In this time of tremendous distress for the financial services sector, the workers’ compensation industry continues to function quite well, with active competition for business and a shrinking residual market.
In fact, the calendar year and accident year underwriting results are approaching break-even status, which is a necessity in this investment climate if the industry hopes to earn a reasonable return on its capital.
However, a low-interest-rate environment that has persisted for several years, combined with the dismal short-term performance of the equity markets, continues to leave the line with post-tax returns that barely meet the industry’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 line in the coming months.
As a result, in our annual forecast for the market, NCCI changed its short-term view of the line from “optimistic” to “guarded,” and the 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 from 2007.
This combined ratio is low by historic standards. However, the pattern of combined ratios for the last five years is starting to look a lot like the pattern in the peak of the last underwriting cycle in the mid-1990s. (In this environment, underwriting discipline may well become a priority given the low interest rates and equity market turmoil.)
It’s always important to note that California is large enough to impact the countrywide numbers for the line. NCCI estimates that excluding California raises the countrywide calendar year combined ratio about five points this year.
The investment gain associated with workers’ comp insurance transactions returned to the 10 percent level it has been near for several years. The investment gain ratio remains dramatically lower than the late 1990s, when interest rates were higher and the stock market produced large gains.
Combining the underwriting loss with the investment gains, the result is a pretax operating gain of 9 percent (see accompanying graph).
This operating result is reasonably close to the industry’s long-term cost of capital, assuming that the assets supporting the surplus earn a reasonable return over time.
Analyzing experience on an accident-year basis can provide additional insights about the underlying performance of long-tail lines like workers’ comp without the distortions of prior-year reserve adjustments.
NCCI estimates the combined ratio for accident year 2008 at 100, meaning that the industry experienced its sixth-consecutive year of no underwriting losses on an accident-year basis.
The current accident-year underwriting cycle peaked in 2006 at a combined ratio of 85. Since 1999 (the bottom of the current cycle), the combined ratio has declined by 58 points. Today, however, it is essentially identical to the calendar-year result at 101.
The exclusion of California from the 2008 countrywide accident-year numbers leaves the accident-year combined ratio virtually unchanged.
NET WRITTEN PREMIUMS
Net written premiums, including the state funds, had a third year of decline in 2008, dropping more than 12 percent to $39 billion, while premium for private carriers dropped by about 10 percent, to $34 billion.
This is the largest drop in workers’ comp net written premium in many years, driven by significant price decreases resulting from bureau-filed decreases and carrier actions, as well as the impact of the dramatically slowing economy in the last half of 2008.
The private carrier reserve position deteriorated slightly in 2008 for the first time in seven years. NCCI’s estimate of the reserve position for private carriers as of year-end 2008 shows a
$6 billion deficiency.
After allowing for the permissible discounting of the indemnity reserves for lifetime pension cases, the reserve position becomes essentially one of adequacy.
NCCI’s analysis shows that substantial progress has been made in reserve positions over the last seven years. And with the cycle turning, the industry will need to continue to work hard to maintain its strong reserve position.
NCCI estimates that the average workers’ comp indemnity claim cost increased 5 percent in 2008. This follows a pattern in recent years that has seen indemnity claim costs increase between 1.5 percent and 5 percent each year–generally in the neighborhood of the 3.5 percent annual change in average wages over the same time period.
Medical average claim costs per lost-time claim continued to increase in 2008, although the increases have tempered a bit in the last few years.
NCCI estimates that average medical claim costs per lost-time claim increased by 6 percent in 2008. This is the third-straight year that the average costs have increased about 6 percent.
NCCI has seen some favorable development in medical cost increases for accident years 2004-to-2006, and we are encouraged that some of the industry’s efforts to control medical costs appear to be paying off. NCCI’s studies of prescription drug costs have definitely shown some favorable trends in that significant cost category in recent years.
Based on a preliminary analysis of data in NCCI states, the frequency of lost-time claims per 100,000 workers declined 4 percent in 2008–greater than the 2.6 percent decline in 2007 (see accompanying graph).
Our research further indicates that the decline in claim frequency is a long-term phenomenon related to improved technology and its application in the economy to create ever-safer workplaces over time.
Some have speculated that things might be different in this downturn given its likely depth. However, our research shows that even in the Great Depression, as well as the deep downturns of 1973-to-1974 and 1981-to-1982, manufacturing injury rates declined. New research by NCCI’s economists explains that the driving force behind the reduction in frequencies relates to changing rates of job creation and job destruction during the economic cycle.
Frequency has declined quite consistently for all injury types except Permanent Total Disability. Although PTD frequency declined from 1998-to-2003, it has been rising since then.
Our preliminary research as to the cause has ruled out the most obvious explanations–law changes, aging of the work force and a particular cause of injury.
Other explanations under investigation include interaction of the workers’ comp system and Medicare set-asides for settled claims and the Social Security Disability Income system.
Depopulation of the residual market continued at a rapid rate in 2008. 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 their residual markets, the overall market share of the residual market pools serviced by NCCI for 2008 dropped to about 6 percent. It is less than 5 percent in states where NCCI calculates the rates for the residual market.
This is a great improvement from the 13 percent market-share peak that was reached in 2004 for this cycle.
The combined ratio for the residual market pools continues the recent pattern of being in the 105-to-115 range. The combined ratio has 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 the current policy year underwriting loss, leaving most pools at or near our self-funded objective.
A GUARDED OUTLOOK
As noted above, NCCI continues to watch several challenges facing workers’ comp insurers, including:
o The underwriting cycle is entering a period of uncertainty.
o Medical costs remain a significant challenge.
As medical costs continue to increase faster than wages, many states continue to look for ways to control this factor in their workers’ comp systems. We expect that NCCI’s medical data call will help to further define the issue beginning in 2010.
o Indemnity claim costs also continue to outpace wage increases.
o Net written premiums, including the state funds, had a third year of decline in 2008–the largest drop in workers’ comp net written premium in many years.
o On the legal front, NCCI is seeing an increasing number of legislative proposals and judicial actions that may serve to increase indemnity costs, as well as undo some of the reform efforts of recent years.
With the political climate changing, and relatively good results experienced in the last few years by the insurance industry, some may feel that now is an opportune time to review benefit levels and past reforms.
o Low investment yields seem likely to be a fact of life for the foreseeable future.
Needless to say, the lower the investment yields, the lower the combined ratio needs to be to maintain a reasonable return on capital.
o The political situation in Washington, with proposals to revamp the nation’s health care and financial regulatory systems, makes for a period of uncertainty.
o In positive market news, frequency continued to decrease in 2008, and depopulation of the workers’ comp residual market continued at a rapid rate in 2008.
In sum, all of the major financial performance measures for the workers’ comp insurance industry continued to perform well in 2008.
However, the series of challenges outlined above make NCCI’s outlook guarded regarding market performance in the coming months.
Given these times of uncertainty, NCCI will continue to work with all stakeholders to help ensure that rates and loss costs are adequate, to provide unbiased quantification of the impacts of legislative reform proposals, and to strive for self-funded residual markets.
In addition, we will continue to produce pertinent and timely research to help stakeholders understand current and emerging trends impacting workers’ comp.
Stephen J. Klingel is president and CEO of NCCI Holdings Inc. in Boca Raton, Fla.
NU Data Insights: Workers’ Comp Results By State