Workers' Comp: A Quiet Crisis No More

Workers' Comp: A Quiet Crisis No More

Move over Kobe, J-Lo and Saddam! Yes, the world of workers' comp is now front-page news all across America.

Behold page A1 of the June 23 New York Times: “Cost of Insurance for Work Injuries Soars Across U.S.,” or The Wall Street Journals July 28 editorial page article, headlined: “Workers' Comp Crisis.”

Even in California, with its three-ring political circus in full swing, workers' comp can still be heard above the roar: “Workers' Comp Costs are Forcing Businesses to Abandon California” screamed the Aug. 5 Investors Business Daily. (One can only wonder whether Arnold Schwarzenegger fully understands what hes getting into!)

Theres no doubt that workers' comp is getting ink these days. The Insurance Information Institutes insurance media index indicated that 4,651 workers' comp-related stories were published during the first six months of 2003 in the nations major newspapers, magazines and trade publications–up 32 percent over the same period last year. In contrast, the number of stories related to terrorism insurance and toxic mold fell by 35 and 28 percent, respectively.

Earlier this year, well before workers' comp made it to the front page, I wrote an article in National Underwriter (and subsequently reproduced in a number of other publications) headlined: “Workers' Compensation: The Industrys Quiet Crisis.” With the business community in an uproar, politicians under pressure, insurers continuing to spill lots of red ink and labor markets in their worst shape in nearly a decade, few would choose the word “quiet” to describe the workers' comp environment today.

To be fair, the performance of the workers' comp line improved dramatically last year. Yet one could not help but feel underwhelmed–the combined ratio remained at a stubbornly high 110, underwriting losses still totaled $3 billion, and reserve deficiencies were a towering $18 billion. The news was also grim from an exposure standpoint–since February 2001, the U.S. economy has shed 2.69 million jobs.

While additional improvements are certain in 2003, the inescapable reality is that workers' comp is likely to remain a problematic line for many insurers for the remainder of this year and into next. The fact is that workers' comp continues to suffer from the same eight problems I identified in my “Quiet Crisis” article earlier this year. I present brief updates on each of the areas I raised.

Poor Underwriting Performance: Lets face it, paying out $1.10 for every dollar you take in means youre losing money–about $3 billion in red ink in 2002. If insurers can shrink the combined ratio to an estimated 105 in 2003, as seems likely, underwriting losses will fall to roughly $1.5 billion.

While the improvement is welcome, the implied rate of return on such business in the current investment environment is in the low single-digits, unacceptably far below the 12 percent or so needed for an insurer to achieve its cost of capital. While workers' comp insurers were able to generate returns in the neighborhood of 13 percent a decade ago with combined ratios in the 97-to-101 range, theyll need to fall to the low-90s before similar returns are realized today.

Achieving unconventionally ambitious underwriting targets is extremely hard in workers' comp. Medical and indemnity severities continue to advance at a prodigious pace12 and 7 percent, respectively, in 2002, according to the National Council on Compensation Insurance in Boca Raton, Fla. Cost containment efforts are bearing some fruit, but in many states, like California and Texas, legislative reforms similar to those recently enacted in Florida will be required.

Softening Pricing: Pricing throughout the commercial property-casualty insurance sector peaked in mid-2002. A notable deceleration in the pace of price increases has occurred since then in most major commercial lines, and workers' comp is no exception.

According to the Washington-based Council of Insurance Agents and Brokers, just 20 percent of policies renewed with increases of 20 percent or more during the second quarter of 2003, compared to 73 percent during the second quarter of 2002 (see chart).

While no all-out price wars have erupted (just 2 percent of risks saw decreases in the second quarter), the general softening in prices is disconcerting given that workers' comp insurers must trim at least 15 additional points off the combined ratio to ensure reasonable rates of return.

Weak Investment Returns: Investment income fell by 2.8 percent in 2002 to $36.7 billion–its lowest level since 1994, and the fourth decline in the past five years. A drop of 0.5 percent was noted during the current first half as well. While some in the industry are excited over this years stock market rally, insurers would do well to view relatively low interest rates and puny stock market yields as a fixture of the economic landscape, and to price policies accordingly.

The moral of this story is clear: There is nothing whatsoever that insurers can do about the depressed earnings environment, so for the indefinite future all the heavy lifting in terms of generating adequate profits will have to be done through pricing and underwriting.

Reserve Inadequacy: As of year-end 2001, the workers' comp reserve deficiency stood as $21 billion, according to the NCCI. The billions that insurers took in reserve charges last year pushed the inadequacy down to $18 billion, but it is clear that eliminating a deficiency of this magnitude will create a drag on workers' comp profits for years to come. Compared to 2002, relatively few insurers appear to be taking large charges.

Rapidly Rising Medical Costs: Workers' comp medical costs are driven by factors that affect all health care delivery systems, as well as some that are more specific to comp. Surging pharmaceutical costs and the high price of tests using advanced diagnostic and imaging equipment, for example, are major contributors to higher health care costs for all financiers of medical care.

The picture emerging in 2003, however, is that traditional financiers of health coverage, such as employer-sponsored health care plans, are beginning to have more success at containing costs than are workers' comp insurers. This success stems primarily from higher deductibles and co-payments for services and prescription drugs.

Such strategies are entirely unavailable to workers' comp insurers and self-insured employers. The marginal cost to many workers of filing a workers' comp claim is by law nearly zero, hence the ability of insurers/employers to change claiming behavior is very limited.

Slow-Growth Economy: The exposure base for workers' comp (payrolls) is nearly stagnant, and the U.S. labor force has shrunk by 2.69 million workers since February 2001 (see chart). The unemployment rate in June 2003 was 6.4 percent–a nine-year high. The U.S. economy lost 486,000 jobs during the first seven months of 2003 alone.

Looking ahead, the economy is expected to grow slowly and wage increases will trail historical norms. This means the workers' comp exposure base will grow only marginally in the next two years. In fact, the employment situation may get worse before it gets better.

Massive Terrorism Exposure: Two years after the tragedy of Sept. 11 ended the lives of 3,000 people–most of whom were on the job–a palpable sense of complacency is beginning to take hold in America with respect to security. Yes, theres noticeably more security at airports, landmark structures and important events, but cash-strapped governments and businesses simply cannot afford to maintain Code Orange security levels for extended periods of time.

So, despite U.S. victories in Afghanistan and Iraq, the threat to the United States and its 130 million workers remains very real. The possibility of terrorist attacks has not yet been fully priced into policies for employers in the most at-risk areas, and insurance departments are balking at the increases and catastrophe loadings being filed.

Another question is whether the loading will stick in the long run or be competed away.

Regulatory Concerns: Arnold “The Terminator” Schwarzenegger versus John “The Regulator” Garamendi–this surreal match-up nearly became a reality, but California Insurance Commissioner John Garamendi ultimately decided not to run, leaving California voters to go to the polls to choose among 200 or so candidates vying to take Gray Davis' spot as governor in a recall election scheduled for Oct. 7.

Workers' comp will be a campaign issue. Mr. Schwarzenegger, in an MSNBC interview, cited high workers' comp costs as the primary factor responsible for driving businesses and jobs out of the state.

While many may view California as a sideshow, states like Texas and West Virginia also need immediate reform. Most states need to approve legislation to give employers and insurers greater latitude in claims management and help clamp down on fraud and abuse.

Financial conditions in the p-c industry come about slowly and can easily try the patience of even the most experienced managers. This is clearly the case in workers' comp, where underwriting improvements are lagging behind other major commercial lines. Key states may be problematic for years.

Unfortunately, experience suggests that nothing short of a crisis will do when it comes to building the critical mass and consensus on workers' comp issues to push through necessary reforms.

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 Property & Casualty/Risk & Benefits Management Edition, August 18, 2003. Copyright 2003 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.