California Workers’ Comp Hanging By A Thread

What’s wrong with workers’ compensation in the state of California? Many would talk of the impending fear that the market is hanging by a thread… a thread that is slowly, but surely unraveling.

With all of the controversy surrounding the workers’ comp crisis, it has become difficult to sort through the myriad of issues facing the market. There are so many—but each holds its part in the crisis and must be acknowledged if California’s workers’ comp market is to ever recover and stabilize.

According to Michael Nolan, president of the California Workers’ Compensation Institute (CWCI), there are several issues stirring up turmoil in the market.

The implementation of AB 749, increasing medical costs, reinsurance issues, rising premium costs, the subjectivity of the permanent disability rating system, and the continued strain on the California Insurance Guarantee Association top the list. “You have a system where costs are rising, haven’t stabilized as yet, and you have a lack of predictability in the California workers’ comp system,” says Nolan.

“The biggest problem is the continued adverse loss development,” says Mark Webb, vice president of state affairs for the American Insurance Association (AIA). “Claims are getting more expensive to adjust, to settle, to dispute, and we, as an industry… are just having too much difficulty keeping ahead of the inflating costs of claims.”

Republican Insurance Commissioner candidate Gary Mendoza says the system is edging towards a meltdown. “There’s going to be more turmoil, and if we didn’t have a budget crisis on the heels of the energy crisis, we’d be talking about the workers’ compensation crisis.”

Jack Hannan, director of Marketing & Communications for the Workers’ Compensation Insurance Ratings Bureau, noted the increase in rates of medical costs as a key issue in the crisis. Hannan suggests that “the rate at which claims are growing is really being driven by medical expenses, more than anything.” He explains that the while the average cost of the claim has been
going up, the frequency has been going down, leaving the marketplace in a precarious position.

Another major issue of concern is the diminishing competition among carriers, resulting from the large number of California workers’ comp carriers that have either become insolvent, exited the market, or are being conserved, liquidated, or under supervision, says Norris Clarke, deputy commissioner of Financial Surveillance at the California Department of Insurance (CDI).

State Fund concerns revisited
In the midst of the crisis emerged the recent rating downgrade to “B+” with a negative outlook by A.M. Best of the State Compensation Insurance Fund. Subsequently, the Fund withdrew the rating. This fueled speculation of possible financial instability—and the potential meltdown of California’s workers’ comp market.

“State Fund is a residual market that is supposed to provide a shock absorber for the changes that occur in the private workers’ compensation marketplace,” says Democratic Insurance Commissioner candidate John Garamendi. “As a result of the failure of several companies and exit of other companies from the private marketplace, State Fund has seen phenomenal growth.” Consequently, carriers who were maintaining a balanced book of business got spooked and exited the market. The under-pricing stemmed from the advent of open rating in 1995.

“The rating agencies downgraded State Fund and that is a sign of financial trouble. Whatever State Fund may say, or want to say, about whether they should or should not be rated, the rating agencies are questioning their financial situation.”

Garamendi further explains that any time an insurance company experiences rapid growth, its financial strength is jeopardized. “You need capital to back up the potential losses. And that capital doesn’t necessarily grow as fast as the premium volume.”

The remedy
If the financial ratings companies are suggesting that State Fund’s financial stability is questionable, then the Fund must react quickly to remedy the situation.

According to Jim Zelinski, spokesperson for State Fund, “We’re finalizing plans to transfer some of our loss portfolio, that will increase not only current, but also for future surplus.” He also suggested the continuance of enhancing efficiencies for policyholders, including electronic claims imaging and filing.

“I would assume that part of what the Department is asking for State Fund to do is to raise its rates on renewal, and in so doing, start shedding some of the business it was forced to take over that it bought out over the past couple of years,” says Webb.

He suggests reaching out to national carriers to mitigate the effect of reserve adequacy. By bringing them back into the market in an aggressive way, the Fund’s rapid growth will be curbed.

Clarke notes the complexity of State Fund’s role in the system, and how it affects the company’s ability to remedy their situation. “There are significant limitations on the way they can actually go out and raise capital,” he says, based on the Fund’s independent entity status. “They’ve sort of run out of the capital to write business on, but the business just keeps coming to them. What they are continuing to work on is to generate some additional surplus by reinsuring some of their old losses.”

“It’s absolutely critical that State Fund be a healthy, viable part of the workers’ comp market, and actions should be taken immediately to assure that,” emphasizes Garamendi.

Who pays?
With all of the speculation regarding State Fund’s future, the question had to be asked: who will serve as guarantor in the unfortunate event that the Fund goes under?

According to Clarke, if State Fund were to enter into a state of insolvency, the fate of the company would be unclear, due to the ramifications pertaining to the Fund under the Insurance Code. “Under the law, the Fund is an independent entity. It’s supposed to be self-supporting from the premium revenue and the profits it’s historically generated, so technically and legally, it’s not a drain on the state budget. Practically speaking, it’s hard to say. A company of its size, and with the number of employers that it insures, might put an unbearable strain on the system if the Fund… was unable to continue writing business. Technically, it’s an insurance company, and if, god forbid, it became insolvent, it would be subject to going into some form of conservation,” explains Clarke.

“The basic underpinnings of the Fund are embodied in the Insurance Code,” continues Clarke. He offers this example: while the insurance commissioner has the authority to conserve and liquidate persons subject to its jurisdiction, and there’s a definition of ‘persons’ in the Insurance Code, it’s unclear if State Fund falls under that definition of ‘persons’.

Therefore, it is unclear as to whether or not that provision of the law would apply to State Fund. “There’s other areas of the code in which it’s unclear as to the applicability of the provisions of the law to the Fund.”

The effect on agents & brokers
What implications does the workers’ comp crisis have on independent agents and brokers? The most significant concern is likely the lack of availability in the market. The increase in premium rates since Sept. 11 concerns policyholders, who are keeping the agents on their toes as they look to other solutions (if any) to the crisis.

“I would suspect [agents and brokers] feel that they’re caught in the middle,” says Nolan. “They have carriers who are increasing prices for workers comp, and the market continues to harden. The agents and brokers have not experienced a hard market for many years. They’ve had to take the message of the hardening market to their clients, and their clients of course feel that workers comp costs are very expensive.”

“It’s very difficult for the agents right now, ” adds Webb. “[There’s] probably a concern about the availability of markets, and this will probably be an ongoing concern as State Fund, under its agreement and its interaction with the Department of Insurance, tries to shed some of the business its acquired over the past couple of years.”

Inviting private carriers back to Calif.
In light of the many events that have taken place over the past couple of years, one of the biggest concerns remains to be the diminishing number of carriers left in California’s workers’ comp market. While many have turned to State Fund for their workers’ comp insurance needs, that alone has attributed to the precarious situation. There is no statutory limit on how much business the Fund can write, which could lead to disaster if they do not maintain the proper capital to pay claims now and in the future.

Mendoza explains the hesitation for carriers to re-enter the market: “There’s so much uncertainty surrounding the viability of the workers’ compensation marketplace that people are reluctant to step in. But a strong and competitive workers’ compensation market is in the best interest for the people of the state of California.” He suggests that when the market stabilizes, they will return.

As for Nolan, he feels the most important role California faces is that of instilling confidence back into the workers’ comp market.

According to Webb, “Very large markets are very interested in having the financial service products available at a broader economic development. So I think part of this is an approach, and an acknowledgment that California is such a large market that it is going to attract capital from companies who have the economic diversity to be able to successfully continue writing this line of business in this state. The notion of trying to regenerate a heavily concentrated domestic mono-line workers’ comp insurance industry in California really goes contrary to the whole notion of effective solvency regulation as we’ve seen develop from the mid 90’s in terms of diversifying the risk both by line and by geography.”

Calif.: a unique state
What we need to remember, amidst this crisis, is the uniqueness of California, not only as a state, but also in terms of the role it plays in the workers’ comp market.

Says Hannan, “Our size makes us unique because it is the largest workers’ comp market [in the country].”

Clarke attributes California’s uniqueness to a variety of factors. “We are the only state that has pure, unadulterated open rating with no requirement for rate adequacy. I think that California’s overall losses have been escalating more rapidly than [in other states].” He also notes the excessive number of insolvencies the state has experienced, “at least in number, if not in magnitude.” Finally, Clarke points to the fact that California is probably among the least competitive markets in workers’ comp, due to the unprecedented number of carriers that have gone insolvent or left the state.

Webb notes California’s inescapable vulnerability to earthquakes. “What happens if a magnitude seven or larger hits in the greater Los Angeles or greater San Francisco areas at 2 o’clock on a weekday afternoon? The pressure would be put not only on California systems, but also reinsurers. It would have global implications.”

Hope for the future
The state of California has some work to do—a lot, in fact, if it wants to prevent the workers’ comp crisis from its ultimate demise. The upcoming commissioner’s race will leave the winner with a full plate the day he steps into office.

Clarke describes some of the attempts the CDI is working on to stabilize the workers’ comp market, which includes sponsoring legislation that would make changes in the open rating law, including changing the standards by which rates and rating plans are deemed adequate. “We believe that will bring a little more stability to the marketplace. Part of the reason for the bill is to stimulate competition and bring new companies into the market.” Clarke says the legislation will minimize the heavy rate discounting that was previously used by a number of companies, and in turn, increase market share.

The role of abuse needs to be closely examined, says Mendoza, as he feels it is the injured workers and the employers that are hurting the most from the crisis. He says, “You know, the employers pay the bills, and the employees receive the benefits. And those are the people we want to pay most attention to.”

Webb offers this suggestion: “If you deal with the adverse rate, you by necessity capture this problem of adverse loss development in years following the policy years, and that is the core element of effective solvency regulation.”

As for the future of State Fund, Zelinski points out:”We would concur that the concern over the conditions of the marketplace are understandable. Really, we’ve faced a pretty big challenge the last couple of years, because basically about 20-25 percent of the private market went either into insolvency, or regulatory supervision. But again, we want to assure everybody that State Fund is financially stable. There is no question about our ability to pay claims now or in the future.

“We’re going to continue to fulfill the same role that we’ve had when we opened our doors in 1914,” says Zelinski. “That is to provide a permanent, stable workers’ compensation market. Our role is the bedrock of the system.”