Over the past year the majorratings agencies have expressed concern over challenges theWorkers' Compensation line has faced during the recession, as wellas the continued pressures it faces in achieving long-termprofitability. In its January briefing, Standard & Poor's wentso far as to describe Workers' Comp profitability as “missionimpossible.”  

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

Despite a favorable trend toward reduced claim frequency since1997, the National Council on Compensation Insurance (NCCI)indicated an uptick in frequency in 2010. This occurred as theeconomy began to recover and companies began to hire more workers.Furthermore, the Obama administration's health-care reforms creatednew and unprecedented uncertainties associated with potentialmedical-loss cost-shifting to Workers' Comp.

Workers' Comp carriers may no longer be able to rely oninvestment income or reserve releases to compensate forunderwriting deficiencies. Although there have been someencouraging signs of firmer underwriting and rate increases inexcess of 5 percent from the most recent Council of InsuranceAgents and Brokers report, notable variability by carrier and stateremains.

As a result, the ratings agencies (as well as reinsurers) arerequesting detailed documentation to determine who is obtaining theeffective rate changes—and who is not. In addition to followingindustry trends by segment to locate areas of relative premiumgrowth and profitability, carriers are being evaluated on theirunderwriting decisions and claims mitigation.

PREDICTIVE MODELING ADVISED

Workers' Comp carriers not adopting strong underwriting orpredictive modeling could be viewed as being adversely selectedagainst—and could lose key market share to those modelers whoare.

Although predictive modeling of claims has been implemented bymany in the industry and has proven effective over the past severalyears, its adoption on the underwriting side is still relativelynew. It is, however, finally gaining acceptance as carriers attemptto differentiate themselves as they seek long-termprofitability.

Well-publicized natural and man-madecatastrophes account for only about 7 percent of insurers'notable capital and surplus impairments that trigger regulatoryaction and concern. Although catastrophe risk tends to makeheadlines on the property side, ratings agencies have beenrequesting and analyzing carriers' Workers' Comp-modeled exposuressince the terrorist attacks of September 11 and especially since2006 when it was incorporated into A.M. Best's supplemental ratingquestionnaire (SRQ).

Terrorism-catastrophe exposure continues to be of particularinterest to them for several reasons. First, unlike propertycarriers, Workers' Comp carriers are obligated to cover terrorismfor every risk in their portfolios. Second, unlike the natural catperils, A.M. Best requires a cedent to model the severityassociated with the highest potential deterministic attackscenarios as well as their frequency as a percentage ofpolicyholder surplus (PHS). This could deliver some notably highresults with the potential for stress testing. Workers' Compterrorism modeling requires a high degree of expertise andunderstanding of complex human-exposure data in order to obtainaccurate results.

Third, although the Terrorism Risk InsuranceProgram Reauthorization Act of 2007 (TRIPRA) provides a federalbackstop for many Workers' Comp carriers, it expires at the end of2014–and its renewal is uncertain. And if it were to be scaled back(as proposed by the Obama administration in 2010), it could createmarket and ratings-agency uncertainty with any coveragegaps—opening the possibility of some ratings actions beingtaken. 

Carriers that currently have notable backstop TRIPRA protectionand losses as a high percentage of PHS should be proactive in theirratings-agency discussions while improving the accuracy of theirdata and modeling output. They should also proactively pursueexposure mitigation through portfolio-accumulation management andother reinsurancesolutions.         

TRIGGERS THAT WILL DRAWATTENTION   

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

Additionally, it has been nearly impossible to accuratelyestimate medical inflation, increases in longevity, changes in theworkplace and constantly legislated indemnity over the course of a20-year time horizon. Reforms enacted in the mid-2000s resulted inlower premiums and loss costs and favorable frequency and severitytrends.

However, Workers' Comp medical expenses, which are higher thanthe overall medical Consumer Price Index, outpaced the recenttrends in lower claims frequency. According to the NCCI, medicalcosts now represent a staggering 58 percent of total Workers' Comploss costs, up from 49 percent in 1991. As these trends change, thepatterns from the past either may not simply repeat or aredifficult to capture. The worst cases of adverse-reservedevelopment occur when there are material and unpredicted changesin the underlying trends, as we are experiencing in the currenteconomic environment.

As a result, estimation of the potential impact of futurechanges in general and medical inflation on current net reserves isbeing requested by A.M. Best in its SRQ enterprise-risk-managementsection. Although property insurers may be able to use a narrowrange for stressing their reserves for inflation, Workers' Compcarriers need to stress more conservatively (for anticipated andunanticipated inflation scenarios) as medical-cost inflationcontinues to outpace general inflation.

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

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

Contemplating the well-established headwinds that Workers' Compis expected to face, the ability of a carrier to focus onprofitable underwriting disciplines; invest in cutting-edgemodeling and actuarial and reserving practices; and exploreinnovative reinsurance solutions should enable them to setthemselves apart to the ratings agencies.