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The widespread growth of professional employer organizations can be a blessing to employers, but they must tread carefully around who is responsible for workers compensation coverage.

Under PEO arrangements, an employer uses the services of the PEO, also known as an employee leasing firm, to supply all or most of its workers for a fee or other form of compensation, generally based on a percentage of the company's total payroll.

In return, the PEO provides a broad range of administrative and human resource services, such as payroll, pensions, employee benefits and workers compensation coverage for everyone.

PEOs often are used by small employers, which are attracted by the economies of scale and negotiating power the organizations can offer.

Small employers "can get similar levels of service that their larger competitors can get and still be competitive in the marketplace" said Rey Becker, associate vp and regional manager at the Alliance of American Insurers in Schaumburg, Ill.

Larger corporations also might use PEOs for services in peripheral areas, such as staffing for the company cafeteria.

"We think what is happening is the movement to PEOs, or employee service organizations, really represents a fundamental structural change in the U.S. economy," said Loren Hulber, president and chief executive officer of NovaCare Employee Services, a King of Prussia, Pa.-based PEO.

In the future, he predicted, "It will be de rigueur for small and medium-sized employers to retain an employee service company to manage on an outsourced basis all of their human resources."

PEOs or leasing companies are similar to but distinct from temporary agencies, which assign their employees to clients for a limited period of time for special work situations, such as employee absences.

Because PEOs were virtually unheard of when most workers compensation statutes were written, the states are playing catch-up in regulating them.

"It's going in a variety of directions, I think," said John Lennes, vp of workers compensation and health at the Alliance. State regulators "have taken varying approaches to that issue," as to whether the PEO or the company client should be the responsible entity for workers compensation coverage, said Mr. Lennes.

"I think the approach that makes the most sense probably" is where responsibility rests with the workplace employer, "but they can change that responsibility if there is a good workers comp policy in place that the leasing company itself has," said Mr. Lennes.

He noted that this was the approach of the National Assn. of Insurance Commissioners in a 1991 model act.

Illinois, California, Kentucky, Maine and Missouri permit a "wraparound policy" that is "pretty much in line with the NAIC model act," he said.

"We think it should be possible for the workplace employer to discharge their obligations. The duty is still on Bob's Ball Bearing, but Bob can do it by working out a deal with Intergalactic Personnel," said Mr. Lennes.

"The good thing about that is, it does allow for the existence of the leasing company," said Mr. Lennes. "It doesn't attempt, like old policies seem to, to deny they exist."

One potential problem is the issue of employers with unsafe work sites that obtain coverage based on a PEO's lower loss experience modification rating to avoid paying the higher workers comp rates that they should be paying.

Illinois legislation that becomes effective in January addresses this. Among provisions in the Employee Leasing Company Act is one that says if an employer's experience modification factor exceeds the PEO's mod by 50% at the inception of the leasing arrangement, the employer's higher factor will be used to calculate the workers comp premium rates charged to the leasing firm for two years.

John Shea, vp-group captives for Fireman's Fund Insurance Co. in Novato, Calif., said this issue "was the phenomena that originally gave PEOs a bad name, because PEOs were seen by insurance companies and regulators as just a way for guys with a debit modification to escape that debit mod."

One approach taken by workers comp insurers has been to have the PEOs adopt stringent loss control measures, said Mr. Shea. In addition, if necessary, most PEOs will charge the employer extra "to be sure they're funding the losses properly."

"As part of our value added, we go through an underwriting process in bringing on new clients," said Mr. Hulber of NovaCare.

"We assess three years of their workers compensation history; we have safety engineers that inspect their facility; we make recommendations for improvement. We partner with our carrier, Liberty Mutual, in evaluating the risk and recommending improvements and, assuming all is in final alignment, then enter into a PEO agreement and go forward," he said.

Even if the employer has a poor record, so long as the client is willing to work with the company, it will proceed with a contract anyway, said Brian Radin, division vp of ADP TotalSource Inc. in Atlanta, a PEO unit of Roseland, N.J.-based ADP Corp.

But if a client is not willing to do so, ADP will turn the business down, he said. And if a client that fixes an unsafe environment later reverts to old habits, "we have the right to terminate" the relationship, said Mr. Radin.

A related concern is keeping track of individual employers' records so that if they stop using a leasing company or switch firms, some record of their loss experience remains intact.

Various states are wrestling with the issue, said Mr. Lennes of the Alliance.

"There's a lot of real discussion going on in the varying states

on. . .how to keep that kind of information available, current and accurate for when it might be needed in the future, even if the carrier doesn't need it now," he said.

"We insist upon client lists from each PEO," which provides information on clients' individual experience, said Mr. Shea of Fireman's Fund.

Mr. Shea said that while he has no problem with most insurance regulation of PEOs, he is unhappy that some states "have what are called a coordinated policy approach, which means individual policies are issued for each and every client for the PEO."

For instance, according to the Alliance, Massachusetts requires the PEO to buy and maintain a separate policy providing standard workers comp as well as employers' liability insurance for each client company.

Ray Sprague, senior vp of Hartford Specialty Co., a unit of Hartford Financial Services Group Inc. in Hartford, Conn., said having to issue these individual policies obviously "adds a tremendous amount of administrative costs" to the process. "It's a big headache for us," Mr. Sprague said.

More regulation can be expected in the future, said Judi Newman, a consultant with Fort Myers, Fla.-based Phaze II Consulting Inc. Most states still have very few PEOs, but regulation is likely to increase as they spread, she said.

Although NovaCare endorses state legislation and state licensing activity for PEOs, "We would caution states.*.*.not to be too restrictive," said Mr. Hulber. "In some states, it takes a period of time to have the mod rate for workers comp for an employee population apply to us as the employer, and I think what is overlooked in some of these instances is the value we add."

Many PEOs have developed their own sophisticated safety and back-to-work programs.

"On the front end, we're proactive in that we're attempting to reduce risk and create a safe workplace," said NovaCare's Mr. Hulber.

On the "back end," he said, Novacare manages claims.

While in years past many PEOs were self-insured, most have now moved to the voluntary insurance market.

"The risk factors associated with self-insuring have been a huge issue" lately, said ADP's Mr. Radin.

"Now the trend is to go back to fully insured, guaranteed cost plans and, because the market is so soft, leasing companies are able to negotiate pretty good rates," he said.

Meanwhile, it is still incumbent upon the employer to make sure adequate workers compensation coverage is in place that complies with its state's regulations.

"There have been a number of instances where in the past the employee leasing company failed to acquire the workers comp, and when there was an actual loss, the employer who leased the employee was found to be responsible," said Phaze II's Ms. Newman.

The transfer of responsibility to the PEO is not always watertight, warned Ward Ching, western regional practice leader for risk and insurance services at consultant Watson Wyatt Worldwide in San Francisco.

"There are instances where the behavior of the employer. . .mitigates or limits the transfer and creates a different kind of liability for the employer," Mr. Ching said.

For instance, an employer that knowingly puts a worker in jeopardy, such as assigning him or her to an unsafe work environment, can be sued for negligence even if a PEO covers its workers.

In the past, there also have occasionally been problems where an employer belatedly learned the PEO had not put together a solid insurance program, perhaps in an effort to reduce costs, said Mr. Ching.

William C. Bruce, an attorney with Mayo, Gilligan & Zito in Hartford, Conn., said, "In my experience, really, where most employers who are considering this as a vehicle go wrong is they need to spend more time looking at their agreement with the leasing company. . .making sure it covers all the contingencies where they might become liable and verifying that the leasing company they're dealing with is able to back up its contractual promises, because you can have a very good contract, but if the leasing company doesn't have the financial stability to live up to its terms, it doesn't mean much."

"The employer does need to be vigilant," said Mr. Ching. "When going through the contract evaluation process, they should dig a little deeper and ask the harder questions, and they should get proof."