In this time of tremendous distress for the financial servicessector, the workers' compensation industry continues to functionquite well, with active competition for business and a shrinkingresidual market.

In fact, the calendar year and accident year underwritingresults are approaching break-even status, which is a necessity inthis investment climate if the industry hopes to earn a reasonablereturn on its capital.

However, a low-interest-rateenvironment that has persisted for several years, combined with thedismal short-term performance of the equity markets, continues toleave the line with post-tax returns that barely meet theindustry's cost of capital.

NCCI's annual “State of the Line” workers' comp market report,released this past May at our Annual Issues Symposium in Orlando,forecast that a series of challenges may negatively impact the linein the coming months.

As a result, in our annual forecast for the market, NCCI changedits short-term view of the line from “optimistic” to “guarded,” andthe long-term outlook for workers' comp to “cautionary.”

NCCI's preliminary 2008 analysis indicates that the workers'comp combined ratio for private carriers was 101–unchanged from2007.

This combined ratio is low by historic standards. However, thepattern of combined ratios for the last five years is starting tolook a lot like the pattern in the peak of the last underwritingcycle in the mid-1990s. (In this environment, underwritingdiscipline may well become a priority given the low interest ratesand equity market turmoil.)

It's always important to note that California is large enough toimpact the countrywide numbers for the line. NCCI estimates thatexcluding California raises the countrywide calendar year combinedratio about five points this year.

The investment gain associated with workers' comp insurancetransactions returned to the 10 percent level it has been near forseveral years. The investment gain ratio remains dramatically lowerthan the late 1990s, when interest rates were higher and the stockmarket produced large gains.

Combining the underwriting loss with the investment gains, theresult is a pretax operating gain of 9 percent (see accompanyinggraph).

This operating result is reasonably close to the industry'slong-term cost of capital, assuming that the assets supporting thesurplus earn a reasonable return over time.

ACCIDENT-YEAR RESULTS

Analyzing experience on an accident-year basis can provideadditional insights about the underlying performance of long-taillines like workers' comp without the distortions of prior-yearreserve adjustments.

NCCI estimates the combined ratio for accident year 2008 at 100,meaning that the industry experienced its sixth-consecutive year ofno underwriting losses on an accident-year basis.

The current accident-year underwriting cycle peaked in 2006 at acombined ratio of 85. Since 1999 (the bottom of the current cycle),the combined ratio has declined by 58 points. Today, however, it isessentially identical to the calendar-year result at 101.

The exclusion of California from the 2008 countrywideaccident-year numbers leaves the accident-year combined ratiovirtually unchanged.

NET WRITTEN PREMIUMS

Net written premiums, including the state funds, had a thirdyear of decline in 2008, dropping more than 12 percent to $39billion, while premium for private carriers dropped by about 10percent, to $34 billion.

This is the largest drop in workers' comp net written premium inmany years, driven by significant price decreases resulting frombureau-filed decreases and carrier actions, as well as the impactof the dramatically slowing economy in the last half of 2008.

RESERVE POSITION

The private carrier reserve position deteriorated slightly in2008 for the first time in seven years. NCCI's estimate of thereserve position for private carriers as of year-end 2008 showsa
$6 billion deficiency.

After allowing for the permissible discounting of the indemnityreserves for lifetime pension cases, the reserve position becomesessentially one of adequacy.

NCCI's analysis shows that substantial progress has been made inreserve positions over the last seven years. And with the cycleturning, the industry will need to continue to work hard tomaintain its strong reserve position.

CLAIM COSTS

NCCI estimates that the average workers' comp indemnity claimcost increased 5 percent in 2008. This follows a pattern in recentyears that has seen indemnity claim costs increase between 1.5percent and 5 percent each year–generally in the neighborhood ofthe 3.5 percent annual change in average wages over the same timeperiod.

Medical average claim costs per lost-time claim continued toincrease in 2008, although the increases have tempered a bit in thelast few years.

NCCI estimates that average medical claim costs per lost-timeclaim increased by 6 percent in 2008. This is the third-straightyear that the average costs have increased about 6 percent.

NCCI has seen some favorable development in medical costincreases for accident years 2004-to-2006, and we are encouragedthat some of the industry's efforts to control medical costs appearto be paying off. NCCI's studies of prescription drug costs havedefinitely shown some favorable trends in that significant costcategory in recent years.

FREQUENCY DECLINING

Based on a preliminary analysis of data in NCCI states, thefrequency of lost-time claims per 100,000 workers declined 4percent in 2008–greater than the 2.6 percent decline in 2007 (seeaccompanying graph).

Our research further indicates that the decline in claimfrequency is a long-term phenomenon related to improved technologyand its application in the economy to create ever-safer workplacesover time.

Some have speculated that things might be different in thisdownturn given its likely depth. However, our research shows thateven in the Great Depression, as well as the deep downturns of1973-to-1974 and 1981-to-1982, manufacturing injury rates declined.New research by NCCI's economists explains that the driving forcebehind the reduction in frequencies relates to changing rates ofjob creation and job destruction during the economic cycle.

Frequency has declined quite consistently for all injury typesexcept Permanent Total Disability. Although PTD frequency declinedfrom 1998-to-2003, it has been rising since then.

Our preliminary research as to the cause has ruled out the mostobvious explanations–law changes, aging of the work force and aparticular cause of injury.

Other explanations under investigation include interaction ofthe workers' comp system and Medicare set-asides for settled claimsand the Social Security Disability Income system.

RESIDUAL MARKET

Depopulation of the residual market continued at a rapid rate in2008. Premium dropped about 30 percent in 2008 and is now at about$700 million–less than half the volume that it was in 2004.

While a few states continue to struggle to depopulate theirresidual markets, the overall market share of the residual marketpools serviced by NCCI for 2008 dropped to about 6 percent. It isless than 5 percent in states where NCCI calculates the rates forthe residual market.

This is a great improvement from the 13 percent market-sharepeak that was reached in 2004 for this cycle.

The combined ratio for the residual market pools continues therecent pattern of being in the 105-to-115 range. The combined ratiohas drifted up a bit in recent years as the pools have shrunk,leaving the more challenging risks in the residual market.

However, just four states contribute almost 75 percent of thecurrent policy year underwriting loss, leaving most pools at ornear our self-funded objective.

A GUARDED OUTLOOK

As noted above, NCCI continues to watch several challengesfacing workers' comp insurers, including:

o The underwriting cycle is entering a periodof uncertainty.

o Medical costs remain a significantchallenge.

As medical costs continue to increase faster than wages, manystates continue to look for ways to control this factor in theirworkers' comp systems. We expect that NCCI's medical data call willhelp to further define the issue beginning in 2010.

o Indemnity claim costs also continue tooutpace wage increases.

o Net written premiums, including the statefunds, had a third year of decline in 2008–the largest drop inworkers' comp net written premium in many years.

o On the legal front, NCCI is seeing anincreasing number of legislative proposals and judicial actionsthat may serve to increase indemnity costs, as well as undo some ofthe reform efforts of recent years.

With the political climate changing, and relatively good resultsexperienced in the last few years by the insurance industry, somemay feel that now is an opportune time to review benefit levels andpast reforms.

o Low investment yields seem likely to be afact of life for the foreseeable future.

Needless to say, the lower the investment yields, the lower thecombined ratio needs to be to maintain a reasonable return oncapital.

o The political situation in Washington, withproposals to revamp the nation's health care and financialregulatory systems, makes for a period of uncertainty.

o In positive market news, frequency continuedto decrease in 2008, and depopulation of the workers' comp residualmarket continued at a rapid rate in 2008.

In sum, all of the major financial performance measures for theworkers' comp insurance industry continued to perform well in2008.

However, the series of challenges outlined above make NCCI'soutlook guarded regarding market performance in the comingmonths.

Given these times of uncertainty, NCCI will continue to workwith all stakeholders to help ensure that rates and loss costs areadequate, to provide unbiased quantification of the impacts oflegislative reform proposals, and to strive for self-fundedresidual markets.

In addition, we will continue to produce pertinent and timelyresearch to help stakeholders understand current and emergingtrends impacting workers' comp.

Stephen J. Klingel is president and CEO of NCCIHoldings Inc. in Boca Raton, Fla.

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NU Data Insights: Workers' Comp Results – Top 50 Writers

NU Data Insights: Workers' Comp Results By State

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