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PEOs: Employer Efficiency Or Workers Comp Bane?

Presented by The Journal of Workers CompensationBusinesses continually seek new platforms for creating leaner, more efficient organizations. One method for cutting costs has been the use of professional employer organizations (PEOs) — as opposed to employees — to provide human resources and risk management functions for the company. Although PEOs have been around for many years under various names, they are becoming a larger part of the business sector due to our faster moving, more highly specialized economy. This growth in the use of PEOs should cause concern in the workers compensation community.

The History of PEOs

The PEO industry got its start in the early 1980s as a niche service provider to independent physicians who wanted to outsource the provision and maintenance of employee benefits to their office staffs. The industry has since evolved largely because of the increased demands that local, state, and federal laws and regulations — the Civil Rights Act of 1964, the Americans with Disabilities Act, the Family and Medical Leave Act, Occupational Health & Safety Administration regulations, the Employee Retirement Income Security Act, state fair wage laws, and so on — have placed on in-house human resources departments.

When all works as it should, PEOs remove the burden of recruiting, retaining, and compensating employees, allowing client companies to focus on producing widgets or whatever it is that they do. PEOs work primarily for small and mid-size companies, providing employees with 401(k) retirement savings plans, health and dental insurance, workers compensation and life insurance, and cafeteria plans at rates comparable to those paid by larger companies. Because they typically work for numerous companies, PEOs are able to combine all client employees into one large group and thus competitively purchase benefits.

The statistics on PEO growth are disarming — they are used by just 2-3 percent of companies with 100 or fewer employees. However, the number of small firms is growing rapidly — up 7.9 percent to 5.4 million between 1990 and 1996, according to the Small Business Administration. This growth has translated into more clients for PEOs. According to HR Magazine, the nation’s largest PEO — Staff Leasing Inc. — has more than 120,000 employees and $2.4 billion in revenue. The National Association of Professional Employer Organizations (NAPEO) reports that the country’s 1,500 to 1,800 PEOs oversee some 2-3 million American workers earning $18 billion in annual wages and benefits. With total industry revenue exceeding $21 billion, NAPEO estimates PEO growth at 30 percent per year, with this rate expected to continue for the foreseeable future.

Failures in Data Collection and Reporting

While professional employer organizations undoubtedly serve a market need, their legal status is often a muddle — largely because they operate in multiple jurisdictions, each with its own laws. According to NAPEO, 17 states currently require PEOs to be licensed, to pay state unemployment taxes, and to purchase workers compensation insurance. Liability in other states and for other employer responsibilities — such as antidiscrimination and sexual harassment laws — remains unclear for the most part, though.

From a workers compensation perspective, PEOs present a number of challenges, most involving the availability and appropriate collection of claims data, which provide the very foundation of the workers compensation system. Among the concerns that workers compensation professionals should share are the following:

  • PEO policies are often written in a manner that merges premium and loss information for all of the PEO’s clients. This is contrary to the traditional concept of workers compensation experience rating, which measures the losses of a single employer in a state against the losses of other employers doing the same type of work.
  • Collecting loss experience by classification code can become a monumental challenge to insurers because it is difficult to properly audit all clients of a PEO when there are hundreds of clients in many different locations.
  • The existence of numerous clients makes it impossible to maintain a proof-of-coverage record for each client. This creates significant problems for state industrial commissions that are required by law to ensure that every employer required to maintain workers compensation coverage does in fact do so.
  • Client companies frequently move from one PEO to another, making it extremely difficult to track that client’s loss experience and coverage without writing separate policies. NAPEO reports that 85 percent of the client companies that cut ties with a PEO go on to a new PEO. Because of this ease of transfer, the potential for fraud exists with firms trying to “hide” poor experience by continually shuffling from one PEO to another.

NAIC Model Regulation

In an attempt to address the negative effect of PEOs on workers compensation data collection, policy forms, and experience rating plans, the National Association of Insurance Commissioners (NAIC) adopted a model regulation and licensing provisions in 1991. The model regulation was intended to help the insurance industry keep track of the loss experience and coverage data of PEO client companies. The NAIC recognized that accurate reporting and tracking of client experience and coverage would be problematic when one PEO can front for dozens or hundreds of individual insureds.

In its Employee Leasing Model Regulation, the NAIC tried to strike a balance between tracking client loss experience and coverage and maintaining a streamlined system for writing PEO policies. The model regulation allows for the writing of “master policies” in the voluntary insurance market and “multiple coordinated policies” in the residual market.

Master Policies

The master policy enables the PEO and all of its clients to be covered by one workers compensation policy, with the PEO the named insured on the Policy Information Page and the PEO’s clients the additional named insureds on an endorsement. Under the model regulation, the PEO keeps payroll and loss information separately for each client company, which the PEO then reports on separately to its insurer. Whenever a client leaves the PEO, the PEO’s insurer must then pass the client’s information on to its rating organization, thus enabling earned loss experience and coverage for each client to be tracked. A new experience rating could then be produced for the client if the data were sufficient.

On its face, the master policy provides a simple solution to the problems that PEOs raise. Insurers, PEOs, and their clients should appreciate the ease of use, reduced paperwork, and lower costs of this approach. However, a difficulty remains: All internal insurer systems, insurer industry data reporting mechanisms, and industrial commission offices are set up to track loss experience data and proof of coverage information from separate policies — not a single policy endorsed with several hundred names. That means that all of these parties to the system must develop manual options to produce the data required to accurately track and report the data needed by industry rating organizations and regulators. This administrative burden — which may or may not be assumed — can lead to errors and additional costs in the workers compensation system.

Multiple Coordinated Policies

In the residual markets, the NAIC model regulation mandates the use of multiple coordinated policies — that is, separate policies for the PEO and each of its client companies. In addition, the insurer must coordinate the effective dates of the client company policies so that they renew on the same date as the PEO’s policy. This is accomplished by writing short-term policies with a common expiration date for the PEO’s new clients in the first year and then renewing all client policies on the same date as the PEO’s policy.

The advantage of this method is that a separate policy is issued for each entity. The separate policies permit insurers, rating organizations, and state regulators to track loss experience and proof of coverage using the traditional industry infrastructure. The disadvantage is that writing and coordinating the policies is cumbersome and expensive for both insurers and PEOs — both of whom presumably pass this cost on to other participants in the workers compensation system.

The Need for More Regulations

Accurate experience rating and verifiable proof of coverage are necessary for the proper functioning of the workers compensation system. An insured’s experience rating attempts to align the insured’s premium with its projected losses; inaccurate experience rating could send insurers into a tailspin of unsurviable unprojected claims. Furthermore, experience ratings that cannot be manipulated by insureds provide a valuable incentive for them to effect safe workplaces. As for proof of coverage, an effective means for verifying coverage is essential because, without it, state industrial commissions will be blindly unaware of those employers who abscond from their responsibility to carry workers compensation insurance.

Today, the growth in the client base of PEOs threatens the validity of the experience rating and proof of coverage components of the workers compensation system. Absent a uniform approach in all states that will allow the tracking of client data and coverage, the workers compensation system will not function as it should.

The PEO industry, to its credit, is attempting to address some of the legal gaps under which it operates. An accreditation system has been established by the Institute for the Accreditation of Professional Employer Organizations that involves in-depth financial analysis, client employee analysis, and a multitiered service checklist to prove that a company adheres to high ethical, operational, and financial standards. Industry groups are also supporting federal tax legislation that will clarify exactly what PEOs are and what they do. Among other things, the industry-supported federal legislation will amend tax law to codify many duties that responsible PEOs already perform. Such legislation would also clarify what PEOs must do vis-à-vis antidiscrimination laws, the payment of payroll taxes, and the sponsorship of benefit plans. It is in the interest of all stakeholders to get in this debate and help the industry arrive at a consensus about the rules necessary for ensuring fair and adequate workers compensation coverage for all employees.


The Journal of Workers Compensation is a quarterly review of risk management and cost containment strategies published by Standard Publishing in Boston, Massachusetts. For more information, please visit our web site,, or contact the editor at 800-682-5759, extension 222, or subscription services at extension 228.

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December 2000 

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