cover themselves for workers' compensation if they choose to, but it isn't required. (An important note, though-these rules vary from state to state and can change over time. So it's always a good idea to check with your particular state's regulatory agency to make sure what the rules are for your state jurisdiction.)

Some states don't require an employee to be covered if he or she is paid solely by commission. Again, check with the workers' compensation regulators in your particular state to see how they handle this.

Interestingly, a few states even give employers the option to not purchase workers' compensation insurance at all. These states are few and far between: Texas and (at least in theory) New Jersey. Remember, though, that just because the state may allow an employer to go without workers' compensation insurance, the employer is still liable under the state's workers' compensation laws for injured workers. Not having workers' compensation insurance, even if allowed by a particular state, does not relieve the employer of financial responsibility for injured workers.

Most states also allow large employers to self-insure for workers' compensation, but the rules about who can and cannot self-insure again vary significantly from state to state. Typically, your state department of insurance can help you determine if your business is required to purchase workers' compensation insurance. A general rule is that if you have employees who aren't owners of the company, you probably need workers' compensation insurance. Speaking of employees, here's a potential trap to be aware of and avoid: under most state's workers' compensation laws, you might have employees you don't know about. That's because most states will treat an uninsured contractor or subcontractor as your employee if he or she is injured while doing work for your company.

Let's say you're operating as a sole proprietor and your state doesn't require you to purchase workers' compensation insurance on yourself. Then you hire a painter to paint your office. If that painter doesn't have workers' compensation insurance on himself and gets hurt working on your premises, he may well be able to make a claim against you. The same holds for a roofer, or a glazer, or a cleaning contractor. Anyone you hire to do work for your company could be eligible for workers' compensation benefits from your company.

That's why many larger companies will contractually require anyone doing work for them to show proof of workers' compensation insurance. A cleaning service operating as a sole proprietor may not be required by the state to purchase workers' compensation insurance, but its clients would be wise to insist on it before hiring that service.

Understanding Your Policy

The Standard Workers' Compensation insurance policy is a unique insurance contract in many respects. Unlike other liability insurance policies, it doesn't have a maximum dollar amount limit to its primary coverage. Your auto insurance policy, for example, has certain specified maximum amounts the policy covers per accident; if the cost of a particular accident exceeds that limit, you'll need to look elsewhere for those additional dollars (either your own pocket or an excess or umbrella liability policy). Workers' compensation insurance policies have a dollar limit also, but only for Part Two of the coverage, employers' liability. But Part One, the part that responds to an employer's statutory workers' compensation liability, has no set limit. Once the policy is in force, the insurance company is responsible for all that employer's claims that arise for workers' compensation benefits in the states covered by the policy.

That's the really beneficial aspect of workers' compensation insurance from the employer's point of view. It's impossible to know in advance how great an employer's liabilities may be in a year due to workers' compensation obligations and thus impossible to budget ahead of time with any certainty. A company might run several months with almost no claims and then be hit with a claim that ultimately costs hundreds of thousands of dollars. But an insurance policy has a predictable cost for which a company can plan and budget-at least in theory. Sometimes in practice, this isn't the case.

Part One of the standard workers' compensation insurance policy (what used to be called Coverage A, for us old-timers) transfers liability for statutory workers' compensation benefits of an employer to the insurance company, whether that liability turns out to be small, medium, or crushing. If a state increases benefit levels during the term of the policy, the employer doesn't have to make any adjustments to the policy-the policy automatically makes it the responsibility of the insurance company to pay all claims due for workers' compensation insurance for the named employer in the particular states covered by the policy.

Employers' Liability Coverage
We've already made reference to Part One of the coverage provided by the workers' compensation insurance policy. But we haven't talked in detail about Part Two-employers' liability coverage. Most workers' compensation claims come under Part One of the coverage-the statutory state benefits for injured or ill workers. But don't ignore Part Two, as it can be very important to make sure this sometimes overlooked area of the policy is set up correctly.

This is the section of the policy that does have a set dollar limit. But employers' liability coverage is not always well understood by employers (or even by some insurance people). Employers' liability insures the employer for liability to employees for work-related bodily injury or illness that isn't subject to the statutory benefits imposed by state or federal regulations. For example, a lot of states exclude certain employees from the statutory benefits covered by Part One or Part Three of the policy. Employers' liability coverage would insure the employer for liability to such employees.

Employers' liability also insures an employer in cases such as third-party over suits, where an injured worker files suit against a third party and that third party then seeks to hold the employer responsible. For example, an employee injured by a piece of machinery at the workplace might file suit against the manufacturer of the machinery. The manufacturer might claim that the employer modified the machinery or used it improperly and is thus responsible for the liability. But since employers' liability has a set limit, it is vital that this limit be correctly coordinated with the excess or umbrella liability coverage that is purchased separately. If the amount of employers' liability coverage on the workers' compensation policy is lower than the amount that the umbrella or excess policy requires for underlying coverage, there can be an uninsured gap. So it is vital to make sure that the employers' liability limit on the workers' compensation policy matches what is shown on the umbrella or excess liability coverage that sits on top of the primary workers' compensation policy.

Steps to Take to Evaluate Your State-by-State Workers' Comp Exposures

  1. Examine your company's possible exposures to workers' compensation claims from different states. If you have employees who live and work or who travel to other states, you need to make sure you are properly covered in each state. Remember, many states treat uninsured independent contractors or subcontractors the same as if they were your employee.
  2. If you have workers in monopoly-fund states, you'll need to arrange coverage through those state funds. Private insurance cannot satisfy coverage requirements for monopolistic states.
  3. If you're based in a monopoly-fund state but have workers based elsewhere, you will need to arrange coverage for those states separate from your state fund.
  4. If you're self-insured in your primary state of operations but have employees or uninsured contractors in other states, you'll need to arrange coverage for those other states.
  5. If you're operating in multiple states, check into possible different classification definitions that apply in different jurisdictions for your operation. Make sure you're properly classified in each state, to avoid either hidden overcharges or an unpleasant audit surprise of an additional premium.
  6. A few states do not use the interstate experience modification factor system, but instead calculate a modifier only for use within that state, based on prior losses and payrolls within that state.These "stand-alone" states are California, Michigan, Pennsylvania, Delaware and New Jersey. If you have operations in these states but also operate elsewhere, make sure proper experience modifiers are used for the stand-alone states.

Controlling Your Costs

Here are some particular areas you may want to focus on to make sure your workers' compensation insurance costs aren't out of control.

. Determine if you're in an assigned risk plan. Sometimes an insurance agent handling the workers' compensation insurance for a small employer doesn't make it clear that the policy procured is an assigned risk policy. And in many states, the rates and premium for an assigned risk policy are much, much higher than for the same policy written through the voluntary market. An assigned risk policy doesn't look different from any other workers' comp policy, except for some subtle differences. So make it a point to insist on knowing if your policy has been written through an assigned risk plan.

If you're in an assigned risk plan, check with your state's insurance regulators to see if assigned risk policies in your state have higher rates and premiums. If this is the case, then do everything in your power to find coverage outside the assigned risk plan. Talk with other agents, talk with direct-writing insurance companies, talk with employee leasing companies, investigate group self-insurance programs available in your state-but don't let it be your agent's responsibility to get you out of the assigned risk plan. Your agent just may not have a viable alternative for you, but that doesn't mean that such an alternative doesn't exist.

. Check what credits may be available to you in your state. If you're not in an assigned risk plan, make sure your policy gives you whatever credits you might be eligible for in your state. If your state offers credits for a drug- and alcohol-free workplace, find out if you're eligible. If your state offers merit rating, see if you're eligible for that from an insurer. If your premium is appropriate, make sure you're getting the proper experience modification factor. If your state offers a small-deductible credit, look into obtaining it.

. Insist on getting audit workpapers after any audit. If the insurance company sends out an auditor to determine your final premium, make sure to request a copy of the audit work papers so you can review them carefully and make sure payroll computation adjusts overtime properly and allocates payroll of different employees correctly.

. Check into alternative sources of workers' compensation insurance. Many business and trade associations sponsor insurance programs that include workers' compensation insurance. Check into all organizations to which you belong or that you might be eligible to join; they may offer sponsored insurance programs that could reduce your rates or premium.

Operating a Safe Workplace
Most of this article focuses on actions employers can take to reduce workers' compensation insurance costs by spotting common mistakes made by the insurance industry that inflate premiums. But keep in mind that workplace safety is also a necessary part of any program to control the cost of workers' compensation insurance. As you've seen earlier in this article, there are direct mechanisms that tie the cost of workers' compensation insurance for most employers to their own company's past losses. The experience modification factor is the most well-known and obvious such mechanism, but there are others as well. The simple truth is that controlling workplace safety is a very effective way to control your company's workers' compensation cost. In the long run, catching the typical insurance industry mistakes that inflate premiums is only half the battle. Here are some tried and true steps that employers can take to improve their workplace safety.

  • Discuss safety at every opportunity. Make workplace safety efforts an important part of every meeting. Don't just make it a part of your managers' meetings-make it a constant topic at meetings with workers. Make sure you communicate to them why safety is so vital, and how it affects the cost of workers' compensation coverage and thus the bottom-line of the company. You might be amazed at how many of your employees don't really understand how expensive workers' compensation coverage is for the company-or even that it's a cost for the company at all. Some employees think it's just some kind of government program that doesn't really translate back to direct costs for the company. So share information about the cost of the company's workers' compensation insurance and how the cost of claims drives up that cost. Post the company's safety goals, and how well the company is doing in regard to meeting those goals. Compare current injury information (without disclosing confidential information about injured workers) with information on recent years.
  • Examine trends in workplace injuries. You can't rely solely on your insurance company to analyze this data and alert you to trends you need to address. Get all the information you can about what kinds of claims are occurring and in what part of your operations. Only by understanding what's causing your claims can you begin to address the causes. It's a terribly overworked clich�, but it's also very true: Safety is no accident. It takes planning, effort and thought.
  • Utilize modern resources. Don't be afraid to search the internet for information about what's working at other companies, safety advice from government agencies, insurance companies, insurance regulators, or even special interest groups. Do a Google search under "workers compensation safety programs," and you'll get over six million sites with information.

Some good sources of information:

This is just a small sample of the wealth of information available over the internet that can help your company improve your workplace safety efforts.

Edward J. Priz has worked in the insurance industry since 1976 as an agent, consultant and expert witness. Currently, he heads Advanced Insurance Management, an insurance consulting company that works with employers nationwide to identify and correct workers' compensation industry overcharges.

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