Insurance Academy

Combinability of Insureds

By | April 8, 2015

Consolidating separate legal entities’ loss experience to develop a common experience modification factor has the potential to cause confusion for the client and sometimes the agent. Clients may view such mixing of loss experience due simply to common majority ownership/interest as less than reasonable, especially if the commonly-owned entities substantially differ with regard to the relative hazard presented (i.e. the owners of a heavy equipment contracting company purchase a marina).

Combinability rules do not merely marry the experience of entities that are currently in operation and related via common majority ownership, they also assure that owners do not avoid their historically poor loss records simply by closing down one entity and reopening and operating under another corporate name. Most agents would agree that such a stunt is unethical at best and may actually be considered fraud. Changing the name of the operation does not change the operational methods of the owner(s).

Understanding combinability rules necessitate a basic understanding of the theory and practice behind the calculation of experience modification factors. Following is a brief synopsis of experience modification calculations.

Calculating Experience Modification Factors

Workers’ compensation loss costs are calculated and charged based on the average expected losses for that particular business classification. All insureds in the same hazard class (based on the assigned code) are charged the same basic loss cost (individual carriers apply conversion factors to these loss costs to develop individual rates). However, not all insureds within a particular hazard class operate in the same manner, nor does each experience the same losses. To adjust for these differences in operation and loss histories, a method had to be created allowing for premium/rate differentiation between the above average, average and below average insureds within any particular hazard class code.

Experience modification factors (experience mods) allow such “customizing” and individualization of the workers’ compensation premium. Basing the standard premium on the insured’s unique loss history allows the class’ average rates to remain relatively constant and the subject insured to be rewarded or punished based on its own experience (rather than be subject solely to the experience of the group).

“Stop loss” limits used as part of the experience mod calculation makes loss frequency weightier than loss severity. One large claim will not damage an experience mod factor as drastically as three small claims in a single experience period (the “experience period” is usually the three years ending 12 months prior to the policy effective date — a 6/1/15 mod would apply the experience for the three years ending 6/1/14).

Calculating experience modification factors is far more complicated than presented in three short paragraphs. Mod calculations are a function of expected losses, actual losses, payrolls, class averages, loss limits (medical only vs. medical plus indemnity) and formulary factors applied by NCCI (or the applicable rating bureau) to all such collected data.

Knowing and understanding that experience modification factor calculations allow for the reward or punishment of individual employers allows one to more clearly view the need for loss experience combinability. Employers should not be freed of their premium responsibility simply due to legal structure. And rarely are majority-owned entities not interrelated such that employees work for multiple entities even though they appear to be operating for just one employer in the course and scope of their daily duties (combinability avoids some of the problems created by the borrowed servant doctrine).

A Case for Combinability Rules

Owners theoretically run each and every operation (past and present) in essentially the same manner and with the same attitudes. An employer that is concerned with safety and strives to provide the best equipment and training will likely always act the same with each entity. Likewise, employers looking for the easiest and cheapest way out will likely continue down the same path in the future. Combinability rules are, to some extent, based around the theories:

  • Employers that operate in the supposed best interest of their employees should have all their entities (current and future) rewarded due to such attitude. Commonly-owned operations will likely be managed in the same manner and the same care and concern is expected to be showed for all employees (regardless of the hazard of the operation).
  • If an employer allows unsafe operations in one entity, it is reasonable to postulate that such attitude will carry over to the new entity and all commonly-owned entities (current and future). Employers not operating (or not appearing to operate) in the best interest of their employees should be subject to their past (or current) experience.

Past actions are not a guarantee of future actions, but they stand as a very good indicator. To not reward or punish allows employers/owners to act with impunity, knowing that as long as no law is broken, all that is necessary to escape a poor loss history is the killing off of an old and birthing a new corporation.

Without the ability to combine loss histories, workers’ compensation carriers would potentially be victims of inadequate premiums. In like manner, average and above average risks would be victimized by higher premiums than necessary. The “average loss cost” balance would be tilted and all employers would likely see an increase in their rates rather than just the ones that “earned” the increase. Rate predictability and possibly rate adequacy may be compromised without combinability rules.

Granted, there are exceptions to every rule such as is demonstrated by the employer that had a hiccup in its loss history not indicative of its past. Not every injury can be avoided, even with top-notch safety and training, bad “things” sometimes just happen. This is why there is underwriting discretion and the availability of rate credits and debits. A historically above-average employer with a bad year or two in their experience modification calculation can have the debit mod negated by a rate credit.

Conversely, an average or below average employer that has been fortunate can be debited to account for the increased hazard presented to the insured. Employers that do not practice or refuse to comply with recommended safety practices, as reported by the loss control department, can see their rates increased by a debit factor in anticipation of the increased potential for employee injury.

Combinability Guidelines

Common majority interest is the basic rule of combinability. When the same person, group of persons or a corporation owns a majority interest in another entity, the owned entity’s loss experience is combined with the owning entity to develop a common (combined) experience modification factor.

The combinability concept seems simple enough, however achieving “common majority interest” can be accomplished in one of several relational constructs:

  • The corporation (a “legal person”) owns a majority interest in other entities. When Corp “A” owns a “majority interest” (this term will be defined in upcoming paragraphs) in Corp “B,” the loss experience of both corporations is pooled to produce a single, combined experience modification factor;
  • The business’ owner(s) (“natural person(s)”) individually or collectively maintain majority interest in more than one entity. If John holds majority interest in Corp “A” and he individually gains majority interest in Corp “B,” the two entities are combined for experience rating. However, if John has majority interest in only one of the two entities, they are not combinable (i.e. John maintains 75 percent interest in Corp “A” but only 25 percent in Corp “B”). To continue, assume that John and Joe combine to own majority interest in Corp “A” and Corp “B;” common majority ownership exists and the experience is combinable;
  • The corporation combines with some or all of its owners to hold a majority interest in another entity. Corp “A” (again, a “legal person”) maintains 30 percent interest in Corp “B;” John and Joe (100 percent owners of Corp “A”) hold 25 percent of Corp “B.” The combined ownership of the legal person and the natural persons result in common majority ownership (55 percent) of Corp “B” making the two entities combinable ; or
  • The business owns a majority interest in another entity which, itself, owns or owned a majority interest in a third entity currently operating or which operated in the last five years.

This is not an exhaustive list of relationships that can lead to combinability of loss experience; it is but a representation of the most common. These guidelines are subject to NCCI and/or individual state rating bureau interpretations. Agents, brokers and carriers should use these descriptions only for informational purposes as final determination rests in these other advisory bodies.

Natural and Legal Persons

Notice the repeated use of the natural and legal person(s) concept in the above paragraphs. Common majority interest can be created when a single “person” or a group of “persons” combine to hold a majority interest in multiple entities. It matters little whether the owners of other entities are natural persons, legal persons or a combination. Nor does it matter how they combine to create common majority interest between or among two or more entities.

Legal persons are generally created by the actions and desires of natural persons. Some legal persons are owned by one or only a few natural persons (a small business) while some are “owned” by many shareholders (traded on the stock exchanges). Natural and legal persons are defined as follows:

  • Natural person: A flesh and blood human being. In workers’ compensation the employer is a natural person(s) in sole proprietorships and partnerships. Managers and members of an LLC are viewed as natural persons in a majority of states making these persons the employers.
  • Legal person (a.k.a. juridical person): A legal fiction, a “person” created by statute and born with the filing of articles of incorporation. These legal persons are given the right to own property, sue and be sued. Corporations are legal persons and several states consider LLCs a legal person.

‘Majority Interest’

Majority interest is created when the same person or group of person(s) combine to “own” more than 50 percent of an entity. But majority interest can be created in many ways. NCCI lists the following:

  • An entity or persons (as detailed above) owns the majority of the voting stock of another entity; or
  • Both entities share a majority of the same owners (if there is no voting stock). Generally these are natural persons that own multiple entities.
  • If neither of the above applies, majority interest is created if a majority of the board is common between two or among several entities;
  • Participation of each general partner in the profits of the partnership (limited partners are excluded); or
  • When ownership interest is held by an entity as a fiduciary (excludes a debtor in possession, a trustee under an irrevocable trust or a franchisor).

Combinability Conclusion

Based on and applying the above common majority interest rules, the possibility exists for more than one combination of common related entities. Deciding which combination of entities applies is based on the following two rules (presented in order of importance):

  1. Which combination involves the most entities?
  2. If the above does not apply, the combination is based on the group that produces the largest estimated standard premium.

Regardless of how a group is created and combined, no entity’s experience will be used more than once.

Finally, although separate entities may be combinable for experience modification calculation, this does not preclude each from having separate workers’ compensation policies. Separate legal entities are entitled (and really required) to be written on separate workers’ compensation policies; combinability rules exist merely to assure that loss histories are not escaped by the creation of multiple legal entities or the closing of one and opening of a new one.

Workers’ Compensation Series

This is the eighth 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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