Beat the spread: workers' compensation results will produce a wide berth between winners and losers. Here are 10 steps to take to be on the right side.

The sea of challenges to workers' compensation profitability seems to stretch endlessly to the horizon: insurer insolvencies and withdrawals from markets, accelerating medical inflation, lengthening claim durations, terrorism exposure, regulatory concern with increasing rates, swelling residual markets and waves of loss reserve hits. Is there any hope for the insurer striving to achieve a reasonable rate of return in this market?

Current workers' comp profitability represents a significant improvement from recent calendar years, which peaked at combined ratios of 118 in 2000 and 122 in 2001. Gazing into the near future, an industrywide workers' comp combined ratio of 102 for accident year 2004 is expected, a result likely to produce a total rate of return on capital only slightly better than simply investing that capital in a pool of equities. On a calendar-year basis, look for a slightly higher combined ratio of 106 in 2004 due to continuing adverse reserve development on prior years--particularly the late 1990s--resulting from accelerating medical inflation, lengthening claim durations and gradual acknowledgement of just how soft the pricing was during those years.

Further improvements in workers' comp profitability will be hard-fought, as accelerating medical costs and social inflation offset claim frequency improvements. Claim frequency movements in the coming years are unlikely to repeat the dramatic claim frequency declines reported in the recent past. Future price increases will be difficult to achieve: We are seeing regulatory resistance to increases at the statewide level, and individual carriers already have squeezed out most of their price discounting that typified marketplace behavior in the late 1990s. Despite these factors, the management team of a workers' comp insurer can produce consistent, profitable results for their company in the current environment.

Around the industry, workers' comp results in the coming years are likely to produce a significant spread between the results of winners and losers. Some workers' comp insurers will find a way to earn a reasonable return and solidify their position in the marketplace; others may retrench from their existing market position in order to maintain a reasonable return in the short run. Some others will continue a slow bleeding of red ink; and still others will suddenly disappear from the business--voluntarily or involuntarily.

Based on work with a wide variety of insurers across the spectrum of the workers' comp industry, here are some of the strategic and operational characteristics that will typify the winners:

(1) Know your target underwriting result. There is a wide range of views about the target combined ratio for a workers' comp insurer to produce a fair return on capital. Even in the recent environment of low interest rates, various opinions suggest a target combined ratio as high as 115. This wouldn't have produced acceptable results even when investment returns were high. Other managers think they need to beat a 100 combined ratio to produce a fair return. More worrisome are the managers who don't know their target. How can these managers expect to achieve or beat an unknown target?

The appropriate target combined ratio is unique to each insurer and may vary for different segments of an insurer's business. It depends significantly on their target return on capital, the investment outlook for the assets supporting the workers' comp book of business, and the cash flow characteristics inherent in the book of business and in the insurer's mode of operation. These cash flow characteristics vary among insurers, based on the insurer's mix of business by state and class, use of reinsurance and deductibles, premium collection strategies and so forth.

Once determined, the target combined ratio (or at least its key loss-ratio component) must be communicated clearly to underwriters, agents and brokers, customers, and others in a position to affect the future actual results.

(2) Know your current results. Management must know where the business stands today. First, develop the best possible estimate of loss and loss expense reserves for recent accident years. Then, translate the resulting estimated loss ratios into measures of underwriting results and profitability for the company's overall workers' comp book of business, and further into corresponding measures of profitability for such market segments as geographies, types of customers, types of products, and agents.

Start with a careful assessment of recent results for a cogent view of the business being written today, tomorrow, and next year. What has changed: mix of business, pricing, claim frequency and claim costs, claim handling, expenses, reinsurance? Project if the quantitative effects of these changes will produce an underwriting result on tomorrow's business that is different from last year's underwriting result.

It can be difficult to establish property/casualty loss and loss expense reserves, including workers' compensation, prominently. Barely a month goes by without some property/casualty insurer announcing that it is boosting its reserves. The process of setting loss reserves is, fundamentally, a prediction of the future: future behavior of claimants, future economic and social conditions, future medical treatments and outcomes, future judicial decisions. For workers' comp, we have recently seen claim durations and payouts that an actuary might have considered in a range of scenarios a few years ago, but would not have projected as a best estimate. As social and economic environment changes are reflected in the claims experience, actuaries have adjusted prior projections--which has impacted the loss reserve estimates.

It is essential to continuously monitor emerging workers' comp claims experience for evidence of changing trends, and to evaluate their implications. These trends will not always match prior expectations. Consequently, actuaries will need to make adjustments--up and down--to reserve indications and to price levels. However, with regular monitoring and communication of the trends and their implications, the necessary adjustments can be made on a timely basis, rather than management waiting for an overwhelming accumulation of bad news.

(3) Choose your customers. Every potential customer can't be insured, so try to choose the right ones. Are there particular niches where you can outperform competitors due to market positioning, specialized expertise, geographic focus, relationships, or your agency force?

Price to the customer's risk exposure, and to your company's ability to help the customer manage that exposure. Quantitative tools such as experience rating and loss forecasting based on the customer's historical claims experience have been in use for years, although some companies seem to have mothballed these tools and substituted large doses of wishful thinking during the mid- and late-1990s. For small to medium-sized accounts, where historical claims experience at the account level has a significant random component, we are seeing the potential for workers' comp insurers to develop inference modeling tools--similar to those used by some personal-lines insurers. These inference modeling tools, built and calibrated using historical insurance and noninsurance data--predict claim likelihood based not only on claim history, but also incorporating other customer characteristics, such as number of years in business, geographical location and business cash flow.

It makes good sense to consider the customer's potential for long- and short-term profitability. Lifetime customer value models consider the cycle of expenses (acquisition, underwriting, loss control), changing patterns of claim likelihood over the course of a relationship, the accumulation of data that can refine future decisions, cross-selling opportunities and the potential to engender customer loyalty.

(4) Know your pricing targets. What overall price level must be achieved to hit the profit target? How does this vary by state or market segment? How much can be achieved by changing manual rates and how much by changing individual risk pricing elements such as schedule rating?

A number of workers' comp insurers get this far in the analysis and stop. It's not good enough. Treat the needed pricing actions similarly to an expense budget; that is, the actual activity levels must be monitored to assure that the needed movements in manual rates and schedule rating are being achieved, and corrective action taken if they are not. This is not a complex undertaking for workers' comp, but it does require the development of targets, tools, and discipline to monitor and act on the results.

(5) Claim management is key. Most of the dollars that come in as premiums will go out as claims. Operationally, the effectiveness of the claims operation is of foremost importance. We find it helpful to focus on several pressure points:

* Assessment and management of the claim immediately following the occurrence. During this critical stage, nothing is more important than performing the basics effectively--collecting information; engaging the injured worker, employer, and medical provider in working together; using claim management tools and techniques; and beginning to develop, deploy, and quantify an action plan to bring the claim to a successful outcome (such as prompt return to full employment) as soon as practical.

* The big claims. For most workers' comp insurers, 90% of the claim dollars are accounted for by 10% of the claims. While every claim needs to be managed, these claims warrant the most intense management and intervention. Proper case reserving is part of this process, as it provides a "bottom line" scorecard on the claim. Interestingly, some of the same inference modeling technology that can be used to identify policyholders likely to have claims, can also be used to identify claims most likely to become very costly.

* Medical management. This focuses on managing the types of care services being rendered, the duration and number of services, the effectiveness of the services, and the cost of the services.

(6) Expense management. As a workers' comp insurer, you may be providing essential services to your customers, but you do so at a frictional cost to these customers. One of your jobs is to maximize the value of the services delivered while minimizing the delivery cost of those services.

(7) Reinsurance. The market has come a ways from the "too good to be true" reinsurance offerings of the early 1990s--offerings that in some cases turned out to be too good to be true. Significant underwriting losses and poor investment returns to reinsurers served as stimulus to a hardening market, and the events of Sept., 11, 2001, accelerated the trend.

For the serious workers' comp insurer, however, reinsurance has never been viewed as a free lunch. Rather, the serious insurer views the reinsurer as a partner that can alleviate volatility associated with large exposures or large claims, improve the predictability of overall financial results, and provide capacity for types and amounts of exposure that the insurer alone could not handle. Of course, reinsurance carries a frictional cost also, and careful analysis is required to weigh the short-and long-term benefits of a particular combination of reinsurance protections against its cost.

(8) Residual market strategies. Residual market pools have grown dramatically in recent years, and we expect a resurgence of focus on residual market strategies.

In states with workers' comp assigned risk plans, insurance company management must evaluate the relative merits of being a direct assignment carrier vs. a participant in pool results; bidding for servicing carrier roles; and purchasing reinsurance to protect against unanticipated pool results. The cost burden of these mechanisms--the anticipated assessment that may be attracted by each dollar of voluntary premium--needs to be contemplated in the rates and in evaluating the profitability of individual insureds.

Many states have implemented state funds (or similar mechanisms) as an alternative of additional vehicle for employers not insured by private carriers. Some state funds are feeling the financial, operational, and political pressures associated with rapid growth. But, where the state fund is providing an effective and strong market, private carriers are realizing that customers won over by the state funds may not be so easy to win back, which produces different considerations.

(9) Knowledge is power. Workers' comp is an information business. The successful insurer will tap a variety of internal information sources, analyses, and tools, such as:

* Information about your customers, your claims, your pricing activity, your financial results.

* Detailed data to improve underwriting and pricing processes, and analytical tools to put this data to work.

* Detailed data about each claim.

* Tools to drill more deeply into the detail of the data, or to view big-picture patterns and trends.

* Analyses of these trends to understand their implications for profitability and operational effectiveness.

The winning company will tap outside data sources as well:

* Customer information of all types.

* Information to help manage medical care providers.

* Industry-based analyses of various jurisdictions, regulatory improvements, and statutory reforms.

(10) No silver bullets. Regrettably, there are no silver bullets to guarantee profitable workers' comp results.

Rather, the profitable insurance company will have engaged a comprehensive set of analytical tools to more fully understand its book of business and its financial performance. Sound operational tactics throughout the life cycle of each customer and each claim, and monitoring tools to trigger corrective actions when results begin to deviate from plan are fundamental to a successful result.

Rough seas are ahead. But, the workers' comp insurer who tends to all of these basics, and successfully navigates the rough workers' comp waters, has the opportunity to serve a significant marketplace need, and produce steady profitable results.

Robert F. Conger is a principal of Towers Perrin and is responsible for managing the Chicago office of the firm's Tillinghast business. Russell H. Greig is a Tillinghast consultant in Towers Perrin's Atlanta office.