WC: The P-C Industry's Quiet Crisis? Show me aline of insurance that managed to lop 15 points off its combinedratio in a single year, realized double-digit premium growth forthe second consecutive year, chopped its underwriting losses bymore than half and cut its reserve deficiency by a billion or two,and Ill show you a line that, remarkably, still has a lot ofproblems.

And so goes the never-ending saga ofworkers' compensation insurance. From balance sheet black hole inthe early 1990s to profit juggernaut just a few years later, thecommercial property-casualty industrys biggest single line ofcoverage today finds itself stuck in profit purgatory. But how canthis be?

Theres no question that moving from a calendar year combinedratio of 122 to an estimated 107 is a giant leap in the rightdirection, and that slicing underwriting losses from $6 billion to$2 billion is impressive. Twenty-plus percent premium growth isnothing to sneeze at, eitherbut is it enough? The answer isunequivocally no.

The fact of the matter is that workers' comp suffers from sevenmajor problems. These are: poor underwriting performance, softeningpricing, weak investment returns, reserve inadequacy, rapidlyrising medical costs, a slow-growth economy and massive terrorismexposure. Let's tackle them one by one:

Underwriting Performance: Lets face it. Payingout $1.07 for every dollar you take in means youre losing moneyandlots of it. With about $29 billion in premiums, workers' compcarriers spilled about $2 billion in red ink in 2002about the sameamount that was lost in the Unicover fiasco a few years back.

How do you stop the bleeding? You set unconventionally ambitiousunderwriting targets. For workers' comp, this means forcing thecombined ratio down to well below 100think close to90.

The accompanying chart suggests that underwriters are faced witha turnaround job every bit if not more daunting than the one theyengineered as decade ago.

In 1993, workers' comp insurers enjoyed a 13.3 percent return onnet worth despite running a calendar year combined ratio of 108.6(although on an accident-year basis, the figure was just 95).Between 1994 and 1997, the combined ratio ranged from 97 to 101,propelling the workers' comp RNW to a lofty 13.5 percent over theentire five-year period.

However, 1993 was on the leading edge of the Wall Street bubbleand interest rates were much higher, so a combined ratio in theneighborhood of 100 was all that was needed to ensure significantprofitability.

Price Softening: Pricing throughout thecommercial p-c sector has softened considerably over the past yearand the general consensus among industry analysts is that thepricing cycle peaked in 2002. Workers' comp is no exception.

A survey by the Washington-based Council of Insurance Agents& Brokers found that 32 percent of policies renewed with hikesof 20 percent or more in the first quarter of 2003, compared to 54percent in the second quarter of 2002.

While no all-out price wars have erupted, the general softeningin prices is disconcerting given that workers' comp insurers musttrim at least 15 additional points off the combined ratio to ensurereasonable rates of return.

Weak Investment Returns: Investment income fell2.8 percent in 2002 to $36.7 billion–its lowest level since 1994,and the fourth decline in the past five years. Interest rates at40-year lows are the principal reason for the drop-off ininvestment income, but three consecutive down years in the stockmarkets have added insult to financial misery.

Since there is nothing whatsoever that insurers can do about thedepressed earnings environment, it is painfully clear that for theindefinite future all the heavy lifting in terms of generatingadequate profits will have to be done through pricing andunderwriting.

Insurers would do well to view relatively low interest rates andpuny stock market yields as a fixture of the economic landscape,and to price their products accordingly.

Reserve Inadequacy: As of year-end 2001, theworkers' comp reserve deficiency stood at $21 billion, according tothe National Council on Compensation Insurance in Boca Raton, Fla.The billions that insurers took in reserve charges last year meanthis figure likely fell somewhat in 2002, but it is clear thateliminating this deficiency will create a drag on workers' compprofits for years to come.

While a quick amortization of the reserve shortfall is a bitterpill for insurers to swallow, shareholders and ratings agencieswill likely react favorably because uncertainty is reduced whilefuture earnings opportunities are enhanced. The unencumberedcapital of an insurer with little reserve overhang will also finditself in a better position to seize growth opportunities in theyears ahead.

Rapidly Rising Medical Costs: Private andself-insured workers' comp medical costs totaled about $30 billionin 2002, up at least 10 percent from 2001. The increase mirrorsnational trends, with national health care costs now exceeding $1.4trillion, or 14 percent of gross domestic product.

Workers' comp medical costs are driven by factors that affectall medical care delivery systems, as well as some that are morespecific to workers' comp. Surging pharmaceutical costs have been amajor contributor to higher health care costs for all financiers ofmedical carewith some workers' comp carriers seeing costs for themost commonly prescribed drugs rise by 100 percent or more over thepast few years.

New and costly threats are never far away. Had hundreds orthousands of health care workers been infected on the job by theSARS virus, as they were in several Asian nations and Canada, theassociated workers' comp costs would have been staggering.

Utilization rates, abuse and outright fraud also remainproblematic, although more so in some states than others.

Workers' comp insurers are doing what they can to tame runawaymedical costs, but they are, in the end, the proverbial flea on theback of the health care elephantaccounting for only about fourpercent of national health care expenditures.

During the early 1990s, the national debate on health carereform contributed to the demise of fee-for-service workers' compsystems, ushering in the era of managed care. No such obvioussolution is on the horizon today, leaving insurers no option otherthan to recoup as much of these costs as possible through priceadjustments.

A Slow-Growth Economy: The exposure base forworkers' comppayrollsis nearly stagnant and the U.S. labor forcehas shrunk by two million workers over the past two years. Theunemployment rate in April 2003 was 6 percent compared to 5.8percent for all of 2002, 4.8 percent in 2001 and 4 percent in2000.

Looking ahead, the economy is expected to grow by 2.4 percentthis year and 3.5 percent in 2004–about half as fast as in 1999 and2000. This means the workers' comp exposure base will grow onlymarginally over the next two years.

The danger for workers' comp insurers is that the only way togrow in a slow-to-no-growth economy is to steal another companyscustomer, usually by offering a lower price. This scenario amountsto little more than rearranging deck chairs on the Titanic. Thesame risks get swapped around among various insurers at ever-lowerprices, while everyone pretends not to notice the listing of theship as it begins to slowly to sink beneath an ocean of redink.

Massive Terrorism Exposure: The Taliban andSaddam Hussein have been vanquished, but the threat of terroriststrikes against the United States and its 135 million workersremains very real. The exposure has not been fully priced intopolicies for employers in the most at-risk areas, and insurancedepartments are balking at the hikes and catastrophe loadings beingfiled.

As a result, insurers and risk modelers find themselves in themidst of what amounts to a long-term program to educate regulatorsand policymakers thatif the post-Hurricane Andrew experience is anyguidewill eventually be successful.

Amid the jubilation over the recent significant improvement inthe p-c insurance industrys premium growth and underwritingperformance, something very important seems to have beenforgottenwere still not making any money. The industrys return onequity–despite the fastest premium growth in 16 years, and the bestsingle-year improvement in underwriting performance in a decade–wasan embarrassing one percent last year. Workers' comp, whichaccounts for about 8 percent of industry revenues and 16 percent ofcommercial premiums, was responsible for a not inconsequentialshare of that poor performance.

Investors are not happy. Lets not test their patience.

Robert Hartwig, Ph.D., CPCU is senior vice president andchief economist at the Insurance Information Institute in New York.He can be reached at [email protected].

Reproduced from National Underwriter Edition, May 12, 2003.Copyright 2003 by The National Underwriter Company in the serialpublication. All rights reserved. Copyright in this article as anindependent work may be held by the author.