What is a premium audit, and how do you prepare?

A premium auditPremium auditA premium audit is the insurer’s review of your actual payroll, sales or other figures after a policy ends, used to replace estimates and set your final premium.Read the definition is how an insurer settles the final price of a policy it priced on an estimate. When you bought workers’ comp or general liability, you most likely gave an estimate of your payroll or sales for the year ahead, and after the policy periodPolicy periodThe policy period is the span of time between a policy’s start and end dates, usually 12 months, during which its coverage is in force.Read the definition ends the insurer checks what really happened. If your actual figures are higher than the estimate, you owe additional premium, and if they’re lower, you may be owed a refund.

For most small businesses an audit is routine paperwork with no accusation behind it, but the owners who get hurt by one usually fall into three groups: their payroll grew and nobody told the insurer, their work was in the wrong classification, or they paid subcontractors who didn’t carry their own insurance. The third group gets the biggest bills, so that’s where this guide spends the most time.

Why the audit exists

Some policies are priced as a rate times a measure of your business: for workers’ comp the measure is payroll, and for general liability it’s often sales or payroll, and since next year’s figures don’t exist when the policy starts, the insurer prices it on your estimate and settles up afterward. California’s Department of Insurance says the final premium of a workers’ comp policy can’t be calculated until the policy term is over, and the NAIC describes the same arrangement for liability policies priced on sales and payroll estimates.

Maine’s Bureau of Insurance has the best analogy for it. The audit, it says, is similar to the income tax collection process: payments are made on an estimated basis during the year, “with a final reconciliation after the year ends.” Your estimate is the withholding, and the audit is the return.

That’s also why a low estimate saves nothing. It just makes the return worse.

What the auditor will ask for

Insurers run audits in different ways. Depending on the insurer and the size of your policy, you may get a questionnaire, a review by phone or online, or a visit from an auditor, and the notice should tell you which records it needs. Expect requests like these.

The auditor is checking two things: how much was paid, and whether it’s in the right class codeClass codeA class code is a number insurers use to classify what your business does, so your rates reflect the typical risks of businesses doing similar work.Read the definition. If you can’t show which payroll belongs in a lower-rated class, it can end up in a higher one. Maine’s guide notes that contractors can split trades only when payroll is tracked for each, so the split only pays off if your time records prove it.

The subcontractor problem

This is where the large, surprising audit bills come from, especially for contractors, yet the mechanism is simple once you see who carries the risk. When you pay a subcontractor who doesn’t have workers’ comp for their own crew, someone has to be responsible if one of those workers gets hurt on your job, and the premium follows that responsibility. Maine’s Bureau of Insurance puts it plainly: if you don’t get proof of a contractor’s coverage, “your insurer might consider the employees of the independent contractor to be your employees and take their payroll into account when calculating your premium.”

Tennessee’s workers’ compensation division explains the liability behind it. Under Tennessee law, a worker employed by an uninsured subcontractor who’s injured on the job can go “up the ladder” and hold the general contractor responsible for compensation, which is why the state tells contractors to keep copies of every subcontractor’s certificate. It goes further on how to check them: to avoid fraudulent documents, contractors should never accept a certificate directly from another contractor and should always confirm coverage with the insurance agent.

So our advice is blunt. Collect a certificate of insurance (COI)Certificate of insuranceA certificate of insurance (COI) is a one-page summary that proves your business has insurance, listing your policies, limits, insurers and policy dates.Read the definition from every subcontractor before they start, confirm it with their agent or insurer, check that the dates cover the whole job, and file it with your payment records so it’s ready when the auditor asks. A certificate you chase down after the audit notice arrives is a certificate for work you may already be paying for, and how to collect and check certificates from your subcontractors has a checklist for doing it properly.

Whether a person is really an independent contractorIndependent contractorAn independent contractor is a self-employed person or business you hire for a job who controls how the work gets done, rather than working as your employee.Read the definition at all is a separate question, one that do independent contractors need workers’ comp? takes up in full, decided by your state’s rules and by tests such as the IRS’s, which look at behavioral control, financial control and the type of relationship.

What happens if you ignore an audit?

It gets expensive fast. California’s Department of Insurance says workers’ comp insurers generally have the right to audit payroll records during the policy period and within three years after it ends, that failing to comply with an audit can lead to cancellation or non-renewal, and that an employer who fails to allow an audit may be liable for a total premium equal to three times the estimated policy premium. In plain terms, ignoring the notice can leave you owing three times what the policy was originally priced at.

The same page says, and this is the part to take seriously, that deliberately under-reporting payroll is considered insurance fraud and can be prosecuted.

Maine adds what happens after an unpaid audit bill. Its guide says audit bills are premium like any other, and that failing to pay or agree to pay one can send it to a collection agency, put a report on your credit file and cost you eligibility for continued coverage until it’s paid.

So however bad the timing, answer the notice, gather the records promptly and keep copies of everything you send.

Your rights vary by state

The 120-day deadline in Maine is a good example of how specific these rules get: the insurer must complete the audit and bill any additional premium within 120 days after the policy expires, as long as you cooperated, but other states have different rules, and these three show the range.

Check your own state’s insurance department or workers’ compensation agency for the rules that apply to you, using the US Department of Labor’s list of state workers’ compensation agencies to find the right one.

A routine that prevents the bill

Most audit bills come from changes the insurer didn’t know about, and a few habits through the year prevent nearly all of them.

1. Update your estimate when things change. California notes that correcting payroll estimates during the term can help avoid a large audit bill, and Maine’s guide notes that many insurers will do a mid-term audit to correct estimates.
2. Track payroll by job. If an employee splits time between field work and office work, keep time records that show it.
3. Track overtime separately. Where your state excludes the extra pay for overtime, the auditor can only exclude it if your records show it.
4. Collect certificates from subcontractors. Before work starts, not when the auditor asks.
5. Respond on time. Gather records promptly and keep copies of what you send.
6. Review the result. Check the audit against your records and raise any errors with the insurer right away.

That last step matters more than it looks. Maine’s guide tells employers to examine the audit information immediately and express any concerns to the insurer at once, and Oregon’s ombudsman warns not to wait if you disagree with an audit or bill, because a deadline may already be running.