Revisiting the PEO, Part II

Look for the biggest and most effective PEOs to get bigger and more effective.

by Randall Mehl

I have to apologize for leaving you hanging. In the last edition, after a brief history of the PEO and a discussion about their recent success in the public markets, I abruptly ended on a quite cynical (okay, dire) note about the future of the industry. Let me clarify.

I believe the co-employment (i.e., PEO) model will continue to work, and for some, thrive. Administaff, GevityHR, and TotalSource all generate (or are on target to generate) operating profit of $100-200 per serviced employee annually-that is real money to which investors and analysts will attach real value. However, I do not expect the sector to swing back into favor in the eyes of investors, and therefore, I do not expect the area to re-emerge as a booming area within business services. What I do expect is the perception of the co-employment model and possibly the PEO business model to change over the next few years.

The staff leasing (predecessor to the PEO) sector was created as a vehicle for small businesses to obtain cost-effective insurance. The idea was that scale, effective claims management, and the ability (sometimes unwarranted) to assume risk enabled the provider to maintain a lower cost of insurance. When PEOs emerged in the public markets in the late-nineties, the value proposition changed to one of fee-based HRO-much like you would find with ADP in payroll or TALX in automated employment verification. The trend has clearly been to de-emphasize insurance as part of the value. Administaff has always maintained a “white collar” focus within its client base; GevityHR has dramatically lowered its workers’ comp exposure; and ADP-TotalSource spent two years cleansing its worksite employee base. I believe the co-employment models-even the ones just mentioned-remain heavily reliant on the value of delivering cost-effective health and workers’ compensation insurance to small businesses. In other words, a substantial portion of the $100-200 per serviced employee per year comes from insurance-related profits, in my view.

Big problem? It depends. Insurance-related profits can be okay, at least for a while. Clearly, there is value to aggregating employees for distribution efficiencies. Insurance underwriters often struggle with cost-effectively serving the small business market, due to high cost of sales and service, and sometimes adverse selection. As a result, it is not uncommon for the premiums for comparable coverage to be substantially higher for small businesses on a per-employee basis, or for underwriters to actually pull out of some small business markets altogether. If PEOs can deliver small business employees to underwriters at a reasonable cost, value is created. How much value depends on many factors, but a good starting point is the sales commission typically paid to insurance agents. A 10 percent commission rate on health and workers’ compensation combined could produce “value” of more than $500 per employee per year or more-interestingly, this turns out to be the difference in gross profit per employee between a co-employment contract and ASO contract.

Insurance-related profits are bad (unsustainable) when the difference between what the PEO pays for coverage and what clients pay for coverage is simply the result of the PEO absorbing a higher level of risk. This is called insurance arbitrage, and is predicated on the notion that PEOs either do a better job than the insurance company in assessing risk (doubtful!), or believe that they can actually reduce risk (a possibility). Over periods where claims experience is relatively light and abnormally few adverse events occur, profitability may appear extremely high. However, the tables can turn quickly, and PEOs often do not have a strong enough balance sheet to handle a worst-case scenario.

The co-employment model will likely survive, but the perception will undoubtedly change over time. If the value proposition of co-employment is largely rooted in efficient insurance distribution, then the sustainable business models must include size, consistent client selection, and effective management and operations. Due to the complexities of employment and insurance, the PEO business is one of the most difficult to manage. Do not expect to see a line-up of new publicly traded PEO prospects coming out of the woodwork. Rather, look for the biggest and most effective to get bigger and more effective.

Posted October 10, 2003 in Engaged Workforce

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