Businesses are misclassified up to 60% of the time

by Jonathan Ringvald in April 28th, 2022

Commercial insurance underwriting is typically more complex than personal lines. The sheer volume of available information can make it difficult to effectively classify and price the risk. In addition, commercial insurance underwriters are not always aware that certain types of businesses may require special consideration.

The Consumer Federation of America estimates that up to 60% of businesses may be misclassified.

This complexity makes it easy for policyholders or agents/brokers to unintentionally or intentionally (wink) misclassify their business during the quoting process. In fact, up to 60% of small businesses are misclassified (1), and many don't even realize it. Business owners who buy the wrong coverage could face gaps in protection or higher premiums than they should pay, while insurers could be on the hook for claims that exceed the policy's limits.

The potential impact of bad industry classification is huge:

Higher claim costs — Industry classifications with a higher level of risk pay more for their coverage because they are at greater risk of loss. So if a business pays premiums based on an industry classification with a lower level of risk, its insurer could be on the hook for larger claim losses than expected.

Reduced profitability — If an insurer sets prices based on an incorrect classification, its profits could take a hit if it must pay out more in claims than expected. This could also happen if a business pays lower premiums

According to the Insurance Information Institute, the insurance industry paid $27 billion in 2010 alone in claims for commercial lines insurance. The problem of misclassification leads to an increase in premiums across the entire industry as actuarial models price in a greater level of risk to account for the problem. 

Common problems include:

Businesses are classified into a generic category, such as "Retail".

Businesses are assigned to a code based on their products and services, instead of their activities, processes and operations.

Businesses are assigned a code that is too broad or too narrow. For example, a business is assigned code 451210 when it should be 451220. Or, it's assigned code 453998 when it should be 453910 or 453920.

In my opinion, the problem comes down to simple data decay. An issue that haunts most industries. Insurance companies often get it wrong because they rely on information from internal or external third party databases that are simply not updated frequently enough.

For example, if a bakery owner thinks they’re in the restaurant category because they offer baked goods and coffee, but they’re actually in manufacturing because they bake bread and cakes, they’re going to be overcharged by 25% on average.

Small business owners may not be aware of the impact their industry classification has on their insurance rates. But when small businesses are misclassified by insurers, they can see up to a 60% increase in their premiums, according to the National Association of Insurance Commissioners (NAIC).

Businesses have several rating factors that influence their premiums, including their payroll, claims history and industry classification. As long as they are categorized correctly, the rating is far more likely to be accurate.

When industries are blended together into one rate, we end up with an inaccurate statistical model that can cause a wide range of premiums for similar businesses doing similar things.

What is the issue?

In some cases, the business owner simply selects an incorrect code during the application process because they don't fully understand how to classify their business. Some businesses may make an honest mistake in classifying themselves when they first open their doors. Other times, businesses change or evolve over time but don't update or report the changes on their workers' comp policy.

According to data from The Hartford's Experience Modification program, up to 60% of new customers are misclassified by another carrier during a new quote or renewal.

Paychex, Inc. surveyed a nationally representative sample of 1,000 small business owners (SBOs) and found that nearly 60% of SBOs either misidentified or were unsure about their business classification.

The survey, conducted by Wakefield Research, examined how well SBOs understood the specific ways their businesses are classified in four areas: industry, employment category, size, and number of employees.

The Paychex report reveals that businesses are being miscategorized at alarming rates.

Despite the fact that SBOs consider themselves to be informed about their business' classification in all four categories, Paychex found that 59% of SBOs are misclassified in at least one area; 29% are misclassified in more than one area.

What can you do to better improve industry classification in your book of business?

Whether you’re a carrier, bank or broker, you can certainly increase the likelihood of good classifications by educating your consumer. Communicating the following can encourage customers to self-classify better, or even reach out for help when classifying.

Try providing a quick educational piece on why, how and when to classify correctly helps them improve their business outcomes.

Describe why classifying correctly is important. It can lead to more accurate premiums, often cheaper, more effective policies for insureds. 

Better classification also leads to better communications between you and your customer. Knowing more can help you to tailor the right messaging and insights to the right customer. If I’m a barber, I’d hate to get a call about a new insurance policy targeting restaurants.

Describe the taxonomy that you use. If you use NAICS codes, provide a simple NAICS search tool for customers to look up their class on their own.

Whenever a business makes a significant pivot, encourage the insured to submit an update, and even incentivize them with better policies, or products come renewal time. Our research shows that small businesses that pivot do so within the first 2-3 years as seek find product/service market fit.

How this affects small business

This ultimately means that loads of small businesses are at risk of losing out on important protections, deductions, and status they deserve.But this isn't just an issue for the insurance industry. Small businesses who have been misplaced incorrectly have no choice but to accept it, and it's probably why you don't hear many complaints about it. 

At Relativity6 we built an automated solution that searches for relevant data about a business and uses artificial intelligence to classify that data into accurate industry classifications. We’re over 90% accurate on searchable businesses and reduce the load on manual verification significantly.

Want to chat? Reach out at hello@relativity6.com or contact us here.


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