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Incorrect classification can have long-term effects, says Amity Insurance

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QUINCY, MA ISSUED DECEMBER 20, 2010…. The insurance pricing mechanism may seem mysterious to business owners, particularly when receiving a bill with a premium that has gone up since the last renewal. While pricing typically involves a certain amount of discretion by underwriters, the starting point is always the type of business being insured, according to Amity Insurance Agency, Inc., the region's leading full service agency.

“What type of business is it?” may appear to be a simple question, but it does not always have a simple answer. To determine the answer, an underwriter must assign the business to one or more classifications. More than any other factor, these classifications establish how much premium the business will pay.

Most state workers' compensation insurance manuals contain roughly 700 classifications; the commercial general liability insurance manual has a little less than double that amount. Compare those numbers to the thousands of business types that exist today and the new ones that will exist five years from now, and it’s easy to see why classifying a business can be tricky.

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 their particular 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.

Moreover, charging an inadequate premium may cause the business's experience modification to be higher than necessary. 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.

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 term, it may prove to be costly in the long run.

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