Filled to the brim: while workers' compensation insurance pools have grown rapidly in the past two years, they are still nowhere near the crisis levels reached more than a decade ago. (Property/Casualty: Workers' Compensation).

Pressured by double-digit medical cost inflation, concentration-of risk worries and falling investment income, workers' compensation insurers have become more selective about the policyholders they want to cover. With the voluntary market shutting its doors on unattractive business, the residual market, the market of last resort, is booming. The residual market pools in 24 states doubled their premium volume from 2000 to 2001; and then doubled again in 2002.

While industry watchers are keeping a wary eye on the growth of the residual market, they say it's still nowhere near the high-water mark of the late 1980s/early 1990s, when many states saw the competitive workers' comp market all but evaporate. And while the profitability of the residual business is on a downslide, it hasn't yet equaled the magnitude of losses seen 15-plus years ago.

"We'd like to have the residual market be as small as possible, which would mean the voluntary market is healthy," said James R. Nau, general manager of residual markets for the National Council on Compensation Insurance. "But at least we have a place where policyholders can get coverage."

The NCCI, which administers the residual markets in 20 states, said the number of new applications increased 29% in 2002 from 2001, on the heels of increasing 35% in 2001 over the previous year. Meanwhile, assigned premiums, or business each workers' comp insurer is obligated to write as part of a pool, rose by 45% in 2002 over the previous year, in addition to rising 92% in 2001 over 2000.

The written premium reached an estimated $1.2 billion at the end of 2002-up from an estimated $627 million in 2001 and from $353 million in 2000, reaching the highest level it's been since 1996 among the states that NCCI administers, Nau said.

It's still far from equaling its peak, or $4.8 billion in premium, reached in 1992, Nau noted.

Demand for the residual market has continued to increase in 2003, according to the NCCI. For instance, applications to the residual market exceeded 1,500 a week in 18 of 52 weeks in 2002. The 1,500-applications a-week mark was broken in three of the first four weeks of 2003.

The rate of growth, however, is beginning to slow down in 2003, Nau said.

Roger Kenney, vice president of research for the Alliance of American Insurers, said the industry is watching the residual market closely, but there's no need to panic yet.

"In 2000, the residual market wrote about 2.5% of all workers' comp business, That increased to 5% in 2001. It makes a nice headline that the residual market doubled, but it was doubling from a small amount," Kenney said. At year-end 2002, the residual market was roughly 7% of the total workers' comp market, Nau said. The residual markets have not grown nearly as extensively as they did in the early 1990s, when the involuntary market reached 85% of the workers' comp market in some states. In 1993, 26.5% of all workers' comp business nationwide, excluding self-insured business, was in the residual market.

Still, Kenney said, "It is disturbing to see this rate of increase over the past two years. The residual market has reached the highest level it's been since 1996. On the positive side, it is still well below the crisis levels of the $4 billion to $5 billion it reached in the early 1990s. Hopefully, the market will correct itself before we see these levels again."

State Regulations Vary

Workers' compensation, which provides medical care and rehabilitation for injured workers, as well as lost wages and death benefits for people injured or killed in work-related accidents, is mandatory in all states but Texas, where about 35% of employers reject coverage, according to the Insurance Information Institute. Almost nine of 10 workers in the United States are covered by workers' comp, according to the Institute.

While all states have created some provision to offer coverage to employers who aren't able to find a carrier willing to cover them, the workers' comp systems vary from state to state. The patchwork-quilt of regulations across the country make it difficult to make many sweeping statements about the residual market.

Five states--North Dakota, Ohio, West Virginia, Washington and Wyoming--have a monopolistic system where only a state-owned entity is allowed to write workers' comp business, except for some self-insured businesses.

In 14 states--Arizona, California, Colorado, Kentucky Idaho, Louisiana, Maine, Maryland, Minnesota, Missouri, Montana, New Mexico, New York and Nevada--state-run funds are allowed to compete with private carriers for business, but often also act as the insurer of last resort to take all business that can't be placed elsewhere. Measuring the residual market in those states can be difficult, because regular business can be lumped in with the business that no private carrier wants to write.

While some states design their state-run workers' comp funds to be self-sufficient, some states set up a system whereby the risks that are rejected by the voluntary market are pooled, and any collective gain or loss from that business is shared among all of the voluntary writers in the state based upon their market share. Employers usually have to show rejections from two to three carriers in the voluntary market to qualify for coverage. These states often hire NCCI or some other organization to administer a workers' comp plan, which uses servicing carriers to handle the back-office work for the policies as if they were their own. Servicing carriers collect premiums, pay claims and provide other services, but they do not take the risk; any gain or loss is ultimately shared by the entire industry in the state. So if the residual market gains significant mass and posts significant losses, carriers who write business in the state incur significant cost.

"It becomes an issue of magnitude," said Tom Driscoll, senior vice president and general manager of the involuntary market for Liberty Mutual, the country's largest writer of workers' comp insurance and a servicing carrier for the involuntary markets in 21 states. Back in the late 1980s and early 1990s, the residual markets exploded, he said.

"There weren't as many state funds at the time. A handful of states--Maine, Rhode Island, Texas and Lousiana--had as much as 85% of the market in the residual market. You had an evaporation of the voluntary market, with no prospect of a return," said Bruce C. Wood, assistant general counsel for the American Insurance Association.

Those states created state funds, which act as the market of last resort, but also are allowed to compete against the voluntary market. With some tax and regulatory advantages, the funds are designed to be self-sufficient so the voluntary carriers won't be assessed if the residual market is unprofitable. Maine's state fund, in fact, has been licensed to compete for business in several neighboring states.

Ideally, state funds take the burden of the residual market from the voluntary carriers. However, several states with competitive state funds, including Texas, Louisiana and California, include the funds in the states' guaranty associations. Like any other insurance company, if the state funds in those states become insolvent, they will trigger the guaranty fund, and the entire industry would be billed to help cover the costs, the American Insurance Association said.

Deja Vu

Historically, residual market growth has been a sign of problems in the workers comp market, Wood said. "In a perfect world, you wouldn't have any residual market. There would be a voluntary market for every single risk," he said.

The profitability of the residual market may be just as important as its size because if it is unprofitable, often the voluntary carriers must foot the bill.

In Texas, for instance, the residual market lost $500 million in 1989. "That's like a $500 million tax on workers' comp that insurers had to pay from surplus. They couldn't pass that on to policyholders. It's not surprising the willingness to write voluntary business all but evaporated. It was a true insurance crisis," Wood said.

In 1985, the residual market administered by NCCI posted a combined ratio of 176. For every $1 of premium the residual market received, it paid $1.76 in expenses and claims. The combined ratio fell in the following years as rates rose and costs were contained. The combined ratio dropped as low as 94 in policy year 1995--which meant the voluntary market actually received money back from the residual market, which isn't typical, experts said. Profitability has begun to fall again, however, and the combined ratios are on the rise, reaching 118 in 2000 and 119 in 2001, meaning the residual market paid out $1.19 in claims and expenses for every premium dollar received in 2001.

Growth in an unprofitable residual market causes problems for the voluntary market, Wood said. "Increased business in the involuntary market increases assessments to the voluntary market, which further decreases the incentive to write voluntary business," Wood said. "It was a vicious cycle that led to a virtual insurance meltdown" in Maine, Rhode Island, Texas and Louisiana in the workers' comp crunch of the late 1980s and early 1990s.

The industry then experienced the worst of both worlds: high costs and inadequate rates, Wood said.

Today, many states have lifted restrictions on rate setting, which has given carriers-and state funds--more flexibility in adjusting rates. There are a number of drivers affecting costs and underwriting, however, including the following:

Increasing medical costs: Medical-care costs rose an estimated 11% in 2001 for workers' comp insurers, and payments for lost wages rose an estimated 6%, according to the Insurance Information Institute. Both the voluntary and involuntary markets are seeing increases in costs, Wood said. Medical costs have risen from about 40 cents of the benefit dollar to 50 cents and even as high as 60 cents in some states, Wood said.

Falling investment income: With continuing declines in the equity markets and the low interest-rate environment, net investment income for the property/casualty insurance industry fell 7.1% in 2001 and is estimated to have fallen another 4.9% in 2002, according to A.M. Best Co. data.

Impact of Sept. 11, 2001: Since the terrorist attacks, workers' comp writers have faced higher reinsurance costs and additional scrutiny from rating agencies over their exposures to man-made and natural catastrophes, the Insurance Information Institute said. As a result, insurers are closely watching their concentrations of risk, and with good reason. Workers' comp claims from the World Trade Center are estimated to be about $2 billion, or 5% of total Sept. 11 losses, but would have been higher if the hijacked planes had not struck at the beginning of the work day. More than 5,000 claims were filed, and 2,191 of them were death claims. Of the remaining claims, some 1,800 involved a component of stress, according to the New York State Workers' Compensation Board.

In addition to future terrorism attacks, natural catastrophes also are a threat to workers' comp writers. Risk Management Solutions estimates that if there was a repeat of the 1906 earthquake that struck San Francisco, it could result in as many as 78,000 injuries, 5,000 deaths and more than $7 billion in workers' comp losses.

"Growth in the workers' comp residual market is another symptom of the overall hard commercial market. It's a bit of deja vu to what happened years ago," said Robert Hartwig, chief economist for the Insurance Information Institute. "Some of the same drivers are in place, which adds up to some marginal difficulty in placing business."

Asked if the market would repeat the turmoil of the late 1 980s and early 1990s, Wood said, "Oh God, I hope not." He said a number of changes to state benefit systems since then have helped. Many states eliminated state-controlled rates, which gives carriers more flexibility to set adequate rates. Also, managed care was used to slow medical-cost increases, and companies were encouraged to launch safety campaigns and return-to-work programs to get injured workers back on the job sooner.

Growth in the residual market is just another risk that workers' comp writers have to consider, said Liberty Mutual's Driscoll.

As a servicing carrier, Liberty Mutual has seen its premium increase by 600% from 1999 to 2003, Driscoll said. "Anyone active in workers' compensation is paying attention to the growth in the residual market," Driscoll said. "But in the past, the primary problem was that rates weren't keeping up with cost increases for carriers on the claims side. That was back at the time when states controlled rates for both the voluntary and involuntary market. There's a lot more flexibility today."

Hartwig agreed that the growth is a concern, but the industry should not be as worried as it was a decade ago.

"So far, the size of the residual market remains manageable. That could change if there is a major terrorism attack, particularly one that affects a large number of workers," Hartwig said.

Driscoll said there's a place for the involuntary market, but the question is: 'What is the right size for the market of last resort? "In several states, it is approaching 10% of the market. That is not a problem as long as the rates of the residual market are sufficient to support the losses the market is generating. If that's not the case, if claims and expenses end up being greater than premium, they'll have to assess the pool members for additional dollars," he said. "The revenue we get from the voluntary side has got to be underwritten properly, but the involuntary side has to be priced properly."

Residual Workers' Compensation Market Combined Ratios

Combined ratios for the residual workers' comp market continue to rise
from a low of 93 in 1995. Data from all pools as of Dec. 31, 2001.

1985     176
1986     165
1987     169
1988 *   166
1989 *   159
1990 *   142
1991 *   125
1992 *   111
1993     102
1994      96
1995      93
1996      97
1997     102
1998     111
1999     116
2000 **  118
2001 **  119

* Exclude Maine residual market pool

** Projected to Ultimate

Source: National Council on Compensation Insurance

Note: Table made from bar graph

Residual Workers' Compensation Market Premiums

After peaking in 1992 at $4.8 billion and dropping to $300 million in
the late '90s, workers' comp residual pools premiums are rising,
reaching an estimated $1.2 billion in 2002.

1985     $1.2
1986     $2.1
1987     $2.6
1988 *   $2.8
1989 *   $3.5
1990 *   $4.0
1991 *   $4.4
1992     $4.8
1993     $4.1
1994     $3.1
1996     $2.0
1997     $1.0
1998     $0.6
1999     $0.3
2000     $0.3
2001 **  $0.6
2002 **  $1.2

* Excludes Maine Residual Market Pool

** Projected to Ultimate

Source: National Council on Compensation Insurance

Note: Table made from bar graph

Top 5 Businesses Needing Workers' Comp Pool Coverage

Ranked by         Ranked by
Policy Count      Premium
Nationally        Nationally

Carpentry         Carpentry
Clerical          Charitable
Trucking (Local)  Trucking (Local)
Outside Sales     Trucking (Long Distance)
Painting          Roofing

Source: National Council on Compensation Insurance

RELATED ARTICLE: Workers' Comp Hot Spots: California and Florida

If costly workers' compensation insurance signifies turmoil in the marketplace, then California and Florida are the poster children for troubled markets.

The Golden State didn't earn its nickname from having expensive workers' comp coverage, but it certainly could have. Employers in California spend about $5.23 per $100 of payroll to purchase coverage there, making it by far the most expensive state to buy workers' comp coverage in 2002, according to the Oregon Department of Consumer and Business Services, which surveyed workers' comp costs in all 50 states, plus the District of Columbia.

The Sunshine State followed in second place, with workers' comp coverage premiums costing about $4.50 per $100 of payroll. North Dakota was the least expensive, with just $1.24 workers' comp premium per $100 of payroll.

California and Florida stand out for having particularly higher workers' comp benefit-delivery expenses, according to a study by the Workers' Compensation Research Institute. Costs for these two states are almost three times higher than costs in Connecticut and Wisconsin, which ranked among the lowest in expenses. The higher costs in Florida and California stem from medical-management costs, and litigation and claims-adjusting expenses, according to the WCRI.

If states such as California and Florida can find a way to reduce the cost of delivering benefits, the money could be redistributed and made available to increase benefits to injured workers or to reduce the cost paid by employers, said Richard Victor, executive director of WCRI.

The study found the average benefit-delivery expense per claim was $2,273 for California and $2,605 for Florida, compared with $943 in Connecticut and $842 in Wisconsin. The average litigation and claims-adjusting expense per claim was $1,522 in California and $1,205 in Florida, compared with $357 in Connecticut and $356 in Wisconsin. Medical-cost containment expenses per claim were $1,201 in California and $1,400 in Florida, compared with $587 in Connecticut and $486 in Wisconsin.

Higher medical-cost containment expenses per claim in California and Florida were primarily related to differences in bill review expenses, largely driven by more visits and services, longer durations of treatment, more frequent changing of medical providers, more disputes about medical issues and greater potential savings with lower fee schedules. The more activity per account, the higher the bill review expenses, the study found.

For example, California had more than twice as many medical visits per claim on average and more than three times the total number of medical services as Wisconsin. Also, the time in which medical treatment was given in California was three times as long as in Wisconsin, the WCRI found.

California has no controls for frequency of utilization and no caps on outpatient services, Peter Gorman of the Alliance of American Insurers said. Doctors can "charge anything they want and treat as often as they want. It's the No. 1 cost driver in the system," he said,

Nicole Mahrt, a spokeswoman with the American Insurance Association, said out-of-control medical costs are the state's biggest problem in the workers' comp market.

"The state fund, self-insured employers and private carriers can't price the product," Mahrt said. "They can't predict what the costs are going to be. They are constantly upping reserves and raising premiums because our medical costs are on auto pilot, and will continue to be on auto pilot unless we get reforms."

Also, California and Florida face higher defense attorney payments. Among claims with defense attorneys, the average expense was $2,698 in California and $2,701 in Florida, almost four times the rate of $695 for Connecticut.

The Alliance of American Insurers is lobbying for a change to the Florida law that would cap the amount that attorneys can receive. Attorneys today have the option of charging a contingency fee or an hourly fee, and tend to generate large hourly fee bills, said William Stander, government affairs representative for the AAI.

"It doesn't serve the injured worker, because it drags their cases out," Stander said. "Our rates are high not because our benefits are high, but because litigation is high. That's why we need to strike at attorneys' fees."

Both California and Florida have complex methods of rating permanent partial disability, which add to litigation and claims-adjusting expenses, the WCRI found. "The California schedule for rating permanent disabilities ... permits considerable room for disagreement by allowing parties to choose the more favorable of two distinct methods of describing a disabling condition," the WCRI said.

Also, the study noted that Florida's design and implementation of its method for determining permanency benefits are the main drivers of much higher defense attorney payments than in Connecticut or Wisconsin. "Despite a statutory design that should generate predictable results...the Florida PPD system has considerable room for disagreement," the WCRI said.

WCRI said minimizing benefit-delivery expenses is not an end in itself because there may be trade-offs between lower expenses and reduced worker outcomes. "With these cases, policyholders have choices to make," the WCRI said.

California Fund: The Bigger They Are, the Harder They Fall?

California state regulators have stepped up their oversight of the largest workers' compensation writer in the country, which, they say, is in perilous condition. That's bad news for all workers' comp writers in the state, since the largest writer is the state-run State Compensation Insurance Fund.

"This has created a crisis atmosphere here," said Peter Gorman of the Alliance of American Insurers.

The workers' comp fund was designed to be self-sufficient, absorbing unattractive workers' comp risks from the marketplace while competing with the private sector to gain enough attractive business to break even, It has redefined what it means to be a "competitive" state fund, however.

The fund doubled its direct premiums written in 2001 to $3.64 billion and rose another 50% to $5.49 billion at year-end 2002, making it the largest single workers' comp writer not only in California, but in the country, for the second year in a row. It writes 54% of the workers' comp market in California, according to the California Department of Insurance.

Dianne Oki, president of the state fund, testified before state lawmakers that it has grown so rapidly because private insurers have abandoned the market. The industry disagrees.

"Our view is quite different," Gorman said. "They have engaged in predatory practice. They've been taking good business away from us."

The state fund offered dividends to policyholders when other carriers would not, Gorman said. The state fund pays agents and brokers commissions of 16% to 18% when the private sector only pays 10% to 12%.The fund gave rating discounts that the Alliance believes were below costs, Gorman said. Unlike private sector insurers, the state fund is exempt from federal taxes, although it does pay state premium taxes.

"They have aggressively been seeking business; it hasn't been thrust on them," Gorman said.

The fund is not simply huge; it's unprofitable and possibly, unstable. The fund posted a net loss of $66.1 million for year-end 2002. Due in part to its rapid growth, the fund has fallen below risk-based capital standards. For the fund's $8.8 billion in reserves, it should have $2.4 billion in surplus, but only has $1.4 billion in surplus.

"They've got to fill that hole quickly to come into compliance," Gorman said. The state fund is already under the second phase of regulatory intervention and requires approval from the California Department of Insurance for most activity. In the first phase, the department ordered the fund to create a remedy plan last year. The third phase, should it come to that, is conservation.

California Insurance Commissioner John Garamendi has outlined a plan to improve operations at the state fund including hiring a management consultant, reducing new business written by requiring policyholders to prove insurance isn't available from another source, increasing rates, lowering broker and agent commissions, and reducing merit rating credits while raising surcharges for unprofitable accounts upon renewal.

Oki testified that the fund should turn away business, saying it's like an over-saturated sponge. Garamendi ordered the fund to continue to serve as the insurer of last resort.

"We support the commissioner's actions and believe he will be successful in keeping the state fund a part of the market," said Mark Sektnan, assistant vice president of the American Insurance Association.

The insurance industry is calling on the state Legislature to enact medical-cost containment. "If we are going to save the [California] state fund from insolvency, we need to have medical-cost containment," Gorman said. In fact, controlling medical costs and the medical inflation rate in workers' comp would help reserves and surpluses to grow, and some of the problems with the state fund would cure themselves, Sektnan said.

The California workers' comp market has been under stress after the state went to an open rating system in 1995. With insurers no longer required to get regulatory approval to raise or lower rates, many dropped rates to gain market share, but were able to make up money lost in unprofitable business through profitable investments. Inadequate rates, rising costs and the downturn in the equity markets left many companies with weak balance sheets, and a string of companies have either fallen into insolvency or exited the workers' comp market in recent years, including Superior National Insurance Co., Reliance Insurance Cos., Paula Insurance Co. and Legion Insurance Co.

The state fund is not insolvent, but if the fund did fail, it would put a tremendous burden on the already strained State Insurance Guarantee Fund. While workers' comp writers in the voluntary market can't be tapped to cover the state fund's losses, they can be assessed to keep the state guarantee fund afloat.

State lawmakers raised the surcharge on insurers to 2% from 1% of direct written premiums in 2001 to help keep the guarantee fund solvent. It is paying up to $85 million in claims a month for insolvent carriers. The state workers' comp fund paid $2.2 billion in claims in 2002.

Florida's Residual Market: Time for Change?

Florida has one of the country's most unusual workers' compensation residual markets, although it is currently a target of reform for some lawmakers as the entire market is in flux.

"We are in the midst of a workers' compensation crisis," said Edie Ousley, public affairs director for the Florida Home Builders Association, who pointed out the market is the worst it's been in 10 years. "We're hearing horror stories from Pensacola to Miami."

The construction industry is the second-largest industry in Florida, behind tourism, and is struggling to deal with mounting workers' comp premiums, Ousley said. Small volume builders are particularly hard hit, as insurers flee the market, saying the rates are inadequate.

All Florida employers faced an average 13.7% rate hike in workers' comp in April, the first double-digit increase since a 21% rate hike in 1992. After that rate hike, the state legislature met in a special session to create the Florida Workers' Compensation Joint Underwriting Association in 1993. The JUA acts as the insurer of last resort. Unlike other residual markets, however, the JUA has the authority to tap its policyholders--the employers--instead of the voluntary market if the business runs at a loss.

Before the system was reformed, the residual market in Florida was the largest workers' comp writer in the state with 48,000 policies and $328 million in premium in 1993. Insurers also fled the market then, saying rates were inadequate, plus the inadequate rates from the residual market were resulting in large assessments to the voluntary market, said William Stander, government affairs representative for the Alliance of American Insurers. The residual market lost $238 million in 1993, he said, noting the private carriers had to pay that loss.

"By making the JUA self-assessable--so no assessment went beyond the JUA--that opened the door for the admitted market to come back in," Stander said. "It was no longer a competitive force; there was no more threat that carriers would have to pick up the JUA's tab."

The JUA shrank to 662 policies with written premium of $6.7 million and a net loss of $1.5 million for 2001, Stander said. "We feel that's pretty successful. It would be a shame if we went back to the old days," Stander said.

The JUA was designed to write business at rates substantially higher than the voluntary market, where rates also are rising--although some insurers say not fast enough. In July 2002, FCCI Insurance Group, the second-largest carrier in the state, said it would stop writing new business because rates were inadequate.

The 13.7% increase just approved is significantly less than the National Council on Compensation Insurance's original request of 21.5%. Last year, the state authorized an increase of 2.7%, when NCCI requested an 8% price hike plus an additional 4% to cover terrorism costs.

In the construction industry, workers' comp premiums can easily equal 50% of a contractor's payroll, and the Florida Home Builders Association estimates that for every $100,000 spent to build a new house, as much as $10,000 goes to workers' comp coverage, Ousley said.

But small builders are now unable to find private carriers to cover them, and are being forced to the JUA where the rates are "astronomical," Ousley said. She said one small Daytona Beach contractor was nonrenewed on a $774 a year policy with FCCI, and would have to pay $7,000 for a new policy with the JUA.

"The JUA rates are set so high, companies are filing for exemptions or illegally going bare," Stander said. As much as $1 billion in premium that should be in the system has escaped through loopholes in the law, he said.

With small businesses complaining that they can't afford workers' comp coverage, lawmakers have drafted a dozen or so proposals to try to fix the system. A coalition of the business and insurance industries is supporting a bill to narrow the loopholes for companies to be exempt from workers' comp coverage. Also, the group supports capping attorneys' fees to help cut costs. The builders association is asking for a provision to reinstate an exemption on workers' comp coverage for commercial jobs, among other changes.

State Sen. Charlie Clary, R-Destin, and Rep. Kim Berfield, R-Clearwater, have introduced bills that would create a nonprofit carrier to operate the residual market and compete with the private carriers. The Florida Employers Mutual Insurance Co. would be modeled after the Missouri Employers Mutual Insurance Co., and would compete with the private market, but have advantages of a state-run company, including tax advantages, and the ability to issue government-backed bonds, a cheaper form of borrowing.

The JUA is a success, Stander said, and cautioned about blaming it for the market's problems.

"If you think things were great back in 1993, when rates were rising 33% and the state was writing most workers' comp and no one wanted to write business in Florida, then go for it," Stander said of changing the system. "There's not a problem with the JUA. There's too much risk in the admitted market for small employers, because the rates had been lower than they should have been. The environment is so risky, companies are taking a look at their books and making choices, which will continue until the Legislature does something to re-establish stability in the claims process and reduce litigation."

Stander said the JUA could consider softening rates for employers with few employees. "That would give the JUA flexibility without throwing the baby out with the bath water," Stander said.