In a 2010 Wall Street Journal
article, Liberty Mutual CEO Edmund "Ted" Kelly is quoted as saying that workers' compensation is a "time bomb." Mr. Kelly further noted that Liberty, the largest workers' compensation insurer in the United States by premium volume, is now reducing exposure to comp business because of concerns about future costs. John Doyle, the president of AIG's U.S. property and casualty business (which is the second-largest U.S. comp insurer) also indicated a reduction in exposure to workers' compensation. Is workers' compensation truly a time bomb?
In May of 2010, the National Council on Compensation Insurance (NCCI), the statistical and rating organization for a majority of states, described the outlook for the workers' compensation insurance market as "precarious." NCCI reported a combined ratio of 110 for the comp industry for calendar year 2009, a nine-point increase from 2008. In other words, the industry paid $1.10 in claims and expenses for every $1.00 in premium. Although the combined ratio for the industry has been 110 or higher for eight of the last 20 years and above 100 for 17 of those, what sets 2009 apart from prior years is the low interest rate environment. The pre-tax operating gain of 1.6% in 2009 represents a very low return on equity.
In May of 2011, NCCI reported continued deterioration in results for the workers' compensation line despite a reasonable year for the property and casualty insurance industry as a whole. The combined ratio increased by another five points, and workers' compensation also experienced its first increase in frequency in 13 years.
Most insurance industry profits, especially for large insurers, result from income on premiums that are invested before they are needed to pay claims. During much of the 1990s, comp insurers were able to earn significant investment returns despite an average combined ratio for the decade of 109. However, investment gains in workers' comp, although up slightly over 2008, remained historically low in 2009 because of economic conditions. Although investment returns increased in 2010, the workers' compensation industry experienced a pre-tax operating loss of 1%. NCCI does not expect continued investment gains unless interest rates increase.
Workers' compensation is a state-regulated system; however, concerns about it were the subject of recent congressional hearings by the Workforce Protections Subcommittee of the House Education and Labor Committee. Members discussed their concerns about the state-regulated system as well as issues with federal workers' compensation programs, following the U.S. Postal Service's announcement of its possible bankruptcy due in part to escalating workers' compensation costs. Professor John F. Burton, Jr., former chair of the 1972 National Commission on Workers' Compensation, testified on November 17, 2010, that during the last 20 years he has seen a "…deterioration in adequacy and equity of state workers' compensation programs…." He recommended a new approach to workers' compensation.
There can be no question that the workers' compensation insurance industry faces major challenges in the current economy. Payrolls have declined because of the rise in unemployment, and this decline has eroded comp premiums that are based on companies' payrolls. Premiums are down by 23% since 2007. Although medical inflation has moderated, it continued to average 5% to 7% a year during the past five years. The low interest rate environment, causing a historical drop-off in investment returns, turns serious concerns into a potential crisis.
But there is another perspective: The challenges the workers' compensation industry faces are typical of those in economic downturns and soft market phases of the underwriting cycle. Because investment returns are an important component of a property and casualty insurer's profit, the industry typically reduces prices during periods of high interest rates to grow premium volume and, hence, earn greater investment returns. The industry invests significant assets in bonds, especially Treasury bonds, because bond values are less volatile than equities and bond durations can be matched to claim payments. When interest rates decline, providing lower investment returns, or when losses increase dramatically as in the aftermath of a catastrophe, the industry usually responds by raising prices and beginning a hard market phase of the underwriting cycle. Although interest rates are now low, the entire property and casualty insurance market remains in a soft market phase.
Christopher Colavita, senior vice president of NJM Insurance Company in New Jersey, believes that "cyclical issues are at play" in the current comp insurance market. Although he acknowledged that his perspective from an essentially one-state comp insurer is quite different from that of a national or international insurer, he believes that "'time bomb' is a little strong" to describe workers' compensation. His view of New Jersey is that there has been a protracted soft market, but he has not seen irrational pricing schemes. He agreed that the low interest rate environment is a concern for all property and casualty insurance lines. However, NJM is not pulling back from writing new workers' compensation business.
Describing the comp business, Liberty Mutual's Ted Kelly said, "Prosperity hides the cracks in the facade." Because workers' compensation is a long-tail line (claim costs are often not fully paid for many years after the loss occurs), problems can smolder for years before they reach a crisis level. For example, an insurer's reserves (the amount insurers set aside to pay future costs of claims) can be insufficient for long periods before an economic downturn or catastrophic losses suddenly push that insurer into insolvency. Prolonged soft markets with decreases in commercial insurance pricing often end with multiple insurer insolvencies.
Judith Vaughan, CPCU, AIC, is director of Content Development for The Institutes.