State Fund Mired In Actuarial, Legal Issues

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Amidst squabbling by auditors over the strength of its reserves,a listing State Compensation Insurance Fund will soon be given newdirectives by the California insurance commissioner to help keep itafloat until an overhaul of the workers compensation system iscomplete.

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State Funds auditors, PricewaterhouseCoopers, and its appointedactuary, Milliman USA, disagree on the amount of reserves needed bythe State Fund, with PwC claiming the reserves are short by $1billion. The DOI said its own findings are similar to those ofPwC.

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The State Fund said in a July 22 statement that it had issuedaudited 2002 financials and that PwC stated that in its opinionState Funds net loss and loss expense reserves should have beenincreased to $9.8 billion, from the $8.8 billion shown in thefinancial statements.

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“The California Department of Insurance concurs that State Fundshould increase its reserves to the level estimated by PwC. StateFund does not agree,” the statement said.

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The statement continued that State Fund estimated its reservesusing “actuarial methods and assumptions about medical andindemnity utilization and costs for as much as 30 years into thefuture, using its best judgment and its significant knowledgeofCalifornia workers compensation insurance.”

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According to State Fund, Milliman USA, in its actuarial opinion,stated that State Funds carried reserves “were reasonable, inconformity with actuarial standards, and met the requirements ofCalifornia insurance law.”

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PwC, however, explained in its audit report that its higherestimates were derived using “several additional actuarial methodsincluding an incurred loss development methodology.” The reportcontinued that State Fund has consistently relied on “paid lossdevelopment and Milliman USA methodologies to estimate loss andloss expense reserves.” Paid loss development is not affected bychanges in case reserve adequacy, PwC noted in its report.

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Norman D. Williams, a spokesperson for Commissioner JohnGaramendi and the California Department of Insurance toldNational Underwriter, “Our own exam concurred with the PwCaudit in that they needed to increase their reserves by $1 billion.And our exam is very similar to an audit.” He added that thedepartments exam was also conducted during the same time period asPwCs in 2002.

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A PwC spokesperson said the company could not comment on thesituation. Calls to State Fund were also not returned at presstime.

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Jim Bartie, vice president and senior analyst with Moody's inNew York, explained that typically several methodologies are usedby actuaries to come up with their results.

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“We can all probably be pretty sure that each of the firmslooked at multiple methods, and so it becomes a question of whichmethod you put more reliance or credibility in,” he said. “Thereare reasons on both sides to want to use one method versus theother.”

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Particularly in a line of business like workers' compensation,and in a state like California, he noted, the methods can produce“pretty dramatic differences, as far as answers.”

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He continued that the difference would be less so in, forexample, automobile claims in a state like Illinois where the courtsystem is stable. “What ends up happening, particularly in aresidual market, you can tend to get pretty dramatic swings in thiscase reserve adequacy issue, which could throw off the incurredmethod, but which would not effect the paid method.”

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This could make the case-incurred method “challenging,” hecontinued, because “as the State Fund grows, and the claims staffgets strained by the workload, they may be unable to have accurateestimates for a particular year on the value or payment of all theworkers' comp cases.

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On the paid side, he said, “you have similar challenges” becauseas the State Fund grows, “what tends to happen is the paymentsas apercentage of what ultimately gets paid outcan drag a little bitfor similar reasons, which is that the size of the staff doesn'tgrow consistently with the size of the Fund.”

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In this case, he said, you could have paid loss methods thatcould lag and then have a period of catching up.

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What affect would a shortfall of $1 billion have on theCalifornia workers' comp market? “Ultimately that shortfall has tobe reflected in premium rates,” Mr. Bartie said. “That's probablythe short-term effect–that premium rates would be pressured to behigher.”

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Commissioner John Garamendi said in a statement that he wouldconstruct a plan to address State Funds “immediate problems.” Healso said that, by July 29, he will notify State Fund “of the stepsit must take to address its reserve shortfall,” adding that thedepartment looks forward “to a cooperative effort with the boardand management.”

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Mr. Williams declined to say what type of recommendations Mr.Garamendi might make. “The plan that we work with State Fund to puttogether, by law, is a confidential plan. So I can't discuss whatit may entail,” he said.

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He said that the issue with State Fund “illuminates the need forsystem reform,” and that State Fund's condition will not beresolved until the workers compensation system is reformed becausecosts are too high.

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“The most important part to [Mr. Garamendi] is that there is aconference committee that will convene in the next couple of weeksto take up workers' comp and they must give us some substantialreform,” he said.

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On July 10, the Assembly Insurance Committee and the SenateIndustrial Relations Committee moved all pending workers' compbillsabout 20to a bipartisan Conference Committee that willconsider broad reforms to the system.

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The panel, he said, consists of three Assembly members and threeSenate members who will “take all of the good ideas from the billsand put them together in a piece of legislation.” This way, hesaid, the “good ideas will be considered and we hope thatsufficient reform is put into place.”

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In the meantime, he said, Mr. Garamendi wants to see that StateFund is operating and that reserves are adequate. “The reserves arevery troubling,” he said. “One billion dollars is a lot of moneyand this is something we've been working with State Fund on sinceMr. Garamendi took office.”

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Early in March, Mr. Garamendi also devised a plan with the StateFund to address some of its financial problems, noting that itspremium writings had grown too rapidly because of reduced businessin the state by private insurers. Specifics of the plan includedputting through a rate increase, reducing broker commissions andscrutinizing business submitted by brokers as well as puttingstronger underwriting practices in place.

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Mr. Williams said the department worked cooperatively with StateFund on the plan, adapting it over time.

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Mr. Williams continued that he could not comment on whatrecommendations Mr. Garamendi might make in the future, butreiterated that the department has been working with State Fund onthe guidelines.

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Meanwhile, a legal action filed by the State Fund accusing theDepartment of Insurance of improper efforts to control itsoperation is on hold until a hearing scheduled Aug. 5.

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In a statement announcing the lawsuit filed in the stateSuperior Court in San Francisco on May 27, State Fund said itscomplaint seeks to “clarify [the commissioner] and CDI's authorityas well as to determine the applicability of risk-based capitalstatutes to State Fund.”

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State Fund said Mr. Garamendi's threats to “usurp control” fromits board of directors and management were improper because itbelieves that RBC statutes don't apply to State Fund.

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“I really can't comment” on the lawsuit,” Mr. Williams said.“There is a hearing scheduled for Aug. 5 at which point they willhear State Fund's injunction and also our demur on that issue.”


Reproduced from National Underwriter Property &Casualty/Risk & Benefits Management Edition, July 28, 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.


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