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WORKERS COMPENSATION IN 2004: WHERE ARE WE HEADED?
The future of the workers compensation market is as murky and uneven as ever. Some insurers are enjoying loss ratios in the double digits, while others are desperately pleading with rating agencies to give them just a few more months to shore up their balance sheets; in a number of cases, insurers are experiencing both events simultaneously. Employers in some states have found that the new year has brought pleasant surprises in their renewal quotes, while others have opened their brokers' letters only to read of rate increases in the 20 percent range or even worse non-renewals.
On the positive side, financial results for many insurers have shown noticeable improvements. Rate increases appear to have moderated in many states; reform efforts have progressed significantly in bellwether states such as California and Florida; frequency rates have continued to decline; and overall health-care inflation rates have dropped into the single-digit range.
Unfortunately, this silver cloud has a gray lining. Some of the less-than-positive forces that cast a shadow include:
- a return on equity that remains considerably lower than market expectations;
- persistent concerns about industry-wide under reserving;
- frequent announcements of rating downgrades, with few counterbalancing upgrade notices;
- continued fear of terrorist actions;
- stumbles in reform efforts in Texas and California; and
- workers compensation medical inflation rates that hover in the double digits.
The muddle of positive and negative news makes it seemingly impossible to discern an overall direction for workers compensation. However, if one looks closely, there are several clear indicators that enable us to predict with some confidence where we are heading, when we will get there, and what bumps we will encounter on the journey.
HOW DID WE GET HERE?
The workers compensation market in 2004, relatively speaking, offers little cause for complaint. Those of us with memories that go back as far as the early 1990s can recall a time when the current rates, retention levels, and policy restrictions would not be viewed as outrageous, unfair, or cynical efforts on the part of greedy insurers to soak poor employers desperate for coverage. In fact, the cost of risk today is not far different from what it was 10 short years ago. When viewed in a historical perspective, things aren't so bad.
In fact, buyers' recent complaints about pricing are, at best, uninformed and, at worst, hypocritical. Few risk managers complained when workers compensation premiums were plummeting by 25 percent to 40 percent per year, as many were in the second half of the last decade. While most risk managers knew that the rate drops were not sustainable, they nonetheless took advantage of insurers' willingness to sacrifice all on the altar of market share. Many employers chose to abandon insurers with whom they had long-term relationships in search of bargain-basement workers compensation insurance; others used competitive bids to leverage lower rates from their incumbent insurer. Certainly, risk managers and other finance officers would have been negligent in their fiduciary duty had they refused to consider lower-priced coverage, but a longer-term view would have helped many avoid their present predicament. Loyalty goes both ways, and many of the employers now crying "Foul!" would have been well served to display the same type of loyalty they are now accusing their insurers of abandoning.
Regardless of what path we took to arrive at our present situation and what mistakes we may have made or avoided on the journey, we now find ourselves at what may be, at least from an academic perspective, a most intriguing juncture. Strong external forces are battering the workers compensation market, while other forces are serving as counterweights. Chief among the factors that are weighing down workers compensation are the same forces that have an impact on the overall property-casualty industry, but also, perhaps more important today than ever, the seemingly intractable problem of rising medical expenses. While other considerations will undoubtedly nudge the market along, none will have the power and force to influence it as directly as these two "main drivers."
The workers compensation market is also subject to other influences that are either specific to, or have more impact on, workers compensation than they do on other segments of the property-casualty industry. Let's examine some of these forces in greater detail.
PROPERTY-CASUALTY MARKET OVERVIEW
The 2003 U.S. property-casualty market exceeded $400 billion in net written premium for the first time in history, an increase of 9.8 percent over 2002. Taking advantage of recent price increases, insurers are busy rebuilding their balance sheets, adding to surplus, and increasing reserves. Reserves were badly battered by reinsurer failures, faulty pricing and reserving practices, and by frequent and expensive natural and man-made catastrophes, such as asbestos settlements.
While a 9.8 percent growth rate appears healthy enough, it must be considered in light of analysts' predictions a scant year ago of 10.8 percent annual growth. Even more interesting is the rapid slowing in the rate of increase during 2003. On a quarterly basis, increases declined from 12.7 percent in the first quarter to 9.3 percent in the second, 8.4 percent in the third, and an estimated 7.4 percent in the last three months of 2003. This "decrease in the rate of increase" has been good news for buyers and, to a certain extent, reflects the good experience of insurers. However, some in the industry are growing increasingly concerned that the hard market may be ending faster and more abruptly than desired. Considering the expansion of the economy and the overall inflation rate, some analysts' predictions of premium growth in the 5 percent range indicate a market that will just keep pace with underlying influences, such as increased employment, greater industrial capacity, and more investment in plants and equipment.
Recent Trends
Few property-casualty insurers have come through the last five years unscathed. During that time, the industry has been hammered by a confluence of events that have resulted in some insurers facing insolvency or merging with stronger partners; others suffering rapid and apparently unpredictable ratings downgrades; and still others the more fortunate, or more likely, better run taking significant hits to their balance sheets in an effort to shore up their financial positions and thus preserve the all-important "A" rating.
The industry's projected 2004 combined ratio of 100.1 (Insurance Information Institute, Groundhog Forecast 2004, Robert Hartwig) represents the first time that the property-casualty industry has broken even in 25 years. That's the good news. The bad news is that even this noble accomplishment is not good enough. The industry relies on investors as well as premiums from insureds and its own invested capital to fund claims, expenses, and profits. Even with the industry's remarkable turnaround, the rate of return on capital in the property-casualty industry is still well under a rate desired by investors. The industry's 2003 estimated return on equity of about 9.5 percent is well below that of the Fortune 500. Investors will be less inclined to bet their hard-earned capital on the property-casualty horse when returns of 13 percent to 14 percent are commonplace among the blue chips, which also have notably lower risk due to the lesser impact of catastrophic events.
The failure of tort reform efforts in the last federal legislative session, combined with an increased awareness of the industry's potential liability for such maladies as silicosis and the ever-present Damoclesian sword of asbestos, make investing in the property-casualty industry a somewhat riskier proposition than buying shares or bonds of PepsiCo or Gillette. Investors are understandably reluctant to bet on firms that have essentially unquantifiable risks, especially when the returns are lower than those they could achieve while being able to sleep at night.
The industry as a whole will have to deliver returns on equity greater than today's average 9.5 percent if it is to receive significant capital from the financial markets. And if capital is not coming from their own investments or the broader investment community, it will have to come from insureds. Clearly, this does not bode well for insurance rates in the broader property-casualty industry
Impact on Workers Compensation
With premium and premium equivalents for 2002 totaling $50 billion, the workers compensation market is a relatively small slice of the property-casualty industry. The impact of the workers compensation segment of the market will be greater than one might think, given the modest 9 percent share of the total property-casualty premiums that it represents. Unlike property insurance, which tends to have a "short tail," workers compensation is a long-tail line. In layman's terms, this means that claims that occur during the coverage period are paid out over many years after the policy term has expired. In fact, a reserving analysis performed by Fitch Ratings indicates that less than 65 percent of total claims dollars are paid in the 36 months following the date of injury; more than 10 percent of total claims dollars have not been paid after 10 years have gone by.1
This slow payout does allow the insurer access to premium for investment purposes, but it also makes it much more difficult to predict what the ultimate claims cost will be. While this has been surmised for many years, recent studies appear to indicate that, as an industry, the workers compensation business is even worse at predicting future claims costs than we had suspected. We'll look at some compelling data before exploring the impact this failure has on the industry as a whole.
The FitchRatings study provides an in-depth analysis of this situation. The study shows that adverse reserve development the need to add more funds to reserves for past years' claims due to higher-than-projected actual payouts has been and will continue to be a major drag on workers compensation financials.
During the period of 1998 to 2001, the property-casualty industry under-reserved to the tune of some $32.4 billion. That is, the industry needed to add $32.4 billion to the established accounts that pay the claims of previous years. Because the premiums for those years had already been collected, the cash had to come from somewhere else. To a large extent, that "somewhere" was from premiums for new policies. Before one starts wondering how any business could somehow be so poorly run as to need more than $30 billion to fix what are essentially math errors, it is important to understand that predicting future costs has been, and from all indications will continue to be, horrendously difficult, if not impossible. To quote the Fitch Ratings report regarding long-tail insurance lines:
in many recent cases, reserving shortfalls are attributable to a failure in the actuarial process, as opposed to actual "cheating" on the part of management at times little reliance or comfort can be placed on a sincere management effort to establish reserves at adequate levels. Often despite best efforts, management is simply wrong because current established actuarial processes are unable to assess loss costs with any reasonable degree of accuracy.
If that doesn't give an investor pause
The cost of these additions to reserves added 3.5 percent to premiums in 2001, and 6.2 percent in 2002. Workers compensation rates have been, and are likely to continue to be, negatively affected by inaccurate actuarial predictions. Another perspective indicates that the insurance rates paid by employers during the period of 1997 to 2001 were simply too low. Again, in their heart-of-hearts, most risk managers likely knew this at the time, so for them to complain now is unfair.
WORKERS COMPENSATION - THE PRESENT SITUATION
Today's workers compensation market has hit a plateau. The price increases of the last three years have gone a long way toward restoring the industry's financial health, but persistent concerns about reserving practices coupled with rising health-care costs are likely to make the visit to the plateau a brief one. And the other side is not a gentle drop but is more likely to be another climb.
Frequency
According to both the U.S. Department of Labor (DOL) and National Council on Compensation Insurance (NCCI), injury rates have continued their decline, with the latest NCCI statistics indicating a decline of 3.7 percent for lost-time claims in 2002. While there is some disparity between NCCI and DOL statistics (likely due to different time frames, reporting standards, and NCCI's more limited geographic reporting area), both are consistent in noting a steady decline averaging 4 percent to 5 percent over the past 10 years for both total injuries and lost-time injuries.
The reasons for the recent decline are several. The economy was in a recession for a good portion of the last three years and, when jobs are being shed and positions eliminated, the injury rate tends to decline as well. The jobs that were lost included a disproportionate number of manufacturing positions; jobs that tend to have higher injury rates than average. Overall there has been a marked shift of manufacturing jobs to locations overseas, indicating an underlying trend that, if anything, was likely exacerbated in the recent recession.
U.S. manufacturers that are fending off their foreign competition are doing so by reducing costs and increasing quality. This often involves automating functions that were previously manual, making greater use of robotics, and increasing automation of the entire manufacturing and distribution process. This increase in automation requires fewer workers, and the ones that are in the plants are no longer lifting and pushing (or at least not as much); instead, they are watching monitors and punching keys. This is not to say that all manufacturing has become completely automated, but that there is enough increase in automation to contribute to the decline in the occupational injury rate.
At some point the injury rate will likely hit a plateau of its own or at least reduce the rate of decline. If and when that occurs, one of the strongest positives will disappear from the workers compensation calculus.
Health-Care Costs
Health-care costs now comprise more than 50 percent of total workers compensation claim costs for the first time in memory and, according to NCCI, are increasing at an annual rate of 12 percent. Although there has been some good news on overall health-care costs, unfortunately it is not likely that the factors contributing to the improvements on the group-health side will have any real positive impact on workers compensation medical expenses.
The Center for Studying Health System Change (CSHSC) recently reported that the overall per-capita growth in health-care costs was 8.5 percent for the first six months of 2003. Although it is hard to believe, this was actually good news because health-care trend rates had been within whispering distance of double digits during 2001 and 2000. On the surface this is good news for all, but when one studies the underlying components of health-care spending, the news is nowhere near as positive for workers compensation as it is for group-health.
Health-care costs are comprised of three main types of services: prescription drugs, physician services, and inpatient and outpatient hospital care. Prescription drug cost increases moderated somewhat over the first six months of 2003, dropping from a 13.5 percent increase in 2002 to 8.5 percent. However, the reasons for this "decrease in the rate of increase" have little to do with workers compensation. Among the factors recently cited by CSHSC were changes in benefit design to increase co-pays for prescription drugs and add more tiers in drug plans, with higher costs for branded drugs.2 There was also more use of generics and a shift from prescription to over-the-counter (OTC) drugs as more drugs received approval for OTC sales from the Food and Drug Administration. In addition, fewer new and consequently expensive drugs came on the market. Workers compensation's "first dollar, every dollar" coverage negates any benefit from the first two factors, and any benefit from the final factor appears to be modest. Even the movement to generics does little for workers compensation payers the 2003 study of drug costs in workers compensation by NCCI indicates limited opportunity for additional savings from switching to generics.3
In contrast to the "good news" on the drug front, hospital costs have recently shown surprising strength. The Center for Health Affairs reported in June that hospital price inflation rates have increased significantly for both inpatient and outpatient services. Cost drivers for hospitals include rapid and large increases for labor costs (up 6.1 percent in 2001 and 5.5 percent in 2002) and an increased ability on the part of hospitals to negotiate favorable reimbursement arrangements with payer networks. The result has been an increase of 6.8 percent for inpatient care and 14.6 percent for outpatient. Just as with drug costs, a key factor that somewhat mitigated the impact of cost increases on group health plans increased patient cost-sharing has no effect in workers compensation.
It is also important to remember that workers compensation medical expenses amounted to less than 3 percent of total health-care costs. Thus, the bargaining power of workers compensation provider networks and payers is limited and the level of interest on the part of many providers in workers compensation is not high.
These factors will all contribute to workers compensation medical expenses continuing to rise at double-digit rates for the foreseeable future.
WHAT DOES THE FUTURE HOLD?
Regulatory reform has garnered much attention over the last 12 months, and for good reason. Certainly, Florida's regulatory reforms have been greeted with delight by any and all participants in that market, with the notable and unsurprising exception of the plaintiff's bar. California, the largest workers compensation market and, for the last few years, the most troubled one, has begun to initiate some rather significant reform measures. Even there, the desire to "get something done now" may cause more pain than relief if ill-considered, or at best, marginally considered, solutions are put in place before their potential effects are thoroughly evaluated.
These and other factors contribute to the financial viability of the workers compensation market, but their significance pales in comparison to that of medical expense and the effects of the overall property-casualty industry. Be prepared for workers compensation rates, retentions, and availability to stabilize somewhat over the near term before the market once again turns hard.
Simply put, the workers compensation market is akin to a sailing ship, with health care providing the winds and the property-casualty market the currents. While we can tack back and forth, seek shelter from the worst of the gales, and if necessary heave to and try to wait it out, unless the winds and currents favor us, we are in for a long, tough, trip. Right now, there is a nasty storm brewing over the horizon.
Endnotes
1. "Special Report Property Casualty Insurance Reserves at Year-End 2002: Filling in the Hole - Slowly," Fitch Ratings (November 11, 2003). www.fitchratings.com.
2. "Tracking Health-Care Cost, Data Bulletin," The Center for Studying Health System Change (June 2003). www.hschange.com/CONTENT/564.
3. "Prescription Drugs: Comparison of Drug Costs and Patterns of Use in Workers Compensation and Group Health Plans," NCCI Holdings, Inc. (August 2003). www.ncci.com/media/pdf/rx.pdf
Joseph Paduda, Principal of Health Strategy Associates, is an independent consultant focused in the Workers' Compensation and managed care markets. His clients include large Workers' Compensation insurers, managed care organizations, self-insured employers, and software and systems companies. Prior to his present position, Mr. Paduda was vice president of MetraComp, a United HealthCare Company specializing in the application of managed care techniques to the Group Disability and Workers' Compensation industry. Paduda was responsible for marketing, sales, and account management. Paduda holds a Master's of Science Degree in Health Management from the American University and is a frequent speaker on managed care issues. He lives and works in Madison, Connecticut and can be reached at 203 245 1249 or jpaduda@healthstrategyassoc.com
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