With all the attention focused on that other recently deregulated market in California, electricity, it’s important to talk a bit about clear and present danger in the market that did it first,workers’ compensation insurance.
Back in 1995, California’s workers’ comp market shed its 75-year-old “minimum rate law” and went head over heels into the great unknown of competitive pricing for workers’ comp insurance.
With California having the most expensive system in the nation at that time and one of the lowest rankings when it came to disabled worker benefits, it was pretty clear what would happen. And it did: Employer premiums dropped on average 34% in the first three years of deregulation. Carrier profits, which were “generous” under the minimum rate law, settled down to something more normal and everything looked good, for a while.
Premium reductions should have stopped a couple of years ago, owing to adverse loss projections, and carriers should have begun squirreling away reserves against those future claims by slowly raising premiums. But they didn’t. Why? Utter stupidity is a possibility, but more than likely it was the quest to maintain or even grow market share: Those companies which could afford to take the losses would drive out the weak competitors and position themselves to reap the benefits of a future oligopolistic market,textbook economics in action.
At about this time a year ago, before any “hardening” of the market had taken place, it was estimated that the workers’ comp system in California was approximately $3.0 billion under-reserved. Now, with prices finally rising by something approaching the 18.4% recommended by the Workers’ Compensation Insurance Rating Bureau and approved by the infamous Commissioner “Quack,” system reserves are now estimated to be $4.7 billion below where they should be.
For 1999, carriers spent 43% more paying losses and covering operating expenses than they took in by way of premiums. A good bond market helped bolster returns on invested reserves, but not enough to offset a horrible cash flow problem. It is going to take some time to catch up.
There’s an interesting parallel here to the situation we presently face in the electricity market, where the wholesale cost to the utilities is running at close to 100% above the price they can charge to consumers under temporary pricing restraints. To date, SCE and PG & E; have racked up more than $3.0 billion in under-collections as a result. The price protection afforded SCE and PG & E; customers ends in early 2002 and, coupled with the huge losses these utilities have accumulated, everyone had better get a home equity loan in order to keep the lights on.
The reasons for this unfortunate situation are different than in the workers’ comp market. Under-capacity and a terribly hot summer all across the U.S. have pushed electricity prices through the roof. Already the state is moving to alleviate the capacity problem by fast-tracking new generating plants. But it’s fair to say that for the next several years the problem will be with customers of SCE, PG & E; and SDG & E.;
If you’re a customer of the Los Angeles Department of Water and Power, on the other hand, you are definitely smiling all the way to the bank. As a municipal utility not subject to regulation by the same entities that oversee SCE, PG & E; and SDG & E;, LADWP has made decisions over the years to build excess capacity and use cheap hydroelectric power whenever possible, thereby protecting its customers from the present crisis.
Returning to workers’ comp, has the market actually become more “concentrated” as a result of strong competitors pushing out weak ones? It is true that there was one significant failure in 1999. But all in all, industry concentration declined in 1999. The four-firm concentration ratio went down to 33.2% from 36.6%, and the more sophisticated Herfindahl-Hirschman Index fell from 590.2 in 1998 to 544.0 in 1999, still indicative of a reasonably competitive environment, as has been the case since 1995. While six firms left the market in 1999, 10 entered. This, too, has been an on-going pattern since deregulation began.
On the national level (California is 25% of the national market based on written premium), industry concentration does seem to be on the rise, however, with cash flow and under-reserving problems, too, but not quite yet at the level of severity encountered in California. Carrier solvency is not really a significant issue, but in California alone there have been several companies which have experienced downgraded ratings of overall financial quality recently.
The good news in California is that claim frequency, which has dropped steadily since a peak in 1991, has remained low. Unfortunately, cost per claim has been rising and hence, coupled with the rapid expansion in employment (therefore covered employees), the overall situation has continued to deteriorate due to the reluctance of carriers to raise premiums. It was Warren Buffet who once said: “The problem with a soft market is that the dumbest competitors set the price.” So maybe utter stupidity is the right explanation after all.
What with some signs of rational pricing returning to the market, the absolutely worst thing that could happen is the governor’s signature on SB 996, which is an attempt to regurgitate last year’s SB 320 that was vetoed. While it is true that California has among the nation’s lowest temporary disability benefits for injured workers, loading a big increase in benefits on right now,even though those increases would not be fully implemented until 2005,is not a good idea. Benefit increases need to be coordinated with other things happening in the workers’ comp market and additional reforms aimed at reducing system costs.
As to the future, over the past couple of years carriers have been using re-insurance to put off the inevitable. That market has effectively crashed, so there really are no other options than a continuing “hardening” of the market with respect to premium levels. How fast premiums rise is a matter of some speculation, but somehow reserves must be bolstered. Look for steady price hikes over the next few years unless additional system reforms are enacted.
Aigner is professor of management and economics in the Graduate School of Management at the University of California, Irvine.
