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Workers’ Comp Pain, Gain

Workers’ Comp Pain, Gain

VIEWPOINT

by Dennis J. Aigner

In my last article on the state of the California workers’ compensation insurance market (“Dereg Update: Good and Bad of Workers’ Comp”) in the Oct. 2, 2000, Orange County Business Journal, I commented that premium reductions should have slowed or stopped entirely after an average reduction of 34% over the first three years of deregulation.

But by 1999 that had not happened, and it was estimated that the workers’ comp system in California was approximately $3 billion underreserved, with carriers spending 55% more covering losses and operating expenses than they took in by way of premiums.

By October 2000, estimated underreserving had grown to $4.4 billion. Premiums had finally begun to rise, with most companies charging 20% or more than they had the year before, but losses and operating expenses still exceeded premiums by 44%,more than four times the level deemed “healthy.” (It’s considered okay if premiums fall as much as 10% below the combined costs because investment earnings are supposed to make up the difference.) Moreover, average premium levels were 7% below the “pure” rate needed just to pay for ultimate accident losses with no allowance for expenses.

What’s wrong with this picture? From the point of view of textbook economics, nothing. Companies that could afford to take such losses for a while did so, thereby attempting to drive out weak competitors and positioning themselves to reap the benefits of a future oligopoly,a market where there are but a few major players who can dictate prices and reap big profits. But that’s not the way it was supposed to happen.

The Workers’ Compensation Rate Study Commission, which I chaired from 1990 to 1992 and which recommended deregulating the market, had feared that rampant cost cutting to gain market share might happen and recommended that a rate “floor” be established at the pure premium rate, underneath which no company could go without Department of Insurance approval.

Unfortunately, that particular recommendation was not enacted by the State Legislature. While the Insurance Commissioner could intervene when carrier solvency was at issue, that authority is less clear and more complicated to invoke than a simple “floor.” Then-Commissioner Chuck Quackenbush was too busy with other things anyway to challenge his brain with the intricacies of helping a failing market for workers’ compensation insurance.

As of 1999, industry concentration was still indicative of a reasonably competitive environment. But things changed significantly in 2000. The four-firm concentration ratio rose to 39.8% (from 33.2%) and the more sophisticated Herfindahl-Hirschman Index rose to 652, a jump of almost 20% in just one year.

The year 2000 also saw the onset of what has become a spate of carrier insolvencies with no serious new entrants. National carriers began taking over the market (which is not necessarily a bad thing), with a 55% market share compared to 45% in 1999 and only 35% back in 1996. The years 1999 and 2000 signaled the first serious trouble for California-based carriers as measured by selected IRIS (Insurance Regulation Information System) ratios, especially those reflecting adverse operating performance and impending insolvencies. Better investment yields and reinsurance had helped stem the tide, but by 2000 the dike had some big holes in it.

Interestingly, claims frequency per $1 million of payroll continued to decline in 2000 and total workers’ comp costs borne by employers remained low compared to pre-deregulation years, at 1.75% of payroll. Total written premiums climbed to $9.2 billion in 2000, reflecting a booming economy and higher payrolls. Rising average claims costs (9-12% per year since 1995) were responsible for putting the squeeze on carriers.

By May 2001, the Workers’ Compensation Insurance Rating Bureau was estimating industry underreserving at $7.1 billion. Its recommended rate increase for 2001, 10.1%, was followed in August by a recommended 8.5% increase for 2002, which was revised to 10.2% in October and 15.6% in December 2001. Actual premium increases for 2001 are estimated to have been 19% higher that 2000, as the market continued to adjust. Nevertheless, workers’ comp costs remained reasonable as a percentage of payroll.

In February 2002, however, after years of trying, a bill promising significant increases in benefits was passed by the Legislature and signed by Governor Davis. AB 749 ultimately increases benefits by $3.5 billion per year while incorporating cost-saving reforms estimated at $1.5 billion per year. First-year additional costs beginning in January 2003 are estimated at 10.7% to the system.

With that looming but not yet accounted for, just last month the WCIRB proposed a very unusual mid-year increase in the pure premium rate of 10.1% (on top of the 15.6% already instituted for 2002), based on abnormal loss development during the last six months of 2001. The Department of Insurance is now asking the Legislature to enact our “floor” recommendation but, as they say, “too little, too late.” Meantime, the State Compensation Insurance Fund, the industry’s largest firm and its carrier of last resort, has expanded so rapidly as to have dipped below the prevailing risk-based capital standards, and has seen its quality rating downgraded.

With year 2001 performance measures about to be released, the industry is not likely to look much healthier. But it is turning around with regard to pricing, and that will help. Since deregulation, California has not been a profitable workers’ comp market overall, compared to the nation or to other lines of insurance in California. That situation is changing, and should eventually attract new entrants and additional capital.

In the meantime, the challenges are to rein in medical costs and to strive for even greater efficiency in administering the system. A big benefits increase can only come with a higher price tag for employers, but even so, payroll costs should remain at 2% or less. Getting the Legislature to go along with the idea of establishing a floor based on the pure premium rate will help down the road.

Aigner is professor of management and economics at the University of California, Irvine’s Graduate School of Management.

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