Profit Pools & Cost Effectiveness
We’ve received requests to write articles addressing two questions.
- Can a PEO be cost effective over a client using a traditional insurance carrier?
- What profit pools does a PEO have available? In other words, how do they make money?
Both of these questions can be answered in the same article as they are in some ways, interrelated. This article will review each question individually and then provide a synopsis at the end. We’ll review if a PEO can be more cost effective than a traditional standalone insurance policy and whether or not it should be. We’ll also look at the main profit pools available to a PEO and the affect that has on PEO pricing.
Can a PEO be cost effective over a client using a traditional insurance carrier?
Yes, but not always. A PEO offers a wider scope of services than a traditional insurance carrier so when comparing the two, all facets must be factored into consideration. I’ve heard it said by some in the PEO industry that comparing a traditional insurance carrier to a PEO is like comparing apples and oranges. That is not entirely correct. While a PEO offers additional services above and beyond the traditional carrier, the commonality is that both offer insurance. Therefore, a better analogy would be that we are comparing apples to apples and oranges.
Therefore, when comparing a PEO to a standalone insurance policy, you must include the “oranges” or alternatives that a buyer would need to use coupled with the insurance policy for an accurate comparison to a PEO.
What are the methods that allow a PEO to be more cost effective when comparing it to the available alternatives?
- Economies of Scale
- Diversity of offering (multiple profit pools)
- High deductible workers’ compensation
- Master group health plan
- Effective reduction of employee turnover
- Risk mitigation services
- Macro vision for HR and employment management
Economies of Scale
It is no secret to business owners that economies of scale allow a business to run more efficiently internally. This means that the cost of goods sold (COGS) and/or selling and general administrative expenses (SG&A) can be a lower percentage of total revenue than for competitors whom haven’t achieved scale. This lower overhead as a percentage of revenue equates to an increase in gross profit (GP). As a result, an organization with economies of scale may have a higher GP and EBITDA than those without. Conceivably, a company of scale can maintain comparable profit margins to that of their competition while still providing a lower price point.
Diversity of Offering
Anyone experienced in insurance understands what a multi-policy discount is. When a company diversifies its risk and has multiple profit pools, it can price more aggressively if it desires to do so. PEOs have a diversity of profit pools rolled into a singular offering. For example, a PEO can generate profit from administrative fees, insurance premiums and rebates, tax deltas and profit from ancillary services such as recruiting, staffing, tax preparation, etc. Some PEOs also have transactional fees associated with their program which we will cover later in the article. With multiple profit pools, it isn’t reliant on one pool to generate all the profit. Some PEO profit pools are predictable such as administrative fees. Others are not, such as insurances (claims) and taxes (unemployment). When a company has a diversity of profit pools, that are managed well, they can become more cost effective. When the profit pools which can be impacted by claims and unemployment are mismanaged, the PEO can have the opposite result.
High Deductible Workers’ Compensation
A PEO only remits a percentage of the premium it collects when it operates on a high deductible program. It then is required to reserve and collateralize against claims maturation to the backing carrier. A PEO that effectively manages its underwriting and risk mitigation programs can create a lower loss ratio. A PEO that utilizes a successful claims strategy can effectively close claims out quicker than claims that are only sporadically touched by overworked claims adjusters. As a result, the PEO is able to keep more of the delta between the costs of the program versus what the client is charged. In this scenario, the PEO can become more cost effective if it chooses to price lower. However, a PEO must be cognizant to appropriately price business and manage their program effectively. A poorly or mismanaged program and underwriting process can act detrimentally to the PEO and erode profit.
Master Group Health Plan
The typical client size for a PEO in the United States hovers between twenty and twenty-five employees (Small Group). Therefore, a PEO generally has improved options for a prospective client through their master health plan. Like workers’ compensation, a solid pricing and mitigation strategy is key to maintaining a “cleaner” pool. The amount of lives a PEO brings to the table gives it leverage over a smaller competitor. However, if the pool begins to get “dirty”, regardless of size, the PEO can lose its leverage on its health benefits plan. A PEO utilizes wellness programs and ancillary tactics to try to reduce utilization rates where possible in order to maintain a healthy pool.
Effective Reduction of Employee Turnover
According to a white paper released by the National Association of Professional Employer Organizations (NAPEO), companies which are partnered with a PEO experience 10% to 14% less employee turnover than those not partnered with a PEO. In nineteen of the fifty States, a PEO will file on their own SUTA number. Since PEO clients have a range of SUTA rates depending on their individual turnover experience, a PEO will generally set up multiple shell corporations in a given State. This allows the PEO to have varying SUTA rates so that they can most closely align their client’s historical SUTA experience with the most appropriate SUTA rate. In States where a PEO files on their client’s SUTA rate through a power of attorney (POA), this is a moot point. In the States where the PEO files on its own SUTA rate, it generally experiences a small profit pool from the delta between the client’s actual SUTA rate and the PEO’s closest SUTA shell. If the PEO is successful in mitigating turnover and fighting erroneous unemployment claims, that gap may widen and the PEO may experience increased profitability. Ultimately, the PEO will likely realign the client to a different SUTA rate if the reduction in unemployment claims appears sustainable.
Risk Mitigation Services
When evaluating risk, there is the underwriting process and the proactive approach to claims mitigation. While the underwriting doesn’t vary significantly between a carrier and PEO, the proactive approach generally does. A good PEO uses a combination of strategy, field consulting and proven techniques to bring awareness to risk mitigation at a client level. Some PEOs use an annual safety incentive rebate to incentivize a customer to pay closer attention to safety, hiring practices and return to work programs. All of which have an impact on managing risk. With most business owners, production is at the forefront of their agenda. A PEO keeps visibility on safety to help manage against future issues. The result of a well-run program is a reduction in claims frequency which supports increased profitability in the premium versus premium remittance delta.
Macro Vision – HR and Employment Management
A PEO has a better vantage point for HR and employment related issues than most companies. This improved visibility on such items is inherent to the PEO model. A PEO HR professional may service fifty accounts. Therefore, they have the ability to see commonality with HR and employment related issues across a wider base of companies than the client would have on its own. If the PEO fosters good internal communication, that vision can be scaled. For example, a PEO that employs twenty HR professionals, whom regularly converse and strategize, has the experience of overseeing one thousand businesses. That insight and experience acts as a valuable resource to an average client with twenty employees. That expertise will save the client time and money and help them avoid potentially costly mistakes.
What profit pools does a PEO have available?
Now let’s take a quick look at the common profit pools a PEO can generate and then we’ll tie it all together at the end of the article.
- Administrative Fees
- Insurance Premium
- Additional Services
A PEO charges a client either an annual per head amount or a percentage of payroll for its administrative fees. These fees pay for the PEO overhead, outsourcing and consultative services. An administrative fee as a percent of payroll can range anywhere from 1.5% to 6% on average. The sweet spot that is charged seems to be in the 3% to 4% range. The administrative fees are the most predictable of the profit pools a PEO can generate. A common metric the PEO industry uses is the internal employee to work-site employee (WSE) ratio. PEOs strive to improve this number through training, technology and infrastructure changes. However, a PEO must be careful not to overextend this ratio or client attrition will occur due to a watered down value proposition and lack of availability from service personnel. When a PEO achieves an optimum balance in the ratio, SG&A as a percent of net revenue decreases which widens this profit pool.
A PEO is responsible for remitting premiums to its carriers in accordance with the agreement between the PEO and carrier. It may also be responsible for some of the claims costs, reserves and collateral requirements. A PEO may receive additional profit from the carrier for good loss years depending on their agreements. Ultimately, a PEO that effectively manages risk can generate profit within the insurance vehicles. However, a PEO that is poorly run can experience major losses due to claims. These profit pools are the most volatile within the PEO model as claims frequency, severity and development can quickly erode profitability.
State Unemployment Tax
As previously mentioned, in nineteen of the fifty States, a PEO will file the client unemployment under the PEO SUTA. This could be the case in some other States as well, but many PEOs opt to use the client’s SUTA and file through a power of attorney (POA). In the States where a PEO files on its own number, it sets up multiple entities so that it has a diversity of SUTA rates to most closely align with the client’s SUTA experience. A PEO would never put a client on a lower than historic SUTA rate to begin the relationship as it would lose money so it picks the closest SUTA rate available that is higher than the client’s historic SUTA rate. Therefore, there is generally a slight overage which equates to a profit pool for the PEO. If the PEO effectively manages the turnover and unemployment claims, that profit pool can increase in direct correlation to the PEOs mitigation efforts. Ultimately, if a PEO client shows a trend of having a lower SUTA rate after being with the PEO, the PEO should look at moving the client into a lower SUTA rate when appropriate. To better understand the PEO pricing models for employer payroll taxes, click here.
PEOs today are diversifying their offering to include services commonly used by small and medium sized businesses (SMBs). For example, a PEO may offer staffing services, direct hire recruiting, tax services, technology, etc. When a PEO offers ancillary services that were not part of the PEO agreement, these services are generally fee based. These fees equate to additional profit pools.
A PEO should disclose any fees that it may charge in the course of the PEO relationship. Those that don’t, I personally would be weary of. These fees may include setup fees, delivery charges, W2 fees, etc. Some PEOs don’t charge for any of these fees, with the exception of delivery charges as those are pretty common. Additional fees, depending on the COGS associated with them can equate to additional profit pools.
Tying it Together
The ability for a PEO to be cost effective depends largely in part on how well it manages its profit pools. A PEO that has achieved economies of scale and effectively manages its profit pools has greater diversity in profit and thicker profit margins. This means a PEO has more profit to play with if it want to price more cost effectively.
However, should a PEO be more cost effective on paper than a traditional carrier? The answer to that question is, it depends. A PEO should not emphasize winning business on price. It invalidates the value proposition to a degree and sets a poor precedence with the sales force and future clientele. Moreover, when comparing cost factors of a PEO to alternative options, all variables must be weighed. These variables may include insurances, payroll costs, technology, etc.
A PEO should be sold on the return on investment to the client driven by the PEO value proposition. This selling process should be handled by an internal PEO employee directly to the clientele whether or not a channel partner was used to source the deal. A PEO with a poor or vanilla value prop shouldn’t expect to consistently win or achieve high profit margins when faced with superior competition. A PEO with a superior value proposition can still generate solid profit margins even if that PEO hasn’t yet achieved scale. To see how a smaller PEO can compete with those of scale, click here.
Ultimately, a PEO’s ability to be flexible on price is a byproduct of how effective the executive team has managed the business. A well-managed PEO can keep a higher price and increase profit margins as a result of protecting profit pools and streamlining internal efficiency. Or, they can reduce their price when appropriate but maintain industry standard profit margins due to their ability to effectively manage the business.
A PEO that does not have scale and poorly manages its profit pool will always be a cost plus program. If the offering is vanilla on top of the lack of scale and poorly managed profit pools, growth is likely to stifle.
Can a PEO be more cost effective? Yes. Can it drive greater ROI than alternatives? Yes. Can partnering with the wrong PEO be a headache for a client? Yes. Were there poorly run PEOs in the past? Yes. Are their well-run PEOs today? Yes. Are all PEOs today well-run? No. Should a prospective client meet/speak with a PEO directly prior to partnership? Yes. Can a well-informed PEO sales professional illustrate the value of the PEO? Yes. Are all sales reps adequately educated on their PEO and alternative options? No. (To learn about a good approach to PEO sales, click here.) Is it tougher to leave a PEO relationship than a traditional insurance carrier? Yes (there are more things to switch for the company; i.e. payroll, tech, insurance, etc.). Can a client impact its renewal pricing with a PEO? Yes. Does the client have complete control over the variables that impact renewal pricing? No. Should a PEO be compared to only a carrier insurance premium? No. Should the full PEO value prop be compared to alternatives (inclusive of all the variables) in the market? Yes.
A PEO is an excellent option for a company that is looking to receive a greater return on the money they spend for insurance, payroll, etc. Not every PEO is created equal. Proper evaluation is key to determining if the PEO model is right for a company and which PEO is the best choice.
Author: Rob Comeau is the CEO of Business Resource Center, Inc., a management consulting and M&A advisory firm to the PEO industry. Business Resource Center’s website is www.biz-rc.com.