Kay Rahardjo examines the outlook for the workers' compensation marketplace.
Workers' compensation has experienced a dramatic turnaround throughout the 1990s. From 1984 through 1992, the industry posted an average pretax operating loss for workers' compensation of 5% of premium, whereas for 1993 through 1997, there was an average pretax operating gain of 15% of premium. This improvement is due to a variety of reasons, among them: effective state reforms, slower growth (even decreases) in claim costs, decreases in claim frequency, managed care initiatives, successful rate filing activity, decreased fraud and litigation, and an enhanced focus on safety and loss control.
Can we expect continued rate decreases and loss cost improvements for workers' compensation? This is a question that is on the minds of many insurance buyers today as they work on renewing their insurance programs. The state of the property/casualty insurance industry today suggests that we can expect rate decreases to continue for the immediate future, even though the days of workers' compensation loss cost improvements seem to be behind us.
State of the property/casualty industry
How can rates continue to decrease in spite of increasing loss costs? To answer this question we must consider the state of the industry. Today's property/casualty marketplace is extremely competitive. Industry capital is at an all-time high - it reached $310 billion at the end of 1997 and leverage, as measured by the premium-to-surplus ratio, is at an all-time low of 0.89, according to Standard & Poor's.
Carriers with "extra" surplus enhance their capacity to provide insurance. However, the increase in capacity to provide insurance has outpaced the increase in the demand to buy insurance, particularly for workers' compensation. From 1987 to 1996, premium for automobile liability grew 60%, while premium for workers' compensation grew only 15%. This reflects the increased popularity of alternative market solutions for financing workers' compensation. Ever-escalating workers' compensation rates throughout the 1980s along with ever-increasing residual market burdens for carriers doing business in many states drove insureds to pursue self-insurance, captives, or large dollar deductible policies.
The industry finds itself in the paradoxical situation of plummeting rates and record surplus due primarily to reserve lowering, fewer catastrophes during 1997, and to the remarkable turnaround in workers' compensation throughout the mid-1990s.
The 1997 composite return on equity (ROE), a bellwether in evaluating stock company performance, was 14.6% for the 22 largest publicly traded property/casualty companies (Source: Fox-Pitt, Kelton, May 1998). Reserve releases from prior accident years added 1.7 ROE points to this return. These reserve releases cause a compensating increase of surplus. Additionally, 1997's relatively low level of catastrophes contributed another 1.9 ROE points, based on the industry's current leverage ratio.
During the past few years, loss costs for workers' compensation have actually decreased relative to inflation. The average indemnity cost per lost time case remained flat from 1990 through 1996, while the employment cost index (which tracks increases in wages) increased over 20%. Workers' compensation indemnity costs replace wages for injured workers while they are out of work recuperating from their injuries. In the absence of other factors, workers' compensation indemnity costs would be expected to increase at roughly the same rate as wages increase, so a flat change in workers' compensation indemnity costs at the same time as a 20% increase in wages suggests a substantial improvement.
The average medical cost per lost time claim has also decreased relative to the consumer price index for medical costs. From 1990 through 1996, average workers' compensation medical costs per lost time claim increased 33% while the medical consumer price index increased 49%.
In summary, the state of the marketplace today suggests that the industry will have to shed some of its massive surplus before rates can begin to reflect the increases in loss costs we are beginning to see for workers' compensation. Surplus can be eroded by catastrophes, by reserve increases, and by continued rate deterioration in the face of increasing loss costs.
Predicting the future
Catastrophes can have both a direct and an indirect impact on the workers' compensation marketplace. There is a direct impact if an event like an earthquake occurs in an urban area during working hours and an indirect impact due to the effect catastrophes can have on industry surplus. Only time will tell if the catastrophe experience throughout the next few years will enhance or reduce profitability. This is because past catastrophe experience is a poor predictor of future catastrophes. However, many industry experts believe that catastrophes will happen more frequently. This is because more of the world's population lives in densely-populated, urban areas today and large concentrations of people and property are prerequisites for catastrophes.
There were four times as many catastrophes in the last 10 years than in the decade of the 1960s and this increased incidence in catastrophes translated into 15 times the insured catastrophe losses. While more catastrophes may serve to decrease the industry surplus, it could have the opposite effect by driving insureds towards non-insurance solutions such as risk securitization.
Past loss experience along with an awareness of the current environment, can indicate future loss performance. For workers' compensation, if we relied solely upon the experience of the recent past, then we would continue to predict rate decreases. On average, workers' compensation rates have decreased almost 30% over the last five years although rates for certain segments have been even greater. Most insureds have come to expect rate decreases with each annual renewal. Many carriers are continuing to meet these expectations, sometimes writing policies at less than expected losses.
What evidence, if any, exists to suggest that workers' compensation costs will increase? One strong piece of evidence comes from a comparison of calendar year combined ratios with accident year combined ratios. For 1997, the accident year combined ratio is 115% versus a calendar year combined ratio of 101% (see Exhibit 1). This suggests that recent policies are less adequately priced than business from prior years.
The industry has obviously been helped by state reform. The National Council on Compensation Insurance (NCCI) suggests the industry saved $3.6 billion from 1991 to 1996 from legislative reforms. Much of the state reform appears to be behind us for now because there are no significant benefit reforms expected in the immediate future. Thus, we cannot expect future reform to continue to dampen workers' compensation costs.
Managed health care strategies have also helped to improve historical loss costs. As mentioned earlier, medical inflation has outpaced workers' compensation medical costs from 1990 through 1996. However, over the last two years, workers' compensation medical costs have increased at twice the rate of medical inflation. In the future, some observers believe workers' compensation medical costs will continue to outpace medical inflation as the workforce ages and as consumers demand more and better quality care from their medical providers.
Today's workers' compensation marketplace is as challenging and competitive as it has ever been. What about the future? Although no one knows when pricing will "catch up" with loss costs, it is not a matter of if the industry will feel the pain of today's pricing decisions, but when.
Kay Rahardjo is vice president and national market actuary for Liberty Mutual. Her responsibilities include strategic planning, pricing, and profitability analysis for the national market, as well as risk management consulting services for national market customers. Prior to joining Liberty Mutual in June 1996, Ms Rahardjo worked closely with large account underwriting, claims, and services for The Hartford. Before joining The Hartford, she was a consulting actuary with Tillinghast-Towers Perrin, where she provided actuarial services to risk managers of Fortune 500 companies.