Risk management experts, safety experts, accountants, actuaries, and other professionals make the distinction between direct and indirect costs of accidents, lawsuits, and similar events.
For example, the cost of turnover in the HR That Works Turnover Cost Calculator includes direct costs (such as paying for a Help Wanted ad) and indirect costs (such as reduced growth due to lack of manpower).
Two of the most commonly insured employee risks are those for work-related injuries and employment-practice claims. The direct costs associated with a Workers' Compensation injury are typically medical expenses and expense reimbursement, which the Workers Compensation carrier usually pays.
We usually recommend that our clients pay the compensatory portion of the claim because if they do not, the insurance company will pay it and then recover those costs by increasing your experience modifier over the next three years; in effect, the insurer finances the claim. If you have questions about this approach, you may want to talk to an agent.
In addition to the increase in the experience modifier (MOD) and cost of future insurance, there are also indirect costs:
- Damage to property (building, tools, machinery, etc.)
- Emergency supplies and their cost
- Possible media exposure or damage to brand
- Investigation time and claim-management time
- Effect on employee morale
- Overtime and costs of replacing the employee
- Increased experience modifier
- Damage to client relations if an accident occurs on site
- Injury to third parties
- Additional legal fees
Of course, these ratios depend on the type of claim or injury, the type of business, days lost from work, and so forth. For example, workers' compensation outcomes and cost patterns can vary significantly by industry; see Sheet Metal Manufacturing Workers Compensation for an industry-specific illustration.
When it comes to an employment-practices claim, direct costs are attorney fees, litigation costs, and any settlement or verdict payout. Indirect costs include loss of employee morale, damaged customer and client relations, copycat claims, and loss of institutional knowledge, training, and experience.
The risk-management literature reports a wide range of expert opinion on the ratio of direct to indirect costs. Only one out of many surveys identifies indirect costs as lower than a 1:1 ratio to direct costs, while some extreme cases report indirect costs as much as 20 times the direct costs—for example, when an expensive piece of machinery is destroyed.
Based on practical experience, a conservative assumption in many circumstances is at least a 1:1 ratio. You might, for instance, pay $50,000 to settle a lawsuit and incur another $50,000 in indirect costs to replace and retrain staff. Often these indirect costs are uninsurable and can dwarf the insurable costs.
Interestingly, the indirect-cost ratio has been diminishing as medical and legal expenses continue to rise.
Factors that affect direct vs indirect cost ratios
Frequently Asked Questions
What is the difference between direct and indirect costs?
Direct costs are those easily attributable to a claim, like medical bills or settlements; indirect costs are secondary effects such as lost productivity, training replacement staff, and reputational harm.
Should an employer pay the compensatory portion of a workers' comp claim?
Many advisors recommend paying compensatory portions when feasible because letting the insurer pay can increase your experience modifier and future premiums.
How can indirect costs affect my insurance costs?
Indirect costs themselves may be uninsurable, but they can lead to higher insured costs over time by increasing your experience modifier and overall claims history.
Are there industries where indirect costs are higher?
Yes; industries with expensive equipment or high skill requirements often see larger indirect-cost multiples compared with direct costs.