Quiet Crisis Persists In WC

A year ago, in the May 12, 2003 edition of National Underwriter, I wrote a column headlined “Workers’ Compensation: The P-C Industry’s Quiet Crisis?” That workers’ comp is still a deeply troubled line cannot be disputed. It remains a money loser for insurers, a costly aggravation for employers and, increasingly, a political hot potato for lawmakers in states across the country.

So a crisis it is but quiet it is not. Surreal might be a better description. A year ago, who could have imagined, for example, that Californians would recall a twice-elected sitting governor and replace him with an Austrian-born, former body builder-turned-actor, who made fixing the state’s dysfunctional workers’ comp system a key component of his election campaign?

Workers’ comp suffers from several major problems, many of them repeat offenders from last year. Let’s look at them one at a time:

Poor underwriting performance.

The good news is that workers’ comp underwriting performance has improved dramatically over the past few years to an estimated combined ratio of 109 in 2003.

That’s also the bad news. Paying out $1.09 for every dollar you take in means you’re losing money and lots of it. With about $33 billion in premiums, workers’ comp carriers spilled about $3 billion in red ink in 2003nearly double the workers’ comp losses paid out as a result of the 9/11 terrorist attack.

How do you stop the bleeding? Substantive, meaningful reform is the only solution a realization that many states, begrudgingly and belatedly, are only now beginning to come to terms with. Florida late last year adopted system changes expected to yield an average rate reduction of 14 percent, and California’s legislature just last month approved a major overhaul that is expected to lop between $4 billion and $7 billion from the state’s annual $22 billion workers’ comp tab.

Nationally, there were 271 bills related to workers’ comp under consideration in 38 states as of mid-April 2004, according to the Property Casualty Insurers Association of America.

Softening pricing.

Pricing throughout the commercial property-casualty sector has moderated considerably over the past 18-to-24 months, and workers’ comp is no exception. While no all-out price wars have erupted, the general softening in prices is disconcerting given that workers’ comp insurers must trim at least 12 additional points off the combined ratio to ensure reasonable rates of return.

A weak and volatile investment environment.

Investment income rose by 3.9 percent in 2003 after falling in four out of the previous five years. Despite the increase the smallest since 1991investment income remains 7 percent below the $41.5 billion peak achieved back in 1997.

Interest rates that tumbled to 45-year lows last year are the principal reason for the drop-off in investment income. Yields remained very low through the first quarter of 2004, although they have begun to tick up a bit in anticipation of Federal Reserve rate hikes later this year.

While the bear that clawed its way through insurer balance sheets for three years finally loosened its grip in 2003, the S&P 500 index was up just 0.6 percent through late April of this year. Surging stock prices in 2003 pushed total investment gains higher for the first time in three years, but were still down considerably from its peak in 1998.

Such returns are likely to be the exception rather than the rule going forward. Extreme stock market volatility and puny yields on bonds underscore the fact that all the heavy lifting in terms of generating adequate profits will have to be done through pricing and underwriting for the indefinite future, especially in long-tail lines like workers’ comp.

Reserve inadequacy.

As of year-end 2002, the workers’ comp reserve deficiency stood at $18 billion, according to the Boca Raton, Fla.-based National Council on Compensation Insurance. The billions that insurers took in reserve charges last year mean that this figure likely fell somewhat in 2003, but it is clear that eliminating this deficiency will create a drag on workers’ comp profits for years to come.

Reserve deficiencies are the leading cause of death among p-c insurers. Many once-venerable but now defunct insurers such as Reliance and Kemper had significant workers’ comp exposure and reserve deficiencies in this line that contributed to their demise.

Virtually every workers’ comp insurer has seen its ratings slip one or more notches over the past three years, causing concerns among customers, producers, regulators and investors. Reserve overhangs are a principal reason why ratings agencies remain skeptical about the prospects of the p-c insurance industry. Event though double-digit commercial rate increases were the norm through 2002 and 2003, downgrades outpaced upgrades by a ratio of nearly four-to-one.

Rapidly rising medical costs.

Private and self-insured workers’ comp medical costs totaled more than $30 billion in 2003, up at least 10 percent from the previous year.

Workers’ comp medical costs are driven by factors that affect all medical care delivery systems, but it is utilization rates, abuse and outright fraud that remain the industry’s most vexing problems. It is hardly surprising that recent legislative efforts to overhaul workers’ comp focus on these difficulties. California’s recent reforms, for example, will require injured workers to choose a doctor from a list, as with managed care plans, and will develop an objective system for assessing impairments.

o Workers’ comp and the “jobless” recovery.

The impact on workers’ comp insurers of the productivity-led economic expansion and weak job growth is generally overlooked. Businesses are producing more with less less capital equipment and (most important from a workers’ comp perspective) fewer workers.

The accompanying graph shows that the American economy shed 2.71 million jobs between February 2001 and July 2003. Since then, job growth has been tepid, until March of this year, which registered a gain of 308,000 jobs the largest increase in nearly four years.

While accelerating job creation is welcome news, there are still two million fewer people employed today than there were three years ago. For workers’ comp insurers, the job losses and miserly salary increases have meant virtually zero exposure growth over the past several years.

Massive terrorism exposure.

Terrorism is more than just a dominant theme in the presidential campaign it is also returning as a major concern for the p-c insurance industry, and for workers’ comp insurers in particular. Although the Terrorism Risk Insurance Act does not sunset until year-end 2005, uncertainty is already creeping back into the market.

The problem is more immediate and more acute for workers’ comp insurers because terrorism and war risk cannot be excluded, the benefits are prescribed by statute, losses are likely to be correlated with non-workers’ comp (for example, property losses), and there is little catastrophic reinsurance protection available.

Insurers have also investigated the possibility of establishing a workers’ comp terrorism pool in the event TRIA reauthorization fails, but a recent Towers Perrin analysis of this concept suggests that it is probably not feasible.

The nature of terrorist attacks on workers is frightening (note the examples in the accompanying table). Given workers’ comp loss scenarios of $50 billion or more in extreme cases, it is clear the case for TRIA reauthorization begins with this critical line of coverage. Short of TRIA reauthorization, an insurer’s only option will be to dramatically scale back exposure through non-renewal of accounts.

Amid recent celebrations over significant improvements in the p-c industry’s premium growth and underwriting performance, something very important seems to have been forgotten we’re still not making much money. The industry’s return on equity was just 9.4 percent in 2003well below the 12.6 percent return generated by the Fortune 500 group.

Workers’ comp which accounts for about 8 percent of industry revenues and 16 percent of commercial premiums was responsible for a not inconsequential proportion of the drag on the industry’s bottom line. There is much more to be done, so let’s get on with it.

Robert Hartwig, Ph.D., CPCU, is senior vice president and chief economist at the Insurance Information Institute in New York. He can be reached at bobh@iii.org.

Reproduced from National Underwriter Edition, April 30, 2004. Copyright 2004 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.