Challenging workers' compensation market.

During 2008, NCCI delivered a cautiously optimistic outlook for the workers' compensation insurance market. But since we first offered that outlook last May, the entire U.S. economy has descended into a deep recession. The numbers of layoffs and profit warnings from major national firms have continued to grow almost daily. And President Barack Obama has repeatedly warned the country that no quick economic fixes are in the offing.

In expressing cautious optimism for the line last spring, NCCI anticipated:

* A second straight year of underwriting profits for the line

* Generally lower bureau loss costs and rate filings across the country

* A continuing favorable claims frequency trend

However, we also observed that the long-term outlook was cautionary due to uncertainties that continued to face the business. Among the uncertainties cited by NCCI were:

* Medical cost increases placing upward pressure on costs

* Low investment yields putting pressure on insurers' ability to earn an adequate return on capital

* A fluid political landscape in many states and at the federal level that puts additional pressure on regulation and reforms

So how did the NCCI prognosis for workers' compensation turn out, given the subsequent development of a severe recession? For the most part, the numbers we delivered last May held up well, although final underwriting results were not as positive as previously anticipated. For example, the 2007 (latest full year) preliminary estimates for workers' compensation industry premium volume that NCCI delivered in May were right on target. Final workers' compensation industry premium results were $37.6 billion for private carriers, representing a 2.9 percent decline in premium from 2006 for private carriers.

However, as noted above, final 2007 underwriting results showed a slight underwriting loss rather than the modest underwriting gain that NCCI originally projected. A deterioration in the combined ratio--from our 99.0 percent preliminary estimate to a 100.7 percent final result--was due almost entirely to underwriting expenses.

The final 2007 investment gain ratio (investment gain on insurance transactions as a ratio to earned premiums) was 12.7 percent versus a preliminary indication of 12 percent. This result was 2.7 percentage points higher than in 2006 and represents an increase from recent historical levels, which hovered between 10 percent and 11 percent.

An upward revision in the investment gain ratio for 2007 helped offset the underwriting result and provided a final pretax operating gain of 12 percent. That result was one percentage point less than the preliminary indication, but it remains at or near NCCI's estimate of the industry's cost of capital for one more year.

Today, NCCI continues to track changing market conditions in light of the difficult economic environment. We will deliver up-to-date market results at our Annual Issues Symposium 2009 May 7-8 at the Loews Portofino Bay Hotel at Universal Orlando and will post those results to www.ncci.com shortly thereafter.

Some Positive Results

One positive market development that NCCI did witness was a continued decline in the residual market population and stable operating results. Through 2008, the number of employers applying for coverage in the residual markets managed by NCCI declined by 18 percent, and newly assigned market premium declined by 23 percent. This marks the fourth straight year of declining applications. Because of fewer applications for coverage, the residual market has declined as a percentage of the overall workers' compensation market to about five percent, indicating a competitive workers' compensation voluntary market. In addition, 2007 residual market operating results remained stable. The operating losses were less than one percent of the voluntary workers' compensation premium. And today, the majority of NCCI-managed residual market states are at or near self-funded status.

For several years, NCCI has reported on a continuing decline in claims frequency. Our research indicates that this decline is likely a long-term phenomenon related to improved technology and competitive market forces working together to create ever-safer workplaces.

Based on a preliminary analysis of the most recent complete data in NCCI states, the frequency of lost-time claims declined 2.5 percent in 2007. This is a significant tempering of the near seven percent declines for the prior two years, and much closer to the historic average of a three to four percent decline per year. NCCI will continue to closely analyze and monitor the frequency change to make sure that we detect and report any changes in the recent pattern of claims frequency decline.

Medical Costs Still a Concern

Medical average claim cost trends continue to grow steadily, rising 5.8 percent. However, it is interesting to note that this latest number reflects a steady pattern of percentage decline since 2005. What NCCI is now seeing in medical trends is somewhat surprising. We had been seeing close to double-digit numbers in medical inflation, but the latest update of accident-year data is indicating that trends in recent years have all come down. NCCI is seeing less development than expected, and we're estimating about a six percent medical severity trend.

Indemnity benefits are accident-year driven (i.e., the wages earned this year drive the benefits gained this year). Medical benefits, on the other hand, are driven by calendar-year medical cost increases. These are based on the charges at the time that medical services were rendered--regardless of the accident date of the claim. It appears that we are seeing the impact of slower calendar-year medical trends--which are, in turn, influencing the accident-year medical trends.

Despite the slowing, these increases remain higher than both average wage increases and the Medical Consumer Price Index, both of which have been rising about 3.5 to 4 percent per year for the last several years. And, as we have reported in the past, medical losses are now approaching 60 percent of total losses in NCCI states. As with general health, the workers' compensation line continues to migrate to becoming a medical management business, with policy makers, employers, and carriers struggling to control the costs of medical care.

Changing Political Landscape

In addition to the historic presidential election of 2008, NCCI has witnessed several years of political change in state legislatures across the country. Looking forward to the 2009 state legislative sessions, we anticipate another active year for workers' compensation. A series of state legislative initiatives are expected to drive the agenda in the coming months. These include proposed benefit increases, medical fee schedule changes, and proposed changes to attorney fees.

The Florida Supreme Court issued an important decision in the case of Emma Murray v. Mariner Health Inc. and ACE USA, No. SC07-244 (Murray) last October. The impact of the Supreme Court's decision was to eliminate the statutory schedule for claimant attorney fees and to return Florida to hourly attorney fees.

In November, NCCI submitted the first of two workers' compensation rate filings to the Office of Insurance Regulation (OIR) in response to Murray. The initial filing proposed an increase of 8.9 percent to the Jan. 1 rate level. NCCI estimated that the full impact of Murray would be an increase in overall Florida workers' compensation system costs of 18.6 percent over two years. On Jan. 26, 2009, the OIR issued an order denying the 8.9 percent increase and requested that NCCI make an amended filing for an overall workers' compensation rate level increase of 6.4 percent applicable only to new and renewal policies effective April 1, 2009. NCCI complied. A filing for the second-year impact of Murray is anticipated later this year. As of this writing, the state's trial lawyers and top business groups are attempting to reach a compromise with Florida legislators on legislation to remove conflicting language in Florida's sweeping 2003 workers' compensation reform package and restore a cap on claimants' attorney fees.

In terms of anticipated federal activities, economic recovery and increased federal regulation of the finance industry appear to be first priorities. What those increased regulations will mean to the insurance industry--and workers' compensation insurance in particular--remains a matter of some debate. In the coming months, NCCI will continue to work with state and federal lawmakers to educate them on the implications and unintended consequences of any and all new proposals.

Past and Future

Looking back, the workers' compensation insurance industry had a solid year of financial performance, with all major financial performance measures continuing to do well. Calendar-year underwriting results continued to show an underwriting gain for a second consecutive year, and accident-year combined ratios, although increasing, remained at near record low levels. However, bottom line financial results, after investment income and federal income taxes, were only at or near historical averages due to an environment of low interest rates and significant federal income taxes. Areas that continue to concern us include:

* Continued rise in medical costs

* Challenges to reforms

* Widespread effect of a declining economy

In the months ahead, NCCI will continue to collaborate with all market stakeholders to meet the challenges that the current difficult economy poses. Our priorities will remain consistent: ensuring that rates and loss costs are adequate, providing unbiased quantification of the impacts of legislative reform proposals, and striving for self-funded residual markets.

Stephen J. Klingel, CPCU, is president and CEO of NCCI Holdings, Inc., in Boca Raton. www.ncci.com.