by Frank Huang and Daniel McHenry | November 23, 2021
Originally published in PEO Insider (November 2021). Reproduced with permission of the National Association of Professional Employer Organizations.
Investors interested in the PEO industry commonly want an overview of the risks facing PEOs. While it is impossible to cover every material risk for every possible transaction in 1,000 words, we accept the challenge and will attempt to cover common risk themes as in-depth as possible.
One of the biggest risks for an investor in a PEO lies in the PEOs workers’ compensation (WC) program.
Generally, PEOs address their WC exposures either through a guaranteed cost (GC) program or a deductible program. With a GC program, the PEO pays a premium to an insurer to transfer all WC claims first-dollar on an unlimited basis to that insurer. With a deductible program, the PEO pays a lesser premium (relative to the GC premium) and retains losses in an agreed upon deductible layer, and transfers losses excess of the deductible to the insurer.
In both financing approaches, the magnitude and trend of ultimate losses is important, but the trend is more important under a deductible program. Thus, the amount of deductible layer losses is the first risk we bring to your attention. The ultimate amount of losses in the layer, and how it trends, can have a significant impact on earnings before interest, taxes, depreciation, and amortization (EBITDA) and pro-forma projections, and thus valuation.
The second risk is that WC liabilities are not appropriately reflected in accounting. There are two common areas where accounting can go awry. The first issue is the accrual method of the unpaid WC liabilities. The PEO’s net WC liabilities within the deductible need to be estimated and carried as a loss liability. The second issue relates to the accounting of the collateral that is held by the carrier. It is not uncommon for deals to be scuttled due to inaccurate accounting in these two areas.
The last group of WC risks lies in the PEO’s understanding and appropriate management of the retained loss liabilities. Strong client evaluation, pricing, claims management, and safety programs are important for all PEOs, but more important for PEOs in higher risk verticals than PEOs only writing lower-risk, white-collar worksite employees.
Healthcare risk is similar in concept to WC risk in that it can be financed away or retained (e.g. on a minimum premium plan). Just like WC risk, health benefits risk is greater when it is retained, which heightens the importance of how the program is being managed.
The first risk in this area lies in client evaluation, especially for new business. Who is doing the client evaluation, and how are they doing it? It is not uncommon for this person to see his or her function connected only to sales and not to risk mitigation, which can result in a myriad of negative consequences.
Another important risk is risk tiering, or differentiating price between clients such that there is adequate pricing at the client level but also at the aggregate level. Not doing so can result in clients with better experience being overcharged, leading to departures. This can potentially lead to greater stress on pricing remaining clients, and potentially to aggregate inadequacy. Over time, this could result in rate increases by the carrier(s), which has the potential to impair sales efforts.
The last risk worth noting is in benefit plan design. Unlike WC, which has statutorily defined benefits, PEOs have the opportunity to align the needs and desires of their clients and co-employees with specific product options. The better that alignment, the greater the enrollment and participation, which can help minimize claim volatility and adverse selection.
NON-INSURANCE OPERATIONAL RISKS
In addition to workers’ compensation and health benefits, a third general category of risk lies in the PEO’s non-insurance operations. While there are too many to cover, we briefly address a few notable ones:
- How likely is the executive team to achieve investors’ short-term and long-term goals?
- Will they sign employment agreements, and will the sales force sign strong restrictive covenants before the acquisition?
- Client Portfolio
- What is the composition and trending of the client portfolio?
- Are there adequate administrative fees? A rule of thumb for a healthy PEO is if the PEO will meet investor goals with just administrative fees.
- Long-term impact of enterprise value based upon organic, broker, or combination models.
- Effectiveness and economics of sales force.
- Understanding the competition and how the PEO compares.
- Understanding potential disruptors.
- Understanding the market and how to compete in an auction process with the consolidators that have an advantage of synergy.
While the risks are many, it is worth noting that all of them can potentially be converted to be financially advantageous. For example, if retained WC and/or healthcare benefits costs are less than what an insurer might charge to assume those risks, then the PEO and its clients benefit. The proper identification and treatment of these risks will improve an investor’s likelihood of success and maximize return on the investment.
 PEOs involved in transactions generally are in deductible programs rather than GC programs.
 Because of the potential impact on valuations, it is important to engage a credentialed actuary who is, at a minimum, experienced in workers’ compensation, and preferably also experience in PEOs.
 It should be noted that, as with both WC and health benefits, analytics are increasingly playing a role in helping drive accurate pricing.
|Frank Huang has more than 15 years of actuarial consulting experience serving a wide range of clients, including serving as ADP’s Chief Actuary. Learn more about our PEO consulting practice here.|