Taking a Different Route to Workers’ Compensation Coverage
Nov 11, 2008
Florida Underwriter–November 1, 2008
By Gary Harvey
Timing is everything. And now may be the perfect time to take a closer look at a different approach to workers’ compensation coverage — the alternative-risk market.
During the past five years, the $3.7 billion (2006) Florida workers’ compensation market has experienced profound change. According to the Florida Office of Insurance Regulation, prior to 2003, Florida was consistently ranked either number one or two as having the most expensive workers’ compensation rates in the U.S. The beleaguered Florida workers’ compensation system had created affordability and availability issues for Florida employers.
With pressure mounting, in 2003 the Florida Legislature passed Senate Bill 50-A to reform the system. The reform addressed many provisions of the workers’ compensation law, including attorneys’ fees, construction industry requirements for workers’ compensation insurance, fraud, and benefits for injured workers.
The reform’s impact has been dramatic and Florida is no longer in the top ten workers’ compensation rate levels. In fact, the reform has been so successful that the National Council of Compensation Insurance (NCCI) has consistently filed rate decreases for Florida .
The latest is an 18.6 percent workers’ compensation rate drop effective January 1, 2009. With this new rate reduction, workers’ compensation rates in Florida will have been reduced approximately 60 percent since 2003.
At the same time, the Florida Supreme Court recently ruled on a significant, potentially far-reaching case. The case of Emma Murray v. Mariner Health/ACE USA challenged the cap on attorneys’ fees, a key provision of the 2003 reforms. The recent decision by the Court could potentially affect post-October 1, 2003, workers’ compensation cases that are currently open as well as new cases going forward.
The Murray case was critical to the success of the Florida workers’ compensation reform and its potential impact looms over the Florida workers’ compensation market.
Challenges on All Fronts
In addition, conditions in the national insurance market are ripe for change. Economic uncertainty hovers. The soft market may be ready to turn. Rising medical costs continue to plague workers’ compensation.
According to the NCCI, nationwide workers’ compensation medical claim costs have increased every year since 1994, reaching an astounding $25.4 billion in 2007. Medical costs comprised approximately 59 percent of total workers’ compensation claim costs in 2007.
With so much market uncertainty, now may be the right time for Florida employers to explore alternative market options.
Alternative-market funding mechanisms enable employers to retain predictable levels of risk assumption and, in exchange, potentially maximize cash flow and investment yields and benefit from tax advantages.
National estimates say that 30-to-40 percent of the commercial property casualty market is now in the alternative-risk market.
With this background, what follows is a discussion of three popular alternative-risk mechanisms.
Self-insurance is considered one of the most cost-effective funding mechanisms to address risk. According to the Self-Insurance Institute of America, it is estimated that more than 6,000 corporations and their subsidiaries conduct a self-insured workers’ compensation program and, in addition, many others participate in group self-insured workers’ compensation programs. In Florida , self-insurance represents a significant amount of the marketplace — 20 percent of workers’ compensation benefits paid in 2005 were to employees of self- insured organizations, according to the National Academy of Social Insurance.
Florida private employers who wish to enter a self-insurance premium must have at least $1 million in premium.
What employers are the best candidates for a self-insurance program? According to Mike Ferguson, COO of the Self-Insurance Institute of America, “First and foremost, you must be strong financially. When you self insure, you are on the hook for claims.” He added the importance of having proactive risk management in place, particularly if you are in a high-risk industry — and these are the industries that can realize the most cost savings from self-insurance. Ferguson also noted the importance of having senior management committed to the concept of self-insurance for the long term. “Companies that try to achieve loss savings in one year with self-insurance are typically not successful.”
A key component in self-insurance is selecting an effective third-party administrator (TPA) to adjust your claims. One common error when selecting a TPA is to focus on upfront costs rather than concentrating on the total cost of claims. Selecting a TPA primarily based upon low claim-handling fees may result in escalating loss costs, as medical and indemnity costs are far more significant than TPA fees. How effective a TPA is in managing these claim costs will have a significant impact on your total cost of risk.
Another consideration in deciding on a self-insurance program is the need for excess workers’ compensation insurance. Employers purchase excess workers’ compensation coverage to protect against catastrophic and unpredictable losses, specific and aggregate. According to Charles Caldwell, president of Midlands Management Corporation, key factors in obtaining excess workers’ compensation coverage include the requirement for a certified financial audit and providing documentation and other records related to your business. In addition, Caldwell said, the excess workers’ compensation insurer evaluates the quality of the TPA that is handling the claims.
What should an employer look for in an excess compensation carrier? “There are several general things that you would look for in a workers’ compensation carrier or even a guaranteed cost carrier, which would be financial stability, A.M. Best rating, and market reputation,” Caldwell noted. “In the excess arena, it’s important to look at the carrier’s or the underwriting entity’s experience in the line of business, the services they provide, and the support that the carrier gives to the TPA and the ultimate insured itself. The buyer should keep in mind that this is a long-tail business and that excess claims would not be paid for five or six years into the future, so the financial solvency of the insurance carrier is of paramount importance.”
The use of a captive is a way to approach risk management that provides advantages over conventional insurance . A captive insurance arrangement can be seen as a type of self-insurance. Captives are owned in whole or part by the insureds in order to self-fund the owners’ risks. Client-owned captives are controlled by their owners, who are the principal beneficiaries, and operate much like traditional insurance companies. Captives pay losses, perform actuarial reviews, and potentially derive underwriting profits and earn investment income on the funds held to pay claims. In most cases, the owner/insured actively participates in decisions, including underwriting, operations, and investments of the captive. Captives can also select a TPA, which can address both allocated and unallocated costs. In Florida , a state with high claim-related costs, the ability to tackle these costs is particularly important.
Rent-a-captives are facilities for employers too small to structure their own single-parent captive. In essence, they “rent” the surplus of an unrelated company by paying a fee. The rent-a-captive insures the risks of its renters and returns potential underwriting profit and investment income to them. Claims are handled by a TPA. Rent-a-captives are operated as income-producing ventures for the companies or “renters” who participate for insurance coverage.
With the insurance industry’s cyclical nature and market fluctuations, the soft market enables employers to transfer risk at lower costs. During a hard market, insurance is generally more difficult to obtain and comes at a higher price.
So which is the more conducive market for forming a captive?
Business owners and brokers have often wondered at what point in the cycle they should consider captive arrangements. “Something will cause the market to fluctuate,” said Jeff Packard, assistant vice president of The PMA Insurance Group. “Whether it’s another year of hurricanes or a tumble in the stock market, something will affect capacity. And when that happens, the more pressing question shifts to how prepared you are to handle it.”
The old adage of “saving for a rainy day” is good advice when it comes to captives. “When capacity is available and reinsurance pricing is reasonable, the timing is optimal for developing captive programs,” added Packard. “Forming a captive in a soft market enables members to build leverage more quickly, something that usually takes years to develop.”
By the time the market begins to harden, it may be too late. When companies struggle with new strategies to regain profitability, reinsurance pricing is already increasing along with primary line premiums. As the market shifts, insurers often enter into re-underwriting periods during which certain classes of business and coverages become unavailable. Rate adequacy strategies also begin changing throughout the industry; the end result is often higher rates for exposures.
Ultimately, a downturn toward a hard market is an adverse time to develop a captive or acquire specific and aggregate reinsurance to protect assets against loss. Once the soft market has passed, the optimal opportunity to enter into a captive arrangement has gone with it.
Large Deductible Programs
For many larger Florida employers who are oriented toward loss-sensitive programs, a large deductible is the product of choice. Under a deductible arrangement, policyholders pay lower premiums in exchange for paying claims within the deductible layer. The ultimate cost of a large-deductible program is the sum of the company’s expenses (deductible premium), paid losses, and loss-adjustment expenses.
Good candidates for a large-deductible program are financially stable employers who have a predictable loss pattern, strong safety and claim management programs, and an appetite for risk — in fact, for some businesses, a large deductible can be the first step toward self-insurance. In Florida , an employer’s standard premium must meet a $500,000 threshold to participate in a large-deductible program.
Benefits of a large-deductible program include cash flow advantages, the opportunity to reduce the ultimate cost of insurance through favorable loss experience, and reduced expenses.
However, before embarking on a large-deductible program, two primary issues must be considered. First is collateral. Insurers require collateral for large-deductible programs, as state law mandates that insurance companies pay all claims, whether or not reimbursement is secured. In light of the current financial market volatility resulting in a tightening of available credit, the employer’s ability to secure collateral needs to be carefully considered — particularly if the business is perceived as financially risky.
Second is the fixed-cost or the deductible premium. Employers can reduce their deductible premium by assuming increased risk. However, the employer must be financially able to handle the risk. Businesses need to have best-practice claims and risk control programs in place — the cost of claims will directly impact an employer’s bottom line on a large deductible. In addition, the insurance carrier partner needs to be carefully evaluated as to its ability to effectively manage claims.
The workers’ compensation market is cyclical and challenging. It behooves agents, brokers, employers, and other market players to understand emerging trends and develop proactive strategies to respond to market fluctuations. Simply put, the best time to consider alternatives for your workers’ compensation program is when you don’t need them. Savvy employers who examine the options now and see how they align with their organizations are in the best position for long-term success, regardless of marketplace conditions.