California’s Workers’ Comp Is It Recovering’

Industry analysts and experts alike all use similar words to describe the state of the California workers’ compensation market—beleaguered, anemic, frenzied, troubled. So when did this market take such a turn for the worse? Better yet: is the California workers’ comp market on the road to recovery?

In the early 1990s, California’s workers’ comp system was in crisis, as premiums continued to rise year after year. To help turn the market around, the shackles were removed in 1994 from the state’s 80-year-old minimum rate system, bringing in an open rating system in 1995—and a whole new meaning to market competition.

For roughly five years following enactment of the new law, intense competition for market share dominated the market. As a result, premium prices dropped sharply while underwriting discipline and strict guidelines went straight out the window. Carriers found themselves pricing policies at rates less than what it costs to service the policy.

Statistics from the Workers’ Compensation Insurance Rating Bureau of California (WCIRB) show that every year since 1997, employers have paid more and more for workers’ comp coverage. Total written premium in California in 1997 was $6.4 billion. By 2000, that number had grown to $9 billion. The combined ratio in California surged from a 1993 low of roughly 84 percent to in excess of 150 percent for calendar year 1999.

The numbers reveal that maintaining a share of the California workers’ comp market was a much greater and more immediate priority than producing sound underwriting results. But this type of behavior can’t last forever.

By 2000, it became clear that the industry was under-reserved by billions of dollars. In fact, in a report published in July 2001, Standard & Poor’s (S&P) quoted a National Council on Compensation Insurance finding that the U.S. workers’ compensation industry was under-reserved by $20 billion, while California carriers were under-reserved by $7.1 billion, according to the WCIRB.

“The market started to turn back in 2000 and rates appeared to be increasing pretty significantly over the last couple of years,” said Dave Bellusci, senior vice president and chief actuary of the WCIRB. “However, the hole is very deep. At the low point, we were estimating in 1999 the actual combined ratio was 170, so it’s going to take some time.”

Getting a grip
In an effort to reverse the trend, many carriers attempted to recoup their losses by charging significantly higher premiums. A number of California specialty carriers ceased underwriting altogether, while some large national carriers decided to exit the market. Clearly, it was time for the California Department of Insurance (CDI) to pull back the reins and get this market back on the right track.

The insolvency trend was led by Superior National Insurance Group Inc., which in 1998 had been the state’s largest private-sector workers’ comp provider. In March 2000, the CDI seized Superior National, citing the company’s hazardous financial condition and severe under-reserving.

According to an S&P report (July 9, 2001), this was the largest takeover since Golden Eagle Insurance Corp. in 1997, which had previously been California’s largest private-sector writer.

Other carriers followed. In the second quarter of 2001, the HIH Insurance Group of Companies and Sable Insurance Co. met similar fates. Lastly, Santa Monica-based Fremont General Corp., the second largest private workers’ comp provider, is now under the effective supervision of the CDI because of its fragile financial condition. Just like Superior National, Fremont’s problems stemmed, in large part, from charging rates that were inadequate to cover their losses and other underwriting costs.

Necessary downgrades
With the insolvencies came downgrades on a handful of companies. During the first half of 2001, S&P’s downgraded the State Compensation Fund of California (“A” to “BBB+”), Argonaut Intercompany Pool (“AA-” to “A”), PAULA Insurance Co. (“Bpi” to “CCCpi”), and Zenith National Insurance Group Intercompany Pool (“A” to “A-“).

Then, on Dec. 4, 2001, S&P lowered its counterparty credit and financial strength ratings on the State Fund to “BB+” from “BBB+” and removed them from CreditWatch, where they had been placed on Nov. 19, 2001. “We immediately withdrew the rating at the Fund’s request,” said Jason Jones, associate for S&P.

According to S&P, these ratings had been placed on CreditWatch because of concerns over the Fund’s very rapid growth, which accelerated in the third quarter of 2001.

“The State Fund is willing to write…anything that has come on to the market…and their management team feels comfortable with their level of capital to support that,” said Matt Mosher, group vice president, property/casualty ratings, A.M. Best. “We have some concerns there, and I think some of the other rating agencies also have similar concerns with their level of capitalization and the sheer level of growth.”

“Clearly, I think what we’ve seen over the last several years is that State Fund’s market share has increased significantly—from 22 percent to roughly 40 [percent]…so there is a capacity issue,” said Matthew Coyle, director for S&P. “And their growth has put a strain on their capital.”

According to SCIF (State Fund) spokesman Ron Christensen, undoubtedly that growth has resulted in surplus challenges for the Fund. “We’re attempting to meet that surplus challenge with a significant rate increase—22.5 percent that has been approved—so we think that will help,” he said. “Plus, we are working on…some reinsurance solutions to generate some capital for our surplus.”

The growth was “unavoidable…and you bet it’s been ‘sheer’ growth…but we didn’t go out and solicit it,” he added, stressing that the reason the State Fund was established was to provide insurance to people when they otherwise can’t find a carrier.

Christensen believes that the State Fund’s growth is on a path to stabilization. “The regulatory action with Fremont certainly contributed to our growth, but there is no reason to suspect that kind of thing will happen in 2002,” he explained.

The bottom line is that there is profitability in the market now. “If the national carriers would take another look at California, we think they’ll come back in. We certainly extend the invitation,” Christensen said.

Norris Clark, deputy commissioner for the financial surveillance branch of the CDI, believes that as the rates return to an adequate level, the market should begin to see more competition from the national writers.

Meanwhile, what S&P’s Jones said he’s been hearing is that there seems to be some hesitancy from the national players to get back into this market in a “meaningful” way.

Downgrades of late
In addition to S&P’s downgrades, the rating agency of A.M. Best had a couple of its own to report. On Feb. 19, 2002, A.M. Best downgraded the “A-” (Excellent) financial strength rating of Legion Insurance Group to “B” (Fair) with a negative outlook.

Less than two weeks later, the rating agency downgraded the financial strength rating to “D” (Poor) from “B-” (Fair) for Pasadena, Calif.-based PAULA Insurance Company, and removed it from under review. The rating had been under review since March 9, 2001, due to uncertainty regarding the company’s recapitalization plans following a series of significant year-end reserve charges and the resulting deterioration in policyholder surplus.

According to a company press release, PAULA Insurance had been seeking new financing since the summer of 2001. Jeff Snider, PAULA’s chairman and chief executive officer, said the company’s poor underwriting results in prior years, combined with reinsurance instability following Sept. 11; uncertainty about the California market and its largest workers’ comp underwriter (State Fund); the “ripple effect” from Enron Corp.’s bankruptcy on actuarial conservatism; and “significant change” in legislated benefits for injured workers in California all resulted in “very expensive, scarce new capital.”

As a result, PAULA will voluntarily cease underwriting workers’ compensation business effective immediately.

“These recent downgrades are certainly going to have an impact on the market,” said Mosher. “One of the biggest concerns we’ve had all along is the level of lost-cost trends in California and the ability of any company to project what their true lost-costs are.”

Two-prong problem
According to WCIRB’s Bellusci, rates are becoming “relatively more adequate.” But there are some issues about many companies having reserve shortfalls for older years. This stems from the extremely competitive market causing a number of insurers to charge insufficient premiums. Unfortunately, their rates were not developed to cover losses, expenses or potential profits. Instead, they were designed to increase market share.

Problems arose when losses were developing at a very late stage of the game—and at a very costly level. “The severities were growing particularly late in the life of claims, which wasn’t recognized by many companies for several years,” Bellusci explained. “So not only were insurers not able to get the price they wanted, they were underestimating their costs, making it a two-prong problem.”

This reiterates the concerns of Mosher. “When lost-cost trends come into play, the company is unable—or has a very difficult time—projecting what their true costs are going to be,” he said. “For example, if it’s a 1 or 2 percent trend, if you miss, you miss by a little bit, but when the lost costs are double digits, you miss and calculate that over a year or two and you miss by a lot.”

Paving the way for a market correction
It’s no secret that over the last three years, insurers have been faced with increased premiums in the workers’ comp market. One of the factors contributing to the rise in cost includes an increase in the pure premium advisory rate. Since 1999, California’s insurance commissioner has approved pure premium advisory rate increases totaling 39 percent. In fact, pure premium rates increased an average of 18.4 percent in 2000.

Prepared by the WCIRB and submitted to the CDI for approval, these advisory rates are used as a benchmark for companies as they develop their own premium rates for specific types of businesses.

So why such sizable advisory premium rate increases? The average total loss per indemnity claim jumped from $18,355 in 193 to $36,643 in 2000. The average ultimate medical cost per claim was $8,916 in 1993; $19,467 in 2000. Lastly, the ultimate indemnity per indemnity claim was $10,283 in 1993; $18,909 in 2000.

Another factor contributing to the rise in cost of workers’ comp coverage stems from a surcharge to cover the cost of carriers becoming insolvent. To cover the cost of the insolvency “meltdown,” the California Legislature passed a law that authorizes an increase in assessments to provide additional funding for the California Insurance Guarantee Association (CIGA) to meet its claim obligations and insurers are now required to pay 2 percent of premium to the state’s insolvency fund.

Legislative band-aids
On Feb. 15, California Governor Gray Davis signed a workers’ comp-related bill, AB 749, which is causing concern that it could lead to further disruption in the system. In short, the new law provides maximum benefits paid to employees for work-related injuries to be increased incrementally over a four-year period—from the current $409 per week to $840 per week in 2005. This bill becomes effective Jan. 1, 2003.

Once fully implemented in 2006, the WCIRB estimates that AB 749 will increase benefit costs by 22.8 percent, or $3.5 billion annually, including the impact of increased benefit utilization.

Industry associations including the National Association of Independent Insurers (NAII), the Alliance of American Insurers (AAI), and the American Insurance Association (AIA) all agree that there is a lack of balance in the bill and that the benefit increases in the bill far outweigh the potential impact of cost savings provisions.

According to Sam Sorich, NAII’s senior vice president, secretary and general counsel, proponents of the bill didn’t take into account that the higher benefits would lead to more use of the system, which means more claims and more employees receiving benefit payouts for longer periods of time.

“There are some parts of AB 749 that we support and there are other things that we are less fond of,” said Keith Bateman, vice president of workers’ compensation and health for the Alliance. “As far as the overall impact…we don’t think it will save the $1.5 billion like the proponents say. Instead, it might save one-half or one-third of that.” AIA urged the inclusion of some components of AB 749, such as extended control over medical treatment for employers and expanded use of the Health Care Organization (HCO) system. But savings from these reforms are not guaranteed and will not occur for three to four years.

Mark Webb, AIA vice president, western region, feels that there are many important reforms that were left out of AB 749. “At a time when state and local governments and businesses throughout California are struggling, there must be a commitment to reduce system complexity, litigation and unnecessary medical treatment, and to restore the expectations of injured workers and the employers who pay their salaries,” he said.

Retroactive premium tax
On Feb. 25, the CDI notified workers’ comp insurers that they would now have to pay taxes on loss reimbursements received by insurers from employers under deductible policies of insurance. The notice reads that the Department will be “ascertaining the deductible amounts previously received for tax years 1997-2000 for the purpose of proposing additional premium tax assessments to the California State Board of Equalization.”

According to the CDI’s Clark, the Department learned of the premium difference after looking at WCIRB statistics. “They consider…the difference between a non-deductible premium for a given policy and the premium for that policy as it’s written with a deductible,” he explained. “So we had this number that had been relatively small in 1995, ’96, ’97, even in ’98, starting to creep up. The estimate for 2001 was that the premium credit associated with deductibles was getting up to about $3 billion.”

Clark estimated that assessments for 1997 alone totaled roughly $8 million.

“We disagree with the Department’s interpretation of the taxable nature of these reimbursements and strongly oppose how the Department notified insurers of its interpretation. It is self-evident that when an agency of state government changes its interpretation of a statute, that decision should be subject to the due process protections of rule-making proceedings,” AIA’s Webb stated in a press release. Upon receiving notice of the Department’s action, AIA submitted a Request for Determination with OAL, seeking its opinion regarding whether the Department’s notice violated the provisions of the Administrative Procedures Act (APA). A decision on that request is pending. AIA’s request was filed Feb. 28. AIA is also pursuing additional legal options.

In addition, AIA recently joined with other insurance industry partners to pursue this matter before the State Board of Equalization, which has ultimate authority over tax matters. Several business and tax organizations share AIA’s concerns over this issue.

A taste of what’s to come
The overall state of the California workers’ comp market has been a concern for all parties involved, and although it’s going to take some time to smooth out the kinks, the good news is that there seems to be light at the end of the tunnel.

“From the insurer perspective, with the rates significantly higher than they were two years ago, there is certainly improvement, but there is still a ways to go,” WCIRB’s Bellusci said.

S&P’s Coyle concurred, adding that this is a market that is still trying to turn itself around. “There is a capacity issue here, there is a concentration issue in terms of who the participants are, and there is additional strain caused by the benefits [increase],” he said. “It really is going to be an interesting year to see how it all plays out.”

According to SCIF’s Christensen, the statistics reveal that the industry is headed right back to where it was before open rating. “Prices are going to soar, employers are going to go nuts, and the Legislature will go crazy,” he said.

“The market shakeout is still going on from what happened years ago,” Alliance’s Bateman said. “We just hope that the hiccups on the road to success are working themselves out.