Insurance headlines over recent months have been full of news regarding industry-wide workers' compensation results for 1999. The National Council on Compensation Insurance (NCCI) announced that the estimated accident year combined ratio for workers' compensation in 1999 is very likely to hit 135%. A number of articles have cited this estimate and gone on to discuss the market conditions that have contributed to this result. None of these articles, however, actually described what exactly makes up this often-used insurance term - combined ratio.

The combined ratio is derived through a formula that uses all losses and expenses in a given year as the numerator divided by premium as the denominator. In other words:

Losses + Expenses/Premiums = Combined Ratio.

This short definition doesn't explain much to a policyholder who is reading about poor results in workers' compensation yet only this year is being potentially faced with an increase in premium. A more detailed description of the numbers behind the formula is warranted to fully understand what is happening in the world of workers' compensation and why a combined ratio of 130% is finally leading to price strengthening efforts among a growing number of larger companies who write workers' compensation.

Losses

Losses in workers' compensation are the dollars that will be paid by the insurance carrier as the result of workplace injuries reported by its policyholders. These dollars will be paid out in three basics forms:

1. Indemnity benefits - these are dollars paid to the injured worker in lost wages and/or additional dollars for any permanent impairment that may have arisen from a workplace injury. These may also involve death benefits in the case of a workplace fatality paid to a surviving spouse and children.

2. Medical benefits - these are dollars paid to physicians, hospitals, nurse case managers, pharmacies, and therapists that provide medical care to the worker for his/her workplace injury. These may also involve very large expenditures for equipment and attendant care if the injured worker is catastrophically injured (brain damage, spinal cord injury, amputations, severe burns).

3. Allocated loss adjustment expenses (ALAE) - these are dollars paid in litigated or suspect claims to attorneys, private investigators, physicians and/or other experts, miscellaneous litigation-related costs and medical cost containment services.

It may strike the reader as odd that the third form of losses (ALAE) is actually called an expense in its title but because these dollars arise from adjusting a specific claim of an injury they are considered a part of the losses.

All losses are stated as “incurred” as opposed to simply the dollars that are actually paid within the given year. Workers' compensation losses are paid over relatively long periods of time, in some cases for the life expectancy of the injured worker. Therefore the only accurate method of stating losses is to include not only the dollars paid within the given year but also the additional dollars reserved to pay for the remainder of the loss. In other words: Paid Loss + Reserved Loss = Incurred Loss.

Expenses

While losses arise directly from workers' compensation injury claims, there are a significant number of expenses that are also incurred by a workers' compensation insurance writer in the usual course of doing business.

Unallocated loss adjustment expense (ULAE) - these dollars pay the claim professionals and related overhead for employing these professionals. These expenses are considered unallocated as opposed to allocated to the loss because the insurance writer has to employ these resources regardless of the number and nature of the losses.

Acquisition and collection expense - these dollars pay the marketing, underwriting, premium audit, health & safety, premium billing and collections professionals and the related overhead for employing these professionals.

General expense - these dollars pay the wide range of management, administration and support personnel that an insurance company must employ along with the related overhead.

Commission and brokerage - these dollars pay the sales commission owed to independent insurance agents and brokers for placing the business with a specific insurance writer. They are paid in addition to the acquisition expense that the insurance writer pays its own employees to find and write business.

Taxes, fees and assessment - these dollars pay the premium tax, any special fees and/or assessments charged by a specific state insurance department.

Dividends - these dollars pay a portion of the premium back to the policyholder, typically six to 12 months after the expiration of those policies that were written including a dividend plan.

Combined ratio calculation

The formula for calculating the combined ratio at the opening of this article simply stated that the loss and expenses are divided by the premium to compute the combined ratio. The actual computation is a bit more complicated.

There are two forms of premium to consider - written and earned. Written premium is the estimated total amount of premium that will be charged for a given policy. Earned premium is the amount of premium that was actually charged as the policy period ages. For example, a policy is written effective 1 March, 2000 and the full estimated premium for that policy is $120,000. Therefore written premium for 2000 would be $120,000. Yet by 31 December, 2000 only ten of the full 12 months of the policy (most workers' compensation policies are 12 month annual policies) would be “earned”. The policyholder could potentially go out of business or terminate the policy early. Earned premium for 2000 would be $100,000.

Losses are divided by earned premium and expenses are divided by written premium in the computation of the combined ratio. The only exception to this rule is dividend expense that uses earned premium in the denominator because dividends are computed well after the expiration of the policy when premium is fully earned.

Each ratio is added together totalling up to the combined. For example:

Losses = 60%

Acquisition Expense = 6%

ULAE = 7%

General Expense = 7%

Commissions = 8%

Taxes, fees, assessments = 6%

Dividends = 6%

Combined Ratio = 100%

A combined ratio of 100% would indicate that for every dollar of premium an insurance company collects, the company is eventually paying back that dollar in losses and expenses. If the combined ratio is less than 100%, the company is obviously making a profit (referred to as an underwriting profit). If the combined ratio is over 100%, the company obviously is losing money on the workers' compensation business that it is writing.

The insurance industry has operated at less than 100% combined ratio in workers' compensation for only two of the last ten years (see the table below):

(Please note the term accident year in the combined ratios in the table above. Accident year captures only those losses that have occurred during the respective year given. There is also a calendar calculation that uses not only the losses within the respective year but all changes in incurred losses from prior years. Accident year combined ratios are considered by most as the true indicator of profitability in workers' compensation because prior year losses can either understate the combined if reserve releases occur from prior years or overstate the combined if reserve increases occur from prior years.)

The “good old days” were 1993 and 1994 when workers' compensation reforms were legislated in numerous states yet pure state-regulated insurance rates had not yet dropped significantly and insurers were just beginning to discount premiums. Since that time, rates and discounting have resulted in premiums being charged that are only 50% of what was being charged in the early 1990s.

Operating ratio

So why have companies continued to write this business and discount premium over the past couple of years? One offsetting factor is investment income. Workers' compensation losses typically take a long time to pay out, so the insurance company collects more cash through premium than it needs to pay the losses within a given year. That cash can be invested to generate investment income. Cash from the previous year's writings and long-term retained earnings are also available to produce investment income. The combination of losses and expenses divided by premiums and investment income equals the operating ratio: Losses + Expenses/Premium + Investment Income = Operating Ratio.

Investment income helps an insurance company that writes workers' compensation stay in business. Without the ability to generate investment income, a company would eventually run out of cash to pay losses at a sustained combined ratio over 100%.

But how much over a combined ratio of 100% can be tolerated? A.M. Best, the principal financial rating institution for the insurance industry, estimates that a workers' compensation writer that has been in the business for a number of years can still squeeze a profit with an operating ratio upwards to 115%.

The impact of a combined ratio of 135%

No insurance carrier can sustain a combined ratio in workers' compensation of 135%. No amount of investment income can cure this ill. The accident year combined ratio in workers' compensation deteriorated dramatically in 1999 and will likely continue this deterioration in 2000 as well. Only a few states have increased pure premium rates for workers' compensation going into 2000 (for example, California increased rates 25%, while Massachusetts decreased rates 25%) and there are a number of smaller workers' compensation writers which continue to discount heavily in order to secure market share.

There is no alternative to price increases as time marches on in workers' compensation. Again, insurance carriers cannot sustain combined ratios at the extraordinarily high levels that they have reached. Understanding the combined ratio should help policyholders understand what is happening in the world of workers' compensation and help prepare them for inevitable price increases.

Jon Gice is president and chief operating officer of ManagedComp.