Workers' Compensation: A Guarded Outlook

Continuing to reduce the size of the residual market

While these familiar issues can be critically important today, they are challenges that have largely been seen before and dealt with successfully — or at least tolerably — in the past. But there are also nontraditional forces at work that have the potential to fundamentally change workers' compensation insurance.

And what are those issues? Terrorism, of course, belongs at the top of any list. Terrorism is completely unpredictable, with the potential to affect us from a personal perspective, a business perspective, and a social perspective.

Second, a looming medical crisis may lead to new forms of health care service delivery, whether through governmental or private programs. Since workers' compensation represents only two to three percent of the overall medical pie, workers' compensation could feasibly be swept along in any medical reform effort. Previously, such efforts have included proposals for 24-hour medical coverage. And today, our national leaders are considering new directions in a number of traditional delivery systems, ranging from the recently initiated Medicare changes to private health savings accounts.

Third, financial markets are becoming ever more global in nature; they are highly technology-enabled and can instantly react to economic, political, and natural forces. And the distinctions are fading between insurance lines, reinsurance, and other forms of financial risk management.

And last on this list of nontraditional issues is the ongoing effect of the Sarbanes Oxley Act of 2002. Since the passage of this act, regulators at state and federal levels have heightened their scrutiny of the insurance industry. Every transaction, process, and financial exchange is more transparent. Over the long term, this should be a positive development for all stakeholders. In the short term, there will be an increased need for clear communication on the best ways to improve regulation while maintaining business goals.

While each of these trends may not individually transform workers' compensation, it seems inevitable that, in some combination, they will bring about change. Workers' compensation is not an insular form of social insurance, nor is it untouchable. It's entirely possible that the system of 2020 will only faintly resemble the system of 2006.

Current Financial Results Are Positive

In the immediate term, however, the market is enjoying good financial results.

The workers' compensation calendar year combined ratio stands at 102 percent for 2005, a five-point improvement from 2004, and the best result since 1997. The accident year combined ratios remain in the low 90s for both 2004 and 2005, nearly a 50-point improvement from 1999.

The investment gain associated with workers' compensation insurance transactions is up a point to about 12 percent. This percentage is still down dramatically from the late 1990s, when interest rates were higher and the stock market produced large gains. However, this investment gain has begun to creep up a bit the last two years after bottoming out at 10.4 percent in 2003.

When the investment gains are combined with the small underwriting loss, the result is a pretax operating gain of about 10 percent. NCCI's modeling indicates that, after including the investment gain on surplus and paying taxes, the industry came close to earning its cost of capital in 2005 in this line for the first time since 1998.

NCCI's analysis continues to indicate that the workers' compensation insurance industry needs to run combined ratios at or near 100 percent to achieve a reasonable return on the capital supporting the business. This target combined ratio is up slightly from recent years due to some increase in the interest rate environment, but is still at (nearly historic) low levels.

Estimates of the loss reserve position of private carriers also improved. The deficiency, which peaked at $21 billion at year-end 2001, has declined to $9 billion at year-end 2005.

Indemnity and Medical Average Claim Costs Experience More Moderate Changes

Medical average claim cost trends have moderated slightly but continue at near double digits, rising 8.5 percent in 2005. Medical costs continue to grow much faster than average wages and the Medical Consumer Price Index. Utilization increases are a significant contributor. Workers' compensation is increasingly becoming a medical management business as policy makers, employers, and carriers strive to control these costs.

NCCI continues to study the causes of medical cost increases in workers' compensation. In the past, NCCI has reported on the impact of prescription drugs and the differences in cost between workers' compensation and group health. The costs of prescription drugs make up more than half of the medical costs in payment years six to nine after the date of injury, as claims enter a "medical maintenance" mode.

On the indemnity front, NCCI estimates that the change in the average cost of workers' compensation indemnity claims rose a modest two percent in 2005. This continues a moderation in the increase in indemnity claims costs seen since 2002. Some of the rapid increase in costs witnessed from 1997 to 2000 (and the moderation seen recently) appears to be related to changing claim frequencies.

Claim Frequency Continues Its Decline

For several years, NCCI observed that the frequency of smaller claims has been dropping more rapidly than larger claims. Recently, that pattern has changed — although frequency continues to decline at about the same rate, the frequency decline seems to be affecting all claim sizes about equally.

Based on a preliminary analysis of data in NCCI states, the frequency of lost-time claims declined another 4.5 percent in 2005. This continues the pattern that has persisted since the early 1990s. The cumulative decline in frequency is in excess of 45 percent over that time period. The decline in frequency has been reasonably uniform across all industry groups.

NCCI's research leads us to believe that the frequency declines in the last decade are driven by improved workplace safety as a result of the application of technological advances to a wide variety of workplace hazards. These include improved material handling, safer motor vehicles, and better workplace design.

Residual Market Update

In the workers' compensation residual market, NCCI finally started to see some significant residual market depopulation in 2005. Overall premium dropped to $1.4 billion from $1.5 billion in 2004. The volume of business in the residual markets remains uncomfortably high, particularly in some troubled jurisdictions, but overall, most markets are benefiting from the depopulation trend. This is a sign that many markets are returning to a healthy environment.

The combined ratio for the residual market pools continues to remain at a relatively stable 113 percent. Although the combined ratio is still above the objective of self-funded residual markets, a few states contribute a significant amount to the underwriting losses, while many other jurisdictions are much closer to the self-funded objective.

Looking Forward

At NCCI, our examination of the fundamental changes taking place in the workers' compensation market lead to the conclusion that, while the short-term results are positive, the long-term outlook remains guarded.

As noted at the outset, the workers' compensation insurance industry had another solid year of financial results in 2005. All major financial measures improved significantly. Both the calendar year and accident year combined ratios are at levels that allowed the industry to strengthen its reserve position and earn a reasonable return on surplus. Reserves are in the best position in a decade.

However, there are immediate challenges that continue to confront the workers' compensation line. While short-term interest rates have increased significantly in the last two years, longer-term rates remain at near historically low levels. This puts pressure on the combined ratios needed to earn an adequate return on capital. Some individual states have workers' compensation systems that are in disarray due to rapidly escalating benefit costs resulting in poor results and market disruptions. Challenges to recently enacted benefit reforms have been mounted or are being discussed in several states, either through the political process or the courts. Although the residual market is seeing depopulation in many states, overall, the volume remains too large, and in some states depopulation is at unacceptably high levels.

These are significant challenges that do not have easy solutions. Throughout the history of the workers' compensation market, the strength and endurance of the industry has always rested on stakeholders working together to find long-term solutions to ensure the health of the system over time. It's a dedication that has sustained the success of the workers' compensation market for almost 100 years, and a commitment that will need to continue if the industry is to sustain recent positive results.