Over the past year the major ratings agencies have expressed concern over challenges the Workers' Compensation line has faced during the recession, as well as the continued pressures it faces in achieving long-term profitability. In its January briefing, Standard & Poor's went so far as to describe Workers' Comp profitability as “mission impossible.”

Workers' Comp statutory combined ratios have continued to increase since 2007 due to a confluence of such factors as a slow economic recovery, anemic premium growth, intense competition, rising medical costs, increasing loss severity, rate inadequacy and low long-term investment returns. With both the indemnity and medical-severity components continuing to rise, the cost of Workers' Comp insurance remains a top concern of insurance carriers and the ratings agencies.

Despite a favorable trend toward reduced claim frequency since 1997, the National Council on Compensation Insurance (NCCI) indicated an uptick in frequency in 2010. This occurred as the economy began to recover and companies began to hire more workers. Furthermore, the Obama administration's health-care reforms created new and unprecedented uncertainties associated with potential medical-loss cost-shifting to Workers' Comp.

Workers' Comp carriers may no longer be able to rely on investment income or reserve releases to compensate for underwriting deficiencies. Although there have been some encouraging signs of firmer underwriting and rate increases in excess of 5 percent from the most recent Council of Insurance Agents and Brokers report, notable variability by carrier and state remains.

As a result, the ratings agencies (as well as reinsurers) are requesting detailed documentation to determine who is obtaining the effective rate changes—and who is not. In addition to following industry trends by segment to locate areas of relative premium growth and profitability, carriers are being evaluated on their underwriting decisions and claims mitigation.

PREDICTIVE MODELING ADVISED

Workers' Comp carriers not adopting strong underwriting or predictive modeling could be viewed as being adversely selected against—and could lose key market share to those modelers who are.

Although predictive modeling of claims has been implemented by many in the industry and has proven effective over the past several years, its adoption on the underwriting side is still relatively new. It is, however, finally gaining acceptance as carriers attempt to differentiate themselves as they seek long-term profitability.

Well-publicized natural and man-made catastrophes account for only about 7 percent of insurers' notable capital and surplus impairments that trigger regulatory action and concern. Although catastrophe risk tends to make headlines on the property side, ratings agencies have been requesting and analyzing carriers' Workers' Comp-modeled exposures since the terrorist attacks of September 11 and especially since 2006 when it was incorporated into A.M. Best's supplemental rating questionnaire (SRQ).

Terrorism-catastrophe exposure continues to be of particular interest to them for several reasons. First, unlike property carriers, Workers' Comp carriers are obligated to cover terrorism for every risk in their portfolios. Second, unlike the natural cat perils, A.M. Best requires a cedent to model the severity associated with the highest potential deterministic attack scenarios as well as their frequency as a percentage of policyholder surplus (PHS). This could deliver some notably high results with the potential for stress testing. Workers' Comp terrorism modeling requires a high degree of expertise and understanding of complex human-exposure data in order to obtain accurate results.

Third, although the Terrorism Risk Insurance Program Reauthorization Act of 2007 (TRIPRA) provides a federal backstop for many Workers' Comp carriers, it expires at the end of 2014–and its renewal is uncertain. And if it were to be scaled back (as proposed by the Obama administration in 2010), it could create market and ratings-agency uncertainty with any coverage gaps—opening the possibility of some ratings actions being taken.

Carriers that currently have notable backstop TRIPRA protection and losses as a high percentage of PHS should be proactive in their ratings-agency discussions while improving the accuracy of their data and modeling output. They should also proactively pursue exposure mitigation through portfolio-accumulation management and other reinsurance solutions.

TRIGGERS THAT WILL DRAW ATTENTION

The risks of managing a long-tailed, heavily legislated line like Workers' Comp are widely known. Loss reserves are arguably one of the most difficult risks on a carrier's balance sheet to estimate and monitor, with Workers' Comp contributing nearly a quarter of the total P&C net loss and adjustment expenses.

Additionally, it has been nearly impossible to accurately estimate medical inflation, increases in longevity, changes in the workplace and constantly legislated indemnity over the course of a 20-year time horizon. Reforms enacted in the mid-2000s resulted in lower premiums and loss costs and favorable frequency and severity trends.

However, Workers' Comp medical expenses, which are higher than the overall medical Consumer Price Index, outpaced the recent trends in lower claims frequency. According to the NCCI, medical costs now represent a staggering 58 percent of total Workers' Comp loss costs, up from 49 percent in 1991. As these trends change, the patterns from the past either may not simply repeat or are difficult to capture. The worst cases of adverse-reserve development occur when there are material and unpredicted changes in the underlying trends, as we are experiencing in the current economic environment.

As a result, estimation of the potential impact of future changes in general and medical inflation on current net reserves is being requested by A.M. Best in its SRQ enterprise-risk-management section. Although property insurers may be able to use a narrow range for stressing their reserves for inflation, Workers' Comp carriers need to stress more conservatively (for anticipated and unanticipated inflation scenarios) as medical-cost inflation continues to outpace general inflation.

Of the remaining impairment triggers cited by A.M. Best, by far the single largest number over the past 40 years has been caused by inadequate pricing and deficient loss reserves. These represent approximately 40 percent of the cases. Furthermore, the Workers' Comp industry's strengthening of prior-year reserve development from the latest soft market (accident years 2007-2010) may continue to impair operating results and profitability.

Although all Workers' Comp writers are increasingly pressured by inadequate pricing, potential adverse-reserve development, regulatory changes and even catastrophe risk, those who are overconcentrated in the line and limited in their ability to grow PHS will be even more challenged and closely monitored by their stakeholders and the ratings agencies.

Contemplating the well-established headwinds that Workers' Comp is expected to face, the ability of a carrier to focus on profitable underwriting disciplines; invest in cutting-edge modeling and actuarial and reserving practices; and explore innovative reinsurance solutions should enable them to set themselves apart to the ratings agencies.

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Thinking About Revising Your WC Underwriting Policies? You&rsquo;d Better Start Now

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