Acquisition Due Diligence: Know the Impact to Your Workers Compensation Mod

May 08, 2012

by G. Martin Irons, CPCU, CIC, ARM, Vice President – Technical Development Department

Let me tell you the story of ABC Company, which completed a thorough due diligence of another company’s financials before acquiring it. They looked under the hood and kicked the tires to make sure it was a good purchase. However, their insurance broker did not review with them the impact this acquisition would have on ABC’s Workers Compensation Insurance Experience Modification. As a result, six months after the acquisition, ABC Company received two surprising phone calls:

Call 1: Their insurance company sent a bill for their Workers Compensation audit, and it was $42,000 more than ABC Company had accrued due to a surprise increase in their Workers Compensation Experience Mod.

Call 2: Their bid on a large job was rejected because their Workers Compensation Experience Mod was now above a 1.000.

So, what went wrong in this scenario?
Put simply, an analysis of the impact to ABC Company’s Workers Compensation Experience Mod was not performed as part of the acquisition due diligence.

The Workers Compensation Experience Mod is a factor calculated by the Workers Compensation Bureau based on a company’s prior loss experience. In simple terms, if ABC Company has lower loss experience than the average company for its class of business, ABC receives a credit Mod (such as .750). This credit Mod correlates into a 25 percent discount off of the standard Workers Compensation insurance rates.

Conversely, if ABC Company has loss experience that is higher than the average company for its class of business, ABC receives a debit Mod (such as 1.400). This debit Mod correlates to a 40 percent surcharge to the standard Workers Compensation insurance rates.

Now, back to our two problematic phone calls; the mistake ABC Company made was thinking that only their loss experience would be used in calculating their Experience Mod. Their insurance broker failed to inform them that when you acquire a company, you will typically also acquire that company’s past loss experience and it will be included in your Workers Compensation Experience Mod calculations. Let’s take a look at two examples that illustrate how this can impact your company either positively or negatively.

Example 1: Stock Purchase of a Distressed Company

ABC Company purchased the stock of a distressed company (XYZ, Inc.). At the time of the acquisition, the Experience Mod of XYZ, Inc. was 1.580 and it was the only company included in this Mod rating. ABC Company added XYZ, Inc. as a named insured on its Workers Compensation policy and retained a substantial portion of the employees of XYZ. The Workers Compensation Bureau included the bad loss experience of XYZ in ABC’s Mod. ABC’s Mod was then revised and increased 14 percent due to the negative impact of XYZ’s bad loss experience, resulting in an additional cost of $42,000 the first year. This problem was further exacerbated since the impact of XYZ’s bad losses was felt for a total of three years – until all XYZ’s bad losses dropped out of ABC’s future Mod calculations. The hidden additional cost of this acquisition was a shocking $92,000 over three years and $800,000 in work was lost due to a higher Mod.

Example 2: Asset-Only Purchase of a Distressed Company

ABC Company purchased only the assets of a distressed company (QRS, Inc.). At the time of the acquisition, the Experience Mod of QRS, Inc. was .780 and it was the only company included in this Mod. ABC Company took over the operations of QRS and retained a substantial portion of the employees of QRS. ABC did not add QRS as a named insured on its Workers Compensation policy. ABC sent an Ownership Change Form to the Workers Compensation Bureau so that ABC Company’s Mod was revised to include the positive impact of QRS’s good loss experience. ABC’s Mod was reduced by 11 percent, resulting in savings of $37,000 the first year, $24,000 the second year and $14,000 the third year. The hidden additional savings due to this acquisition was $75,000 over three years.

Lessons Learned

Purchasing another company will likely impact your Experience Mod (either positively or negatively) for three years. This analysis should be reviewed by your insurance broker as part of the due diligence prior to the acquisition.
However, it is important to note that purchasing another company will not always impact your Experience Mod. Here are some additional items to consider:

Two or More Companies and You Buy Only One: Our examples reviewed the impact of buying a single, stand-alone company. If however XYZ or QRS are part of a combined Experience Mod rating with other commonly owned entities and ABC only purchased one of the entities, ABC would not assume the prior loss experience of XYZ or QRS. This could have either a positive or negative impact depending on the Mod of the company being acquired. Hence, as part of the acquisition due diligence, it is critical to verify if there are any other commonly owned entities that are combined in the Experience Mod of the company being acquired.If you buy one entity that was classified by the Rating Bureau as two combined entities for Mod purposes, then you do not assume Company A’s prior loss experience (either good or bad). The seller will typically continue to use the prior loss experience generated by both entities. Therefore, it is worth doing a detailed analysis of the Experience Mod of the target company.
Partial Sales: If an entity disposes of only part of its assets or operations but otherwise continues to operate its business, all loss experience prior to the sale will remain with the seller. The purchaser’s Mod will not be impacted.
Not Retaining Most Employees: The Workers Compensation Bureau indicates that you will assume the past loss experience of the acquired company if you maintain a “substantial portion“ of the employees of the acquired company (typically the Workers Compensation Bureaus view this as retaining 51% or more of the company’s employees). If your intent of the acquisition is not to maintain a “substantial portion” of the employees, you will likely not assume the prior loss experience of the acquired company.

Keep in mind that these transactions are complex and answers vary based upon circumstances and the procedures of the specific State Workers Compensation Bureau. Prior to making an acquisition, a thorough analysis of the impact to your Workers Compensation Experience Mod should be completed by your insurance broker based on the specific situation. This analysis may uncover extra savings created by the acquisition or prevent the surprise of additional costs that develop after the acquisition has been finalized.