Bearing a Heavy Load.

State funds are counting on customer focus and service efficiencies to help them pick up riskier business cast aside by commercial carriers.

In the workers' compensation arena, market cycles define the environment in which insurers operate. The market ebbs and flows like an ocean's tide. Competitive state compensation insurance funds, and their commercial carrier counterparts, respond in ways dictated by their business objectives.

Today, the workers' comp industry is cycling from a soft to a hard market. The former is marked by strong operating results, high profits and intense competition among all carriers. The latter results from eroding performance, lower profits and changing carrier behavior in the marketplace.

Huge shifts in market share are common when cycles change in either direction. Many state funds see their share soar during hard markets and decline during soft. But some of them feel they are poised to carve out permanent gains from this hard market cycle, because during the recent soft market they became highly focused on their customers' needs, adopted operating principles that provide service efficiencies and greater effectiveness and organized in ways to best support their new operating environment.

To understand how market cycles impact state funds, it is important to understand their role in the industry. Their mission is "to provide a ready and stable market for workers' compensation insurance at the lowest possible cost," according to an American Association of State Compensation Insurance Funds' special report, "State Compensation Insurance Funds: Still the Best Alternative."

How they carry out their mission varies by state. Some are "monopolistic" and provide the only source of insurance coverage in their state, although self-insurance is allowed in some of these jurisdictions. Other funds are competitive," since applicable statutes allow competition with commercial carriers. Most of the funds established in the early and mid-1990s were created as fully functional mutual insurers. They also complete with commercial carriers.

Some of the funds are the carrier of last resort in their state. Some write coverage in more than their home state and some can claim exemption from federal income tax (see "Taking Precautions" on page 70).

In spite of these differences, the competitive funds were created to provide market stability and balance in their respective states. For most, "ready market" and "lowest possible cost" drive their actions in the marketplace.

Ready and stable market: State funds exist to provide workers' comp coverage. They specialize. Most write and service accounts that other carriers ignore. Consider this illustration: There are not many businesses in Tortilla Flat, Ariz.--primarily a restaurant, a souvenir and gift shop, an ice cream store and a convenience store. The few there are too small to interest commercial carriers. Not enough profit. No growth potential. Annual premiums won't cover costs. But the Arizona Fund--and others like it from California to Maine, New Mexico to Montana--write accounts such as these. Their ready-market philosophy is unaffected by policy size or remoteness of location. They strive to meet the needs of their entire market.

Lowest possible cost: State funds were created to be no more nor less than self-supporting. Not having stockholder profit objectives to satisfy, many use some of their assets to lower customer costs. In combination, rate discounts and dividends have produced premium returns of 50% or more.

Mission and good intentions aside, state fund market shares are shaped more by commercial carriers than by anything else. Commercial carriers flourish in soft markets. Out of necessity to maintain suitable profit margins, they become more selective and less prominent in hard markets. When that happens, state funds naturally write a larger share of the available business.

Market Conditions

Data and analyses by the National Council on Compensation Insurance the industry's data-gathering leader, and evidence from several state funds confirm that the market is hardening (see "Key Workers' Compensation Market Indicators and Results," above).

Prominent commercial carriers in the market track these trends. They are more clearly active when market indicators are strong. They are less so when results worsen. It is an ebb and flow seen during every market cycle.

NCCI Chief Executive Officer Bill Schrempf summarized the market's condition during the Workers Compensation Research Institute's 2000 annual conference by saying, "There is no question that pressure for change is building in the way workers' compensation works." lie now says that industry challenges exceed those of any other time in history. Other industry analysts agree.

So what are the implications and challenges brought on by the hardening market? Consider the last hard market. It occurred in the late 1980s and early '90s. Much of what happened then could occur again today.

The Late '80s

The profitability of the workers' comp product line slipped in the middle and late '80s. This forced commercial carriers to adopt belt-tightening underwriting guidelines. As they became more selective, state funds assumed more of the market. That did not occur, however, without consequences for the funds or the industry. Policy and claim volumes forced many of them to change how they operated. Customer service turned to customer processing. Policyholder and injured worker satisfaction turned to dissatisfaction. Broad carrier availability turned to limited choice. And all of this happened while costs increased and services decreased.

Following are some of the specific challenges that state funds faced during the last hard market. Most will encounter many or all of them again soon. Some say they already are.

Sudden Influx of Accounts and Premium. Sudden and significant growth in policy and claim counts caused state funds to face service challenges in the past. They may again as commercial carriers adjust to the market by insuring fewer accounts. Can the funds absorb greater market share? Will they again be driven to processing work instead of servicing accounts? If so, commercial carriers stand to make significant market inroads when the market next softens.

Change in Account Mix. State funds insure most small accounts. These employers have limited service needs. A change in account mix could unbalance state fund workloads. They'll need flexibility and adaptability to meet demands. Do they have it? Many do. Others may not, which could mean customer service needs go unmet.

Change in Service Capability. Consider this scenario. You are a state fund policyholder. Your policy generates $20,000 in premium. Many funds use premium to set service strategies. One day you are at the "right level" for full service. The next you're below it. Services you want or need are stopped. That has happened, often without explanation. Then again, what explanation could a fund give that would satisfy you if it arbitrarily changed its service?

The hard market can change a fund's service capability. However, the type and quality of service provided in the soft market will become the expectation regardless of market conditions. Customers won't care about a state fund's increased service demands. They will have demands of their own. If unfulfilled, customers will look for a carrier that can satisfy them, leaving future openings for commercial carriers.

Change in Type or Intensity of Services or Programs. Higher claims frequency and severity will raise expectations for certain services from state funds. They include:

* higher policyholder expectations for loss control service and results;

* greater policyholder oversight of and involvement in claims management and reserving; and

* rate increases, which could limit deep rate discounts and dividends.

Customers hold state funds to a higher service standard as costs increase. Can they meet these expectations, or will service weaken as in past hard markets?

Increased Potential for Complaints and Allegations of Bad Faith. Insuring more large policies will increase claim counts and chances for complaints and allegations of bad faith/unfair claims processing. That happens often when trying to balance the interests of injured workers, policyholders, the medical community, insurance regulators and others.

Responding to these interested parties takes time from servicing other stakeholders. Can state funds minimize these complaints? Can improved processes and structure help? Some funds would answer yes. They have recent history to prove it. Others will again face the challenge.

Lower Administrative Expenses. This could be a false positive. A sudden premium increase and drop in administrative expense ratio (all else being equal) should not mask inefficient and expensive work processes. Some funds have developed efficient processes that truly lowered expenses. Others are just now considering options. All recognize the need.

These challenges are or will be real for the state funds. How they respond will be important to building and maintaining policyholder loyalty. Clearly, continued carrier/policyholder relationships hang in the balance.

The Early 1990s

When the market softened in 1993, commercial carriers assumed a larger role. They offered quality service and prices that rivaled or bettered those of state funds. Building on the failure of some funds to maintain quality service during the '80s hard market, commercial carriers prospered. But many state fund executives predict it will be different this market cycle. They predict that changes made during the latest soft market will sustain them into, during and out of the current hard market. They feel better prepared to serve customers and maintain policyholder relationships during this market cycle than ever before.

That is because many fundamentally changed their business operations during the soft market, knowing service demands would increase when the cycle changed again. It was a natural progression for these funds as they sought to become more customer-focused and adopted sound organizational principles and practices.

Many of the funds began providing service through multifunctional teams instead of the functional service silos they used for so long. Team members collectively "own" their accounts and the results they produce. Members are highly focused on their customers and are expected to make service decisions without need of unnecessary reviews or approvals. Performance is targeted toward a core set of success measures that, when achieved, satisfies short- and long-term financial and customer-service goals.

Customer Focus

Several funds segmented their markets, which enables them to best match team service delivery with the wants, needs and expectations of customers. Work processes have been streamlined; service hand-offs that didn't add value have been removed. These funds have created virtual one-stop service processes where they can satisfy customer service needs in a complete and highly efficient and effective manner.

The new customer-focused funds have adopted new, flatter and leaner organizational structures that are built around contemporary leadership principles. They are structured to support the best ways of doing work instead of requiring work to be clone based on how they were structured. Their new service culture enables employees to excel and makes it easier for customers to do business with them.

Some funds also use a Gainsharing Incentive Compensation Plan to instill an ownership culture by sharing a portion of additional profit with the teams of employees who helped create it. Gainsharing also creates a continuously changing environment where employees constantly look for better ways of doing work and satisfying customers. That is the ideal operating environment for ensuring ongoing best results and customer satisfaction.

So, what if these changes actually produce intended results for state funds? Will it create a new market dynamic to which commercial carriers will need to react? Will state funds actually achieve their long-desired objective of being the undisputed carriers of choice in their respective states?

The verdict is still out on the last question, but recent surveys of State-fund customers revealed higher overall satisfaction resulting from improved service. If funds can sustain this improved service level, greater customer loyalty can be expected when commercial carriers look to re-emerge as a force in the market the next time it softens.

The new customer focus adopted by many funds may, at a minimum, prompt commercial carriers to question their business strategies and focus during this hard market. If they have not already clone so, making some or all of the changes made by certain of the funds could help the commercial carriers meet their customers' long-term service expectations.

The insurance consumer and the industry generally will benefit from commercial carriers maintaining a more balanced role in the market. Continued competition will hold rate increases to an absolute essential minimum, and state funds and commercial carriers will both work harder to maintain service quality. Policyholders will benefit. Injured workers will benefit. And the industry will benefit by avoiding the potential criticism that often results when a single carrier dominates its market.

But if commercial carriers choose to ignore the improved capabilities of state funds, and if they fail to make improvements of their own, they could impair their ability to acquire a desired market share when conditions improve. Only time will tell how deep the cuts may go, but many state funds do seem capable of carving some measure of permanent gain out of the existing hard market.

Gregory D. Casadei is a senior management consultant with the McDonald Consulting Group, a Minneapolis-based firm specializing in the insurance industry.

                    Key Workers' Compensation Market
                         Indicators and Results
                                     Past Results
Key Indicators                       (Leading to and during the
                                     soft market)
Claims Frequency - Measures          Improved 24% from 1990 to 1998.
number of claims per defined
unit of exposure.
Claims Severity - Measures           Experienced low single-digit
average cost per claim.              increases in the early
                                     and mid-'90s.
Expense Ratio [*] - Measures         Industry average was
relationship of expenses             17.2% in 1989.
to premium.
Combined Ratio - Measures            Industry average was 97% for
premium to losses, loss-adjustment   accident year 1994.
expenses and administrative
expenses.
Reserves - Money insurers set        Used to support business
aside to meet future claims and      operations. During 1994-97,
claims-management expenses.          reserve releases reduced
                                     calendar-year loss ratios by
                                     8.3%. Were estimated to be
                                     deficient by $600 million
                                     industrywide in 1994.
Surplus - Money insurers retain      Was 1.9 to 1 for workers'
as a buffer to ensure reserve        compensation predominant
adequacy. Measured in raw            companies in 1989. Like
dollars and in relation to premium.  reserves, was used to
                                     support business operations
                                     during the 1990s.
Investment Income [**] - Measures    Grew considerably during the
investment returns in raw dollar     1990s due, in part, to
and in relation to premium,          strength of the equities
                                     market. Supported carrier rate
                                     discounts and dividend returns.
Pretax Operating Results [***] -     Was -7.9% in 1991. Moved to
Measures insurer profitability       19.8% in 1995.
based on all sources of income
and expense, excluding taxes.
                                     Current Results
Key Indicators                       (Leading to the hard market)
Claims Frequency - Measures          Slowed to 1% improvement in
number of claims per defined         1999. Could continue to
unit of exposure.                    worsen. Cannot now offset
                                     increased claim costs as
                                     in the past.
Claims Severity - Measures           Indemnity expenses were up
average cost per claim.              5% in both 1998 and 1999.
                                     Medical expenses were up
                                     6% in 1998 and 5% in 1999.
                                     Additional increases
                                     are expected in both.
Expense Ratio [*] - Measures         Industry average grew
relationship of expenses             to 26.8% in 1999.
to premium.
Combined Ratio - Measures            Industry average was 134%
premium to losses, loss-adjustment   for accident year 1999.
expenses and administrative          Will likely worsen.
expenses.
Reserves - Money insurers set        Were estimated to be
aside to meet future claims and      deficient $10 billion
claims-management expenses.          industrywide by year-end
                                     1997. The amount has grown
                                     to an estimated $18.3 billion
                                     at year-end 1999.
Surplus - Money insurers retain      Improved to 0.67 to 1 in 1999.
as a buffer to ensure reserve        Created excess capacity, which
adequacy. Measured in raw            drove competition and rate
dollars and in relation to premium.  discounts. As results erode,
                                     carriers may lose their
                                     ability to support business
                                     operations as in the past.
Investment Income [**] - Measures    Declined 30% on average
investment returns in raw dollar     over last two years.
and in relation to premium,          Condition of the equities
                                     market makes immediate
                                     improvements unlikely
                                     absent changes in
                                     investment strategy.
Pretax Operating Results [***] -     Declined steadily since 1995.
Measures insurer profitability       Was 4.2% in 1999.
based on all sources of income
and expense, excluding taxes.

Source: Data from a variety of National Council on Compensation Insurance (NCCI) sources.

(*.)Per NCCI, at today's expense levels, loss ratios need to be 9 points lower to achieve the same combined ratio as 10 years ago.

(**.)NCCI estimates that across the industry, a 1-point increase in a carrier's investment yield is 3.5 times more valuable than a 1-point improvement in loss ratio.

(***.)Many state funds are exempt from paying federal income tax.