How Builders Can Survive the Dreaded Premium Audit

Insurance Audit

The audit is the final word on the true cost of your Workers’ Compensation and General Liability. It’s critical that you understand the mechanics of the audit and prepare for it throughout the entire policy year. Doing so prevents you from making costly mistakes that can result in a huge audit bill that can be thousands of dollars and more. I’ve seen builders get hit with unexpected audit bills exceeding $20,000.


Why Will You Be Audited?

Both Workers’ Comp and General Liability polices are subject to audit. You may also have a Builders Risk policy that’s also subject to audit, but that’s a topic covered in full here.

The risk of loss fluctuates in Workers’ Comp and General Liability with the amount of work that’s performed by a builder. The more work, the greater the risk of a claim and the corresponding need for your insurance carrier to collect more premium. The insurance industry figured out that the best way to account for the risk of claims and the corresponding need to collect premium is to tie them both to payrolls paid to employees and amounts paid to uninsured subs. The General Liability policy also tracks amounts paid to insured subs, as well as the number of rental dwellings and acreage of vacant land and real estate development property.

Because no builder knows for sure the amount of work that he’ll perform over a 12-month policy year, Workers’ Comp and General Liability policy premiums are designed to expand and shrink to take into account the actual work actually performed during the policy year. This way, both the insurance carrier and builder get the exactly what they deserve in terms of matching the risk of loss with the premiums that are paid to offset loss risks

When purchasing or renewing a policy, your insurance agent will ask you to estimate your payrolls, amounts paid to uninsured and uninsured subs, etc. Based on your estimates, the agent provides a quote and when you accept the quote, your policies are issued based on the work estimates that you provided.

After the policy year ends, you’ll be audited to determine your actual payrolls, amounts paid to uninsured and insured subs, etc. You’ll then be presented with a final audit bill, which compares the estimates that you’ve already paid for against the actual figures. You’ll either get a refund if you overestimated or you’ll owe an additional premium if you underestimated.

A Word of Caution

Some builders like to intentionally underestimate their work projections when setting up their policy to play a cash flow game. However, this is dangerous because they may not be able to pay a large audit bill that will be due in full within 30 days of receipt. This will result in cancellation of the existing policy as well as dealing with collection agencies. Once you’ve been cancelled for non-payment of a premium with one carrier, it’s unlikely that any other carriers will want to voluntarily insure you. Taking a risk to gain a cash flow advantage doesn’t make sense because almost all carriers offer low or no-interest payment plans that will allow the builder to spread the insurance costs over many months. Also, many Workers’ Comp carriers now offer a monthly self-reporting form so that premium payments can be matched to the exact amount of work that’s performed on a monthly basis.

Audit Basics

Audit appointments are typically scheduled one to two months after your policy expires. Insider tip: When the auditor calls to schedule your appointment, return the call promptly – even if you’re not yet ready. It’s not a good idea to aggravate someone who holds a lot of discretionary power and can make your life difficult. If you fail to get in touch, the auditor can inform your underwriter and your underwriter can cancel your existing policy. In addition, the auditor can actually perform the audit without you and jack up your existing payroll and subcontractor figures – maybe by 15%.

There are two types of audits:

A self-audit or voluntary audit requires a form that you complete indicating the payrolls paid to all employees by classification code, as well as amounts paid to all uninsured subs by classification code. The form is sent back to the insurance carrier and they send a final audit bill based on the numbers you reported. Most insurance carriers that insure builders don’t use a self-audit because they’re afraid that some builders will under-report their building activity.

A physical audit involves a visit by an auditor from your insurance carrier to review your records and ask questions. The auditor may be either an employee of the insurance carrier or a contract auditor who works for an auditing company. Some auditors show up with a laptop that they use to directly input information and they can actually provide the results on the spot after the audit has been completed. However, in many cases, the builder must collect additional information to forward to the auditor before the audit can be completed.

The audit can take place either at the office of the builder or at the office of the builder’s CPA or bookkeeper. Regardless of where the audit occurs, it’s critical for an owner or manager to be present to answer questions about specific invoices or the type of work that was performed by each employee or sub. Often times, your in-house bookkeeper or outside CPA won’t know how to answer all of these questions and it can result in costly misclassifications.

Depending on how prepared you are, the audit meeting typically ranges from one to three hours. It can last longer, of course, for large builders with complex operations and multiple business entities.

Most auditors want to perform your audit as quickly as possible and move on to the next job to get their quotas in. If you’re prepared and cooperative, they’ll often help you and give you advice on what you can do to save money. In many cases, if you’re a new builder and didn’t understand exactly what you were supposed to do with your records, they may be lenient on the first year’s audit. On the other hand, if you’re not prepared or are uncooperative, the less professional auditors can make your life difficult by not giving you the benefit of the doubt on certain interpretations. This can result in thousands of dollars in additional audit premiums.

Records You Need to Provide

When reviewing your books to extract needed information on payrolls and amounts paid to subs, auditors generally want to review both your summary records and your source records.

Auditors prefer to work from summary records, whether computerized or manual, because this makes their job easier. Summary records tend to be more legible and the payrolls and amounts paid to subs are pre-categorized. However, auditors also want to access the source records to perform periodic spot checks to make sure that the summary records are accurate.

Most builders use QuickBooks or a similar program that produce very nice summary reports for both payrolls paid to employees and amounts paid to subs. If the builder isn’t automated, the auditor will want to view manual summaries such as a cash disbursement journal or a general ledger. If neither automated nor manual summaries are available, the auditor will be forced to use source records such as checkbook registers or bank statements. Forcing an auditor to pour over tedious source records can be a big mistake because they’re often not legible and can lead to misunderstandings resulting in costly classification errors.

You’ll also need to provide certificates of insurance for each sub to prove that they were insured at the time that they performed work for you. This means that you might need two different certificates of insurance for each sub since their policies might expire while they’re in the middle of a job. Also, if your certificate of insurance looks suspicious to the auditor, he may call the insurance agent for verification.

Tax Records You Need to Provide

Your auditor will want to verify that you’re being honest about the employee and sub figures that you’re showing on your books. They do this by comparing your books to what you report to the federal and state government on your tax records.

For verification of your payroll, the auditor can use your 941 or W-3 forms. If you don’t have employees, they’ll want to verify by looking at your Schedule C from the previous year’s tax return.

For verification of your amounts paid to subs, the auditor will want to see your 1099 and your 1096 summary forms. For builders that don’t issue 1099s to corporations and LLC’s, the auditor will need to supplement this with your vendor list.

Important Record Keeping Details

It’s very important that your payroll records are broken out into overtime or double time because you should only be charged for regular time on your Workers’ Comp and General Liability audit. Severance pay and sick time should be broken out as well because these are also not chargeable.

The rules for division of labor permit splitting out the payroll of an individual employee who performs more than one type of labor into separate classification codes. This can save money if one class code is less expensive than the other. However, your records must show the exact number of hours and payroll amount allocated to each classification code. The auditor won’t accept an estimate on a percentage breakout basis. But you need to be aware that you’re not allowed to split payroll for an employee into non-labor classification codes such as clerical, outside sales, driver, or executive supervisor.

It’s also important that your subcontractor invoices break out the amount paid for labor vs materials since you should only be charged for labor on uninsured subs. This is called the materials credit. If the original invoice did not include this breakout, you should ask your sub to recreate the invoice to show the breakout. If you can’t get your sub to do this, your auditor can estimate the percentage breakout at his discretion. Many auditors follow rules of thumb, generally allocating 50% or more to labor in most cases. However, a different rule of thumb is used for subs that provide heavy equipment. Many auditors will allocate only 33.33% to labor in these cases due to the high expense of using such equipment.

Questions the Auditor Will Ask

The auditor will ask a number of questions about your business entities, ownership percentages, operations, changes in your operations, and the states in which you’re operating.

If your operations have experienced a temporary increase in work due to a one-time job, you need to let the auditor know. Otherwise, once the underwriter reviews the audit, the underwriter may want to increase the projections on your current policies, which would result in a midterm additional premium endorsement that isn’t justified.

The auditor will want to know the type of work performed by each employee and uninsured sub. The auditor will not blindly accept records have the job description or the classification code of an employee or sub pre-labeled. He or she may ask follow-up questions about the employee or sub to verify your classification.

The two biggest classification problems experienced by builders are the proper use of the residential carpentry and executive supervisor class codes.

Residential carpentry is generally a very expensive class code for Workers’ Compensation. A National Council on Compensation Insurance (NCCI) classification rule indicates that residential carpentry is to be used if an insured is a general contractor for all of the carpentry operations at a jobsite, including framing, siding, roofing, interior trim, wallboard, and hardwood floor installation. This classification rule says that residential carpentry must be used for inside cleaning and yard debris removal in most cases. If you did not deduct the proper rate for these types of uninsured subs, you’ll be in for a rude shock upon receiving your final audit bill. Not all carriers follow strict NCCI rules but you need to be aware of how your carrier will handle this situation to prevent a problem on your audit.

Executive supervisor is a favorable classification code because the cost is much less than that of residential carpentry. The classification rules published by NCCI are a bit strict on when the executive supervisor classification can be used and auditors often try to force what I consider to be true executive supervisors into the more expensive residential carpentry classification. Under the technical classification rules, an executive supervisor spends his day arranging for delivery of materials, scheduling subs, and briefly visiting each job site no more than once a day to inspect the work of the subs. This is a brief summary and oversimplification of the rule but I think you get the point. If you tell the auditor that your executive supervisor spends a lot of time on the job site and that he personally supervises the work, he’ll be reclassified as residential carpentry, which will cost you a lot of money.

The Final Audit Bill

Shortly after the completion of your audit, you’ll receive your final audit bill from your insurance carrier indicating whether you owe more money or are due a refund. If you owe an additional premium, you’ll have 30 days to make full payment. If payment is not made within 30 days, the insurance carrier can initiate collection proceedings for your audit and cancel your current policies.

If you’re going to dispute your audit, you should notify your agent in writing within two weeks of receiving your final audit bill.

When verifying your audit for accuracy, you should always request a copy of your audit worksheet. The audit worksheet is the detailed record of your audit. Your auditor will not automatically provide a copy of the audit worksheet to your insurance agent due to privacy law concerns. However, if you want your agent to assist you in verifying your audit and in correcting mistakes, you should always request that the auditor forward a copy of the audit worksheet to your insurance agent.

5 Common Audit Worksheet Mistakes

Check for these common mistakes and ask your auditor to review and correct them if necessary.

  • A payroll charge is incorrectly made for an owner who’s excluded under Workers’ Comp.
  • The wrong classification assigned to an owner, employee, or uninsured sub.
  • An insured sub being charged as an uninsured sub.
  • The auditor allows an inadequate materials credit when the sub’s invoice doesn’t break out labor vs. materials.
  • A math error in computing incorrect number for a payroll amounts paid to an uninsured or insured subs or amounts paid to an insured sub, or a math error in totaling a row or column.

Avoiding Audit Mistakes

  • Preparation and proper record keeping start at the beginning of the policy year and you can’t put this off until right before your audit. If you don’t know the audit rules up front and if you haven’t kept the proper records, you’ll likely get burned on your audit.
  • Maintain summary documents on your payrolls and sub expenses and don’t totally rely on source documents like a checkbook register. Auditors hate reviewing checkbook registers and their frustration can lead to incorrect assumptions.
  • Never commingle your personal expenses with your business expenses. This makes for an auditing nightmare and the auditor will likely pick up personal exposures that were not even insured under the policy.
  • Being uncooperative with your auditor by missing appointments, not being prepared, or by being combative is asking for trouble. Some unprofessional auditors will likely hold such actions against you and be less willing to give you the benefit of the doubt on matters relating to classification and material credits.
  • Have an owner present during the audit. It is unlikely that your back office support person or your CPA will be able to answer all questions related to what type of work is performed by each employee and sub.
  • Be sure to take advantage of payroll credits such as overtime, double time, sick pay, and severance pay.
  • Know how to take advantage of the division of payroll rules to save money where a single employee performs different duties that have different classification codes.
  • Make sure that you collect valid certificates of insurance from all subs prior to paying them.
  • Make sure that all invoices break out labor vs. materials.