Workers' Compensation 101

If you have employees, you need workers' comp insurance. We'll help you wrap your head around what you need to do to ensure your business is covered.

Editor's note: This article was excerpted from Entrepreneur Magazine's Ultimate Guide to Workers' Compensation Insurance

Almost every business in the United States that has employees has to handle the problem of workers' compensation. Most states (with a few important exceptions) essentially require employers to purchase an insurance policy to handle their statutory obligations to workers who are injured or made ill due to a workplace exposure. Whether your business is small or large, handling the expense and effort of meeting those statutory obligations is an ever-present challenge.

As a consultant to employers on their workers' compensation cost and coverage, I've seen firsthand that the cost of workers' compensation is a universal concern of business owners and managers. Whether working with a small machine shop that employs 30 people or a Fortune 100 corporation that employs thousands across many states, I've found that the details may vary but the concern remains the same: how can the voracious cost of workers' compensation be controlled effectively?

Some researchers have suggested that the earliest roots of workers' compensation can be traced back to the code of Caribbean pirates: those who were injured plying their dangerous trade would be compensated with shares of booty taken by their able-bodied fellow buccaneers. Colorful as that conjecture may be, workers' compensation requirements in the United States began early in the 20th century, back in 1911.

Before then, workers who'd been injured or made ill on the job had to take legal action against their employers, resulting in a system that simultaneously made it difficult for workers to obtain compensation for such injuries and yet exposed employers to potentially devastating financial penalties under the tort system. Beginning in 1911, an historic compromise solution was devised by the various states. Wisconsin was the first, but other states quickly followed, enacting a "no fault" system intended to make sure workers received fair and prompt medical treatment and financial compensation for workplace injuries and illness. This compromise system also established limits on the obligations of employers for these workplace exposures, so that the costs could be made more predictable and affordable.

Today, modern workers' compensation laws provide fairly comprehensive and specific benefits to workers who suffer workplace injury or illness. Benefits include medical expenses, death benefits, lost wages, and vocational rehabilitation. Failure to carry workers' compensation insurance or otherwise meet a state's regulations in this regard can leave an employer exposed not only to paying these benefits out of pocket, but also to paying penalties levied by the states.

But our federal system in the United States means that workers' compensation regulations, for the most part, are the jurisdiction of the individual states. There are some federal workers' compensation statutes, such as for longshoremen and harbor workers, but for most employers, the system of workers' compensation rules and regulations they usually deal with is enacted by the states (along with Washington D.C. and Puerto Rico). This means that workers' compensation in the United States has something of a patchwork quality to it. There are great similarities among the workers' compensation systems enacted by the various jurisdictions, but also important differences.

How States Differ
In most jurisdictions, employers can meet their workers' compensation obligations by purchasing an insurance policy from an insurance company. However, five states and two U.S. territories (North Dakota, Ohio, Puerto Rico, the U.S. Virgin Islands, Washington, West Virginia, or Wyoming) require employers to get coverage exclusively through state-operated funds. If you're an employer doing business in any of these jurisdictions, you need to obtain coverage from the specified government-run fund. These are commonly called monopoly state funds. A business cannot meet its workers' compensation obligations in these jurisdictions with private insurance.

Nevada was a monopoly state until recently, but now it's shifted to a system of private insurance and the former state fund has morphed into a mutual insurance company. Thirteen other states also maintain a state fund, but the state funds compete with private insurance. In these states, an employer has the option (at least theoretically) to use either the state fund or private insurance. Those states that offer employers this option are Arizona, California, Colorado, Idaho, Maryland, Michigan, Minnesota, Montana, New York, Oklahoma, Oregon, Pennsylvania and Utah.

The State-by-State Mosaic
Since workers' compensation is primarily regulated by the individual states (and territories), there is no single cohesive set of rules governing benefits, coverage, or premium computation. Even if you have considerable experience in dealing with one state's workers' compensation system, if your business expands to a different state, you can easily find yourself dealing with very different rules.

The closest thing there is to a uniform set of rules for premium computation are those established by the National Council on Compensation Insurance (NCCI, This organization creates policy forms and writes the rules for premium computation in the majority of states.

NCCI is what used to be called a "rating bureau." Nowadays the organization tends to prefer the term "advisory organization," although a lot of folks still use the older term. NCCI performs a number of important tasks for the workers' compensation system in the states that use NCCI. It gathers the statistical data from insurance companies that is used to develop rates, for instance. It also creates the standardized policy forms that are approved by state insurance regulators. Perhaps most importantly, from the standpoint of those who buy workers' compensation insurance, NCCI writes the manuals that govern how workers' compensation insurance premiums are calculated.

If you have a high tolerance for technical and obtuse language, try reading the fine print of your workers' compensation insurance policy. If you stick with it, you may notice something interesting: the policy itself doesn't really spell out how the premiums for the insurance are calculated. Instead, the policy states that premiums on the policy are just an estimate and that the final actual premiums for the coverage will be calculated in accordance with the insurance company's manuals of rules.

But in practice, insurance companies don't write their own manuals of rules. Instead, they find it more practical to use the manuals developed by rating bureaus like NCCI. (Remember: NCCI isn't the rating bureau in all states. Some states maintain their own independent rating bureaus. These other bureaus also develop manuals that govern premium computation in their particular states.)

Also, even among the various NCCI states there can be important differences. Some states tinker with NCCI rules in various ways, so that in some fundamental rules there can be very important differences even among NCCI states.

So to figure out what rules govern the computation of your workers' compensation insurance premiums, you have to first identify the states and then figure out which rating bureau (and thus which manual of rules) has jurisdiction in those particular states.

Workers' Comp--Who Needs It?
That may be the first important question that a business needs to address, because not every business is required to purchase workers' compensation insurance. Generally speaking, sole proprietors and partnerships aren't required to purchase workers' compensation insurance unless and until they have employees who aren't owners. Most states will allow sole proprietors and partners to cover themselves for workers' compensation if they choose to, but it isn't required. (An important note, though-these rules vary from state to state and can change over time. So it's always a good idea to check with your particular state's regulatory agency to make sure what the rules are for your state jurisdiction.)

Some states don't require an employee to be covered if he or she is paid solely by commission. Again, check with the workers' compensation regulators in your particular state to see how they handle this.

Interestingly, a few states even give employers the option to not purchase workers' compensation insurance at all. These states are few and far between: Texas and (at least in theory) New Jersey. Remember, though, that just because the state may allow an employer to go without workers' compensation insurance, the employer is still liable under the state's workers' compensation laws for injured workers. Not having workers' compensation insurance, even if allowed by a particular state, does not relieve the employer of financial responsibility for injured workers.

Most states also allow large employers to self-insure for workers' compensation, but the rules about who can and cannot self-insure again vary significantly from state to state. Typically, your state department of insurance can help you determine if your business is required to purchase workers' compensation insurance. A general rule is that if you have employees who aren't owners of the company, you probably need workers' compensation insurance. Speaking of employees, here's a potential trap to be aware of and avoid: under most state's workers' compensation laws, you might have employees you don't know about. That's because most states will treat an uninsured contractor or subcontractor as your employee if he or she is injured while doing work for your company.

Let's say you're operating as a sole proprietor and your state doesn't require you to purchase workers' compensation insurance on yourself. Then you hire a painter to paint your office. If that painter doesn't have workers' compensation insurance on himself and gets hurt working on your premises, he may well be able to make a claim against you. The same holds for a roofer, or a glazer, or a cleaning contractor. Anyone you hire to do work for your company could be eligible for workers' compensation benefits from your company.

That's why many larger companies will contractually require anyone doing work for them to show proof of workers' compensation insurance. A cleaning service operating as a sole proprietor may not be required by the state to purchase workers' compensation insurance, but its clients would be wise to insist on it before hiring that service.

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