WC Insurers Enjoy Excellent Performance, But Challenges Could Put Profits At Risk

o Claims frequency trends continue to be favorable, allowing for a generally stable loss-cost environment.

On the cautious side of the ledger, however, are a number of challenges confronting the line, such as:

o Post-tax returns on surplus are not close to record levels and are only modestly above the average for the last 20 years–due to low interest rates in recent years and significant federal income taxes.

o Medical costs continue to increase at or near double-digit rates, pushing medical costs to nearly 60 percent of total losses for NCCI states in 2006.

o Low investment yields–particularly for longer-term investments–mean combined ratios need to be at or near historic lows for insurers to earn an adequate return on capital.

o The changing political landscape in many states and at the federal level may put additional pressure on reforms. This pressure may make it more difficult to enact new reforms to help troubled systems, as well as increase the desire to revisit reforms in place since the last workers' comp crisis in the 1980s and 1990s.

o The Terrorism Risk Insurance Extension Act is expiring at the end of 2007, and its future is uncertain.

o The current underwriting cycle is likely at its peak.

On the optimistic side of the ledger, the 96.5 calendar-year combined ratio is very encouraging–and accident-year numbers were similarly positive. The change in the combined ratio breaks down as follows:

o Most of the improvement was due to a 6.5-point drop in the loss ratio, to 58.

o The loss adjustment expense ratio-to-premium declined one point to 14 percent of premium–whereas it rose 1.5 points to 24 percent of losses.

o The underwriting expense ratio-to-premium rose one point, to 23.2 percent.

o The dividend ratio remained at about 1 percent of premium.

On an accident-year basis, workers' comp had its fourth-straight year of underwriting profits. We estimate the combined ratio for the 2005 and 2006 accident years at 87, and the 2004 accident year at 88–more than a 50-point improvement since the 140 combined ratio of 1999.

It is important to note the substantial effect California's results have had on the overall workers' comp numbers. For example, excluding California's results alone would raise the calendar-year net combined ratio about 10 points, to over 105.

There is a similar impact on the accident-year combined ratio. Excluding California would raise the accident-year combined ratio from 87 to 95. This somewhat dampens the overall results for the entire country, and it reminds us of the distortions caused by a single large state that is adjusting to its post-reform environment.

In terms of private-carrier workers' comp reserve position, 2006 marked another year of improvement. NCCI's estimate of the reserve position for private carriers as of December 2006 shows a $4 billion deficiency–a $5 billion improvement from year-end 2005.

After discounting the indemnity reserves for lifetime pension cases, the reserve position is slightly more than adequate. NCCI's analysis indicates the industry has made significant progress on its reserve deficiency over the last five years, and that the current cycle of strengthening reserves on older accident years is likely near an end for this cycle.

The investment gain associated with workers' comp insurance transactions is about 10 percent–a level it has hovered near for the last five years. This level is down dramatically from the late 1990s and 2000, when interest rates were higher and the stock market produced large gains.

When we combine underwriting profit with investment gains, the result is a pretax operating gain of about 13.5 percent. Our analysis indicates that the workers' comp industry earned little more than its cost of capital for the first time since 1998.

However, if we exclude California, the industry may not be earning its cost of capital in the remainder of the country. Indeed, insurers must run combined ratios at or near 100 to achieve the reasonable return on capital needed to support the business.

In 2007, the political environment has changed considerably–both at the state and national levels. At the midpoint of this year, we have already observed more legislative activity than in 2006.

NCCI has priced more than 155 bills this year–compared with 130 for the entire 2006 session–and some states have expressed renewed interest in revisiting issues that had been settled in past reform efforts.

Given the relatively good results posted for workers' comp insurers and for the property-casualty industry in general, some participants may feel that now is a good time to review benefit levels, administrative guidelines and cost controls–all to the potential detriment of an efficiently running and well-balanced workers' comp system.

Also, as noted earlier, rising medical costs continue to be a major concern. Medical average claim cost trends continue to grow significantly–up 7.5 percent in 2006, after an 11.7 percent gain in 2005.

These increases are much higher than both average wage increases and the Medical Consumer Price Index–both of which have been rising about 3.5-to-4 percent per year for the last several years.

Today, workers' comp continues to evolve into a medical management business, with policymakers, employers and carriers struggling to control the costs of medical care. The increased interest in medical benefits and costs on the part of lawmakers, regulators and carriers is creating the demand for ever more detailed medical data.

Acting as something of a counterbalance to rising medical costs, the frequency of lost-time claims declined another 6.8 percent in 2006–the second year in a row of frequency declines near 7 percent. This pattern has persisted since at least the early 1990s, with the cumulative decline in frequency nearly 50 percent since 1991.

In terms of indemnity costs, some of the rapid increases from 1997 to 2001 appear to be related to changing claim frequencies by size of loss.

For several years, we have observed that the frequency of smaller claims has been dropping more rapidly than the frequency of larger ones. This would tend to raise the rate of change in the "average" claim size by two-to-three points per year.

Last year, NCCI reported a more rapid drop in the frequency of small claims in relation to other claims. This may explain some of the moderation in the rate of change in the growth of indemnity claims in recent years. An increase observed in 2006 may indicate a return to the pattern of claim frequency changes by size of claim observed in the late 1990s.

While we are pleased to report that all of the major financial performance measures for workers' comp experienced significant improvement during 2006, it is important to note that the record low interest rates of recent years–as well as the industry's need to strengthen its reserve position–made these types of results a necessity.

As always in a cyclical, long-tail line such as workers' comp insurance, we need to be mindful of the challenges that threaten to negatively impact the business. To recap, these include skyrocketing medical costs, low investment returns, a changing political landscape, and the projection that the current underwriting cycle is likely at its peak.

Finally, although the underwriting cycle appears to be turning–with stable overall loss costs and stable interest rates–there may be some hope that this cycle will be less severe than the last one.

The outlook remains optimistic for market participants–at least for now. However, if the industry is to continue to improve its financial performance, the challenges noted above will require ongoing attention and decisive action to sustain the current positive environment.