Workers' Comp Market Looking Good In Short Term, But Threats Still Looming

Where does the prospect of increasing health care costs, a faltering economy, a challenging investment environment and a rapidly changing political environment leave decision-makers in the workers' compensation insurance market?

In May, the National Council on Compensation Insurance issued its annual "State of the Line" workers' comp market analysis, reporting that carriers turned in solid overall results in 2007 and that the short-term view for the market is optimistic.

However, the long-term outlook for workers' comp remains cautionary, due to a collection of uncertainties that continue to confront the market.

In real terms, this year's NCCI report indicates that the workers' comp calendar-year combined ratio stands at 99--the second-consecutive year that the line has realized an underwriting profit, albeit with a six-point deterioration from 2006.

However, NCCI continues to observe that a low interest rate environment, combined with the modest performance of the equity markets, have left the line with post-tax returns on surplus that are far below record levels--and these results barely return the industry's cost of capital after the significant payments of federal income taxes.

In other 2007 results, calendar-year net written premium declined for private carriers for the first time in eight years. (It was the second straight year of workers' comp premium declines, inclusive of the state funds.)

We also reported that the 2007 accident-year combined ratio came in at 92. On an accident-year basis, the current underwriting cycle peaked in 2006, with an 84 combined ratio (more than a 55-point improvement since 1999).

As NCCI's "State of the Line" report (available at www.ncci.com) points out, there is a significant impact on the countrywide numbers caused by the state of California. Excluding California would increase the calendar-year combined ratio by about five points--to more than 104. And excluding California from the accident-year combined ratio would raise it from 92 to about 97.

In terms of pricing, declines in workers' comp insurance rates accelerated in 2007. Significant reductions continued in California and Florida, since the reforms in those states favorably impacted costs and improved marketplace conditions.

Other key findings in the NCCI analysis included the following:

o Favorable frequency trends continued--and along with payroll increases, were more than enough to offset medical and indemnity claim cost increases.

This resulted in bureau loss cost and rate filings that generally were downward last year, with a couple of notable exceptions.

o Although frequency continued its downward path during 2007, it did so at a slower rate than the last couple of years.

For NCCI states, the frequency decrease for 2007 was 2.5 percent. (The prior two years had very large frequency decreases of almost 7 percent in both 2006 and 2005.) The 2.5 percent decrease in 2007 is closer to the longer-term trend for the frequency decline.

Of note, NCCI has found that frequency tends to decline during periods of economic slowdown. Therefore, despite the ease from declines of previous years, the frequency decline should continue.

o NCCI's estimates of the reserve positions of private carriers improved to about a $2 billion deficiency at year-end 2007. After consideration of the allowable discounting of the indemnity reserve of lifetime pension cases, the reserve position is fully adequate.

This is in sharp contrast to the $21 billion deficiency at year-end 2001. Achieving reserve adequacy is one of the major accomplishments for the industry in the last five years.

o Depopulation of the residual market continued at an accelerating pace in 2007 and 2008. Premiums dropped to about $1 billion for policy-year 2007, down from $1.2 billion in 2006.

Overall, the market share of the residual market pools serviced by NCCI for 2007 dropped to about 8 percent, down from about 10 percent in 2006. This is a great improvement from the 13 percent market share peak reached in 2004 in this cycle.

o NCCI is estimating that the average workers' comp indemnity claim cost increased 4 percent in 2007. This is slightly lower than the 5 percent increase in 2006, and is only modestly higher than the change in average wage levels last year.

As noted at the outset, NCCI's short-term view of the line is positive. However, even in this time of excellent underwriting results and good financial performance, areas of concern remain.

Among these issues are low investment yields, with the potential of a stagnant stock market. That means combined ratios need to be at or near historic lows for insurers to earn an adequate return on capital. Additionally, the current underwriting cycle is past its cyclical peak.

Other issues of concern include:

o Medical costs, which continue to increase at or near double-digit rates, pushing health care to nearly 60 percent of the total losses for NCCI states.

The increased interest in medical benefits and costs on the part of public policymakers, regulators and carriers is creating the demand for ever more detailed medical data.

In 2007, for example, NCCI was called on to provide pricing analysis on more than 100 legislative proposals. Of those, approximately 30 percent included a medical component.

As medical costs escalate, states continue to develop various cost-containment proposals. And they depend on the availability of relevant, reliable information to assist them in forecasting the impact of proposed reforms.

NCCI anticipates that its establishment of a new "Medical Data Call"--announced in late 2007--will provide an important new source of data that will begin to meet the informational needs of all market participants.

The development of the new data call is by necessity a multiyear, highly detailed process. However, the availability of comprehensive new medical data will further allow NCCI to provide analysis and support to workers' comp stakeholders seeking better methods for controlling health care costs.

o The slowing economy, which has dominated the headlines for the better part of a year, will have an impact on workers' comp.

In general, recessions adversely affect growth in payrolls--and, hence, growth in workers' comp premium. It is not surprising that in the year after a recession starts, salaries tend to either decline or significantly slow their rate of growth.

Employment trends also stand to be affected. Recessions historically have the greatest impact on the more hazardous manufacturing and construction sectors.

Manufacturing has traditionally been the most affected, but today the construction sector seems likely to be most severely impacted due to a downturn in residential and commercial building.

Because workers' comp premiums in construction are higher than most other categories--since rates are higher--the negative impact on premiums might be especially pronounced.

The "good news" about economic slowdowns is that they do tend to place downward pressure on claim frequency, due to a decrease in the number of inexperienced workers in the work force. In fact, in the most recent recessions, frequency dipped noticeably.

If claim frequency falls, will both indemnity and medical severity decline as well? While the implications of a recession on indemnity and medical severity are less well established, we believe we can make some logical assumptions.

To the extent that recessions result in a reduction in wage growth, that will likely place downward pressure on growth in indemnity severity, since increases in wages are a key driver of increases in indemnity benefits.

(For more on how the slowing economy will affect workers' comp, see the accompanying sidebar.)

o The regulatory landscape is also shifting, impacting workers' comp.

Indeed, after the 2006 midterm elections, the political landscape for many states changed considerably. As a result, NCCI observed increased legislative activity in 2007 compared with 2006--a pattern we expect to see continue into 2008.

In some states, there has been renewed interest in revisiting issues that had been dealt with in past reform efforts. And other states have expressed interest in reviewing reforms that have been in place for over a decade.

Given the relatively good results posted for workers' comp insurers and for the property-casualty industry in general, some parties may feel that now is a good time to review benefit levels, administrative guidelines and cost controls--to the possible detriment of efficiently run and well-balanced workers' comp systems.

o On the terrorism front, Congress approved a seven-year extension of the Terrorism Risk Insurance Program, created in the aftermath of the Sept. 11, 2001 attacks to provide $100 billion in insurance capacity for terror-related commercial property-casualty risks.

President George W. Bush signed the bill--the Terrorism Risk Insurance Program Reauthorization Act of 2007--on Dec. 26, extending the current program through 2014.

The bill eliminated the distinction between foreign and domestic acts of terrorism, but otherwise kept the program largely intact under its former terms.

A key component of the first House bill--the requirement that most insurers provide coverage for nuclear, chemical, biological and radiological attacks by 2009--was dropped. Instead, the Senate's call for a year-long study of the NBCR threat was adopted.

Despite some characterizations of TRIA as an insurance industry "bailout," NCCI's modeling shows that under current law, for 99 out of every 100 modeled scenarios, the federal government would pay virtually nothing.

As reported above, the workers' comp insurance industry financial results were solid in 2007.

Moving into 2008, NCCI will continue to work with all stakeholders to help ensure that rates and loss costs are adequate, to provide unbiased quantification of the impacts of legislative reform proposals, and to strive for self-funded residual markets.

These objectives will help to maintain a healthy workers' comp market--able to deliver promised benefits quickly, fairly and efficiently to the injured worker and to provide the proper incentives to create the safest workplaces possible.