Every business owner who has ever received a bill for an insurance premium has wondered how the insurance company came up with the price, especially if the premium has gone up since the last renewal. While the insurance pricing mechanism can seem mysterious, and may involve a certain amount of discretion by underwriters, the starting point is always the same: The underwriter must answer the question, “What type of business is this?”
That may appear to be a simple question, but it does not always have a simple answer. When the underwriter answers the question, she assigns the business to one or more classifications; more than any other factor, these classifications determine how much premium the business will pay. Classifying a business can be straightforward or it can be more art than science. Most state workers' compensation insurance manuals contain roughly 700 classifications; the commercial general liability insurance manual has a little less than double that. Compare those numbers to the thousands of business types that exist today and the new ones that will exist five years from now, and you get a sense for why classifying a business can be tricky.
In addition, while workers' compensation, general liability and property classification descriptions are similar in some cases, in many others they bear no resemblance to each other. The underwriter who knows she has correctly classified the business for one type of policy may find that classification to be of no help for the others.
Though it may appear that determining the correct classification is only the underwriter's problem, it also has short- and long-term effects on the insurance buyer.
The correct classification ensures that the buyer pays the appropriate rate and that all buyers in that classification receive fair treatment. If the classification is incorrect, the buyer will pay a rate that is either too high or too low for that type of operation. For example, compare two contractors — one installs plumbing systems in commercial buildings, the other installs automatic sprinkler systems in them. If the plumber's work is faulty, a pipe may leak and cause water damage to furniture and equipment in one or more rooms. If the sprinkler contractor's work is faulty, the sprinklers may not work when a fire breaks out and the fire may destroy the entire building. The risk of a severe loss resulting from completed operations is much higher for the sprinkler contractor than it is for the plumber. If the underwriter classifies the sprinkler contractor as a plumber, the sprinkler contractor pays a much lower rate for completed operations coverage than it should. In the long term, loss experience will cause the rates for plumbers to increase. This is unfair to plumbers and to sprinkler contractors whose underwriters classified them properly.
Also, charging an inadequate premium may cause the business's experience modification to be higher than it should have been. The experience rating formula compares actual losses to the losses a typical business in that classification with that level of payroll or sales would have. If the classification is wrong, the formula will understate the level of expected losses, resulting in a higher debit or lower credit.
The rating manual rules require that policies issued to businesses in some classifications carry specific endorsements (policy changes.) For example, the rules for restaurants require the company to attach an endorsement that changes the definition of the products-completed operations hazard. Use of the wrong classification can result in the wrong policy terms for the business.
A business owner should work closely with a professional insurance agent to ensure that insurance companies are using appropriate classifications. While the wrong classification may appear to save the business money in the short run, it may prove to be costly in the long run.