CARVE-OUT ARRANGEMENTS AND OTHER CLIENT SERVICE AGREEMENT CHALLENGES

Recently, I had an opportunity to speak at the NAPEO Operations Workshop, held in New Orleans on April 8, 2025, on the topic of Carve-Out arrangements. My co-presenter was Paul Hughes of Libertate Insurance, a leading expert in workers’ compensation insurance and PEOs.

I was pleased to see that we had standing room only for that presentation on the topic, since carve-out arrangements are so frequently used but often overlooked by the industry. It was the audience’s participation in that session that led to me to want to write this article since the audience members were trying to help other PEOs by openly discussing their own client service agreement challenges. That discussion was a profound reminder of what an amazing industry we work in when competitors volunteer insights to help each other. It was clear from that conference and from several cases that I have been retained on that our industry has some fixable problems with carve-out arrangements that we need to address.

As background, for those who may not be familiar with the term carve-out arrangement, this is a term of art used to describe a PEO-client relationship in which the client maintains their own workers’ compensation insurance policy. It is also frequently referred to as a client-based policy arrangement.

Although it seems simple, one of the most frequent issues that I have encountered is that many PEOs do not have a carve-out specific client service agreement. That means that the PEO is typically using a standard client service agreement, which, in most instances, indicates that the workers’ compensation insurance coverage is through the PEO’s policy, not the onsite client employer’s policy of coverage. As a rule, when contracting with a client that will have its own workers’ compensation insurance policy, there must be a client service arrangement that makes it clear that it is a carve-out arrangement. That client service agreement must clearly state that coverage is with the client and its carrier and not the PEO. A failure to have that specific carve-out language in a client service agreement can result in multiple issues. For instance, I have encountered cases where the onsite client’s carrier has demanded to see the client service agreement between the PEO and their insured. When that carrier determines that the workers’ compensation insurance coverage is listed in that agreement as being through the PEO’s carrier, they quickly deny coverage on the claim. While that is a problem, the larger problem happens when the PEO’s insurance carrier is presented with that denial and then declines coverage on the accident since the onsite client location was not reported to the carrier or referenced in the policy.  That is not a situation that any PEO wants to be in. When that happens, the PEO better have excellent relationships with its insurance carrier, broker, and the onsite client company owner, because getting the problem fixed will rely heavily on their cooperation.

Many PEOs’ sales and risk teams believe that once the client has secured their policy of coverage in a carve-out arrangement, then that is the end of their worries. Unfortunately, that is not the case, especially when the PEO usually does not have any involvement with that policy. In those instances, the client pays for the workers’ compensation policy directly and deals with their carrier and/or broker directly.  That may initially sound great to the PEO as it is one less thing to monitor. What happens, though, when the onsite client fails to make the payments on that policy, or if it gets cancelled? In this real-life scenario, the PEO can only hope that it will get notice of that cancellation, even in the best of relationships with the client. Without any notice of the cancellation, the PEO would continue to provide services while unknowingly doing so while bearing all of the risk should a workplace accident occur.

When possible, PEOs will want to get endorsed on the client’s policy for extension of coverage. That would also create an avenue for notice of the cancellation of that policy. Unfortunately, that is not often practical since most insurance carriers are fearful that doing that opens the door to the risk of the entire PEO rather than just the worksite employees. The liabilities of carve-out arrangements can be complicated and is a subject that I have previously addressed in PEO Insider.

Surprisingly, another issue of great importance deals with all client service agreements. Remarkably, especially in this age of the availability of so much technology to copy and preserve documents, an issue that I have frequently encountered is that many PEOs have lost their client service agreements. I know that many readers will read that and believe that it cannot happen to their company. I am just telling you that it can and that it does happen at PEOs of all sizes and sophistication. In a complex litigated case or one with high exposure, the loss of the client service agreement creates multiple challenges for your legal team, especially when your counsel is trying to get the PEO out of that exposure. The client service agreement is the foundation of the PEO/client relationship and is essential in any effort to get the PEO extricated from litigation. When that client service agreement doesn’t exist anymore, it creates significant logistical challenges to the PEO’s legal team.

Another issue I have encountered that is just as troubling occurs when one party signs the client service agreement but not the other, or the Agreement has not been signed at all. I was surprised how many hands went up at the Operations Workshop when I asked the audience if they had that issue with their agreements. It is surprising how frequently this happens. An agreement that is not fully signed is just a piece of paper, and it makes it easy for an attorney or carrier to argue that there was never any contract between the PEO and the client. Making sure that the client service agreement is signed and dated by both parties is vital. Accordingly, when client service agreements are reviewed, and any agreement is not fully signed, then the missing signature(s) should be secured. In addition, those agreements should also be electronically scanned and protected in your database in a manner that allows you to easily access those documents. This will also make it easier for your company at the time of any renewal.

As you can see, most of the issues discussed above can be avoided with a simple process in place. If your company does not have these processes in place, I would encourage you to do so.