Workers compensation: Finding the way forward

System faces some unknowns, but some of the things we DO know about must change

By Michael J. Moody, MBA, ARM

One of the basic precepts of today's employment setting between employer and employee is that if the employee is injured while on the job, the employer will pay for medical care and loss of wages. This bond is formalized via the purchase of a workers compensation policy (work comp) by the employer. A core concept to this relationship is that the coverage is provided, without regard to fault. It is a concept that has survived a 100 years in the United States—2011 marks the centennial anniversary of when Wisconsin signed the first true work comp legislation.

While many have noted that the basic concept that supported work comp had already begun in Europe, they actually were not the first to subscribe to the idea. It may surprise some to learn that one of the first recorded uses of the work comp concept was with the pirates who roamed the Caribbean. They had their own system of caring for fellow pirates injured in the line of duty. Bottom line, they basically provided medical care and loss of income protection to mates who had suffered a workplace injury.

As work comp evolved in the United States, it was left to the individual states to control the actual scope and conditions of coverage. While work comp is based on legislation that is passed at a state level, with the exception of minor differences, the concept is similar to that which was signed in Wisconsin 100 years ago. The intervening years have seen some technical and operational refinements, but the law still preserves the important employer/employee relationship.

However—the work comp market will have to deal a number of critical challenges over the next few years, if work comp is to stay true to its original concept.

Going from bad to worse

At last year's Annual Issues Symposium in May, the National Council on Compensation Insurance (NCCI) described the workers comp market as deteriorating, and there is clear evidence that since that meeting, the situation has not improved. California, which accounts for about 26% of the work comp market nationwide and which in the last few years has been a very bright spot in the workers comp arena following the passage of significant reforms, has suddenly turned sour.

Nationally, the last major work comp crisis was in the 1999-2001 time frame and California was in the middle of it. In order to stem the tide, California was forced to endure several painful rate increases and, more important, meaningful tort reform during 2003-2004. After the fact, California became a role model of effective legislative reform that served as a role for other states. However, the intervening years have slowly eroded the hard-fought measures that resulted in cost savings, to the point where California work comp carriers' combined ratio reached 127% for accident year 2009. And things have only gotten worse, so that earlier this year, the Workers' Compensation Insurance Rating Bureau requested a 40% pure rate increase in order to achieve rate adequacy. It has since watered down its request to a 27.7% increase, still a meaningful increase by anyone's standards.

The California work comp system has a tough road ahead. While the state rating bureau has been proposing significant rate increases over the past few years, insurers have been obtaining only about 5% on average, due in large part to the state's competitive environment. Add to this the fact that the state insurance department has had to take over Majestic Insurance Company, a major California work comp carrier, and it foretells more troubles ahead for California comp writers. According to court documents, Majestic had insufficient reserves to continue to operate independently since they were reported as having underfunded reserves of $46.4 million. Obviously, California, like a number of other states, has significant work comp issues that will have to be dealt with soon.

Economic woes

It is still anyone's guess as to when the economy will actually begin to see meaningful improvement. Most economists believe that the worst is now behind us, but everyone can see that it is still a steep climb to get the economy back on solid footing. From a work comp standpoint, the current economic situation has had a number of profound effects on the state of the market.

Among the most obvious is that the lower employment and payroll numbers have taken their toll on overall premiums. According to the Insurance Information Institute, the effect of unemployment and under-employment on work comp premiums today "amounts to hundreds of millions of dollars in lost premium." However, it should be noted that work comp premium reductions had begun long before the recent recession, thanks in large part to the continual movement of buyers to the alternative risk transfer (ART) market, including such things as large deductibles, captives and self-insurance. As a product line, work comp has been losing premium for years.

Claims frequency concerns

One of the constants over the past 10 to 12 years has been that the work comp market has managed to find ways to maintain static claims frequency statistics, which has contributed greatly to a more stable market. However, 2010 appears to have broken this string of over a dozen years. And while NCCI hints that there are structural reasons for this increase, they also raised a red flag of concern about its increasing importance. They indicate that this aspect warrants increased oversight to make certain that it is an aberration rather than a trend.

Conventional wisdom would indicate that there might be some malingering after a work comp injury; however, that may not necessarily be the case. Based on the findings of the Integrated Benefits Institute study, while the median costs associated with work comp claims rose slightly, the median duration of a work comp claim "has remained largely flat since the beginning of the recession three years ago."

Another major area of perennial concern is the cost of prescription drugs. NCCI Holdings recently released a report in which it noted that prescription drugs accounted for an estimated 19% of work comp medical costs in 2009. NCCI also noted that this number is pretty much in line with their earlier projections. "The Workers Compensation Prescription Drug Study: 2011 Update," states: "In total, medical costs per workers comp claim averages more than $6,000 and soars to almost $25,000 for lost time claims." The study also found that cost increases were driven more by a rise in utilization than by increases in the prices of prescription drugs.

Increasing combined ratios

NCCI also reported earlier this year that the combined ratio had again deteriorated. It noted that both the accident year and calendar year ratios had gone up five to six points from the prior year—the accident year ratio from 109 to 114, and the calendar year ratio from 109 to 115. This is a trend that most experts agree is unsustainable in the long run. A number of major work comp carriers have begun to develop specific strategies to combat these ratios.

One of the other issues that is affecting the combined ratios is the sorry state of investment income. Work comp is a long-tail coverage. Because a significant amount of time elapses before a claim is finally settled, it is an excellent product to provide investment income. However, over the past few years, we are obtaining historic lows in interest rates and thus little in the way of investment income. A.M. Best has estimated that a 1 point reduction in investment yield requires a 5.7 point improvement in the work comp combined ratio.

Health care reform uncertainty

In March 2010, President Obama signed into law the Patient Protection & Affordable Care Act (aka ObamaCare) and the companion Health Care Education Reconciliation Act of 2010. While ObamaCare has many far-reaching features, most do not take effect for several years. As a result, the Act's ultimate effect on work comp remains unknown. However, some experts anticipate that the overall effect could be positive, since there should be less cost shifting because more people will have health insurance, and will not need to look fraudulently to work comp for needed coverage.

Fraud has always been a concern with work comp coverage. The current financial crisis has only heightened the concern about this issue. The concerns expand beyond those employees who may try to "fake" an injury or the extent of the injury; today it is also a concern about employers who try to "game" the system. Many employers are just trying to find some way to keep their doors open for one more week, so they under-report for premium purposes. According to the National Insurance Crime Bureau's Suspicious Claims Report, the number of suspicious work comp claims for the first quarter 2011 was up 24% compared to the same time period in 2010. Somewhat surprising is that the most common reason for suspicion was for inflated medical billing.

Conclusion

The work comp market will require some close monitoring to make certain that it remains a viable, sustainable system. As the NCCI has indicated, today the current work comp system can be classified as "deteriorating." So it is extremely important to take appropriate actions to get the work comp market back on a profitable trajectory.

Certainly the overall economy will continue to affect the market, but in the long run it will be the underwriting performance that will drive results. To that end, there are several alternatives, as California learned about 10 years ago, that must be taken under advisement. One of the most obvious solutions is to increase rates—easier said than done, for sure. The second option is to begin to implement tort reforms that are aimed at controlling rising costs—again not the easiest of tasks. Unfortunately, the third alternative is a combination of both of the above options. For the most part, the easy solutions have all been tried, and we are left with the harsh reality of a line of coverage that is "deteriorating."

Since work comp is such an important line of coverage to any business's commercial insurance program, it is essential that brokers closely monitor the situation in the states where they operate. As can be seen in the case of California, things can change quickly.