Reducing workers' compensation costs.

REDUCING WORKERS' COMPENSATION COSTS

Conducting a self-audit and investigating alternatives to traditional insurance.

The majority of companies doing business in the United States continue to face rapidly escalating workers' compensation costs. Workers' compensation premiums are increasing at a faster pace than the total premiums for property and other lines of liability insurance. There is every indication this upward cost spiral in workers' compensation premiums will continue well into the 1990s.

A number of factors have led to the escalation of workers' compensation insurance prices. They include increased benefit levels mandated by state legislatures, rapidly expanding medical costs, broader scopes of coverages mandated by individual states and more workers in the work force based on a full-employment economy.

It is thus extremely important for chief financial officers, corporate controllers, risk managers and other financial officers to understand workers' compensation insurance. They must be able to compare the costs of their companies' programs to those of similar companies audit workers' compensation programs and study and suggest alternative funding mechanisms that can help reduce premiums. Even if traditional, commercial insurance is the only viable option available to a company, a self-audit of the workers' compensation program usually results in substantial savings.

This article reviews the self-audit techniques that can be used to help control these costs and discusses alternative funding programs that have been used successfully by many companies to reduce costs further.

WORKERS' COMPENSATION SELF-AUDIT TECHNIQUES

Workers' compensation insurance rates are promulgated and designated by state workers' compensation rating boards. Standard rates per $100 of payroll are developed by the boards for different classifications of industry jobs. The rates are based on expected injury rates for a class of operations. An employee working in a production job would have a higher rate than an accountant or clerical worker would, because the production worker is more likely to injure himself or herself.

The rates are provided to insurance companies. Based on the payroll for each rate classification, insurers use these rates to develop their premiums. The insurance companies can increase or decrease the rating board's standard rate, using an experience modification factor. This factor is a percentage of the standard rate and based on the difference between actual and expected loss experience. For example, if the actual loss experience for a job classification is double the expected loss, the insurance company will use the experience modification factor to double the premium. The converse is true as well.

STEPS IN THE AUDIT

The two major factors in premium determination for workers' compensation insurance are

* Payroll classification of jobs.

* Rate determination, including experience modification.

Payroll classification. The first step in the audit process is to determine if the insurance company has properly classified all job functions within the insured company. Many times the insurance company incorrectly applies a higher rate than the actual job classification calls for and the insured company is charged a higher premium. To prevent this, a description of each classification as it is used on the policy should be obtained from the insurance company and matched with actual jobs at the insured company. If there is a discrepancy, the insurance company's classifications should be changed. This could reduce premiums substantially.

Experience modification. The next step is to evaluate the experience modification factor used by the insurance company. If it is a debit factor, the actual loss experience of the insured company is higher than industry standards for the same job classification. As with any other line of insurance, reducing losses will lead to a reduction in premiums.

There are a number of areas that affect workers' compensation loss experience. Each must be looked at in order to reduce losses.

The review of loss experience should start with a review of loss summations or "loss runs" provided by the insurance company. The loss runs, generally issued on a quarterly basis, list claims that have occurred at the insured during the quarter. These losses are the ones used to calculate the experience modification factor. Therefore, it is important to review all losses to be certain they have occurred.

The reserve amounts used by the insurance company also should be reviewed. Reserves are the insurance company's estimation of how much a loss will be settled for and are used in calculating the experience modification. A review of reserves in the loss run can result in reductions. It is common for insurance companies to overestimate reserves and a careful review and analysis of them can substantially reduce reserve amounts. If reserves are reduced, so are the loss ratio and resulting experience modification.

Review of loss runs also can help reduce the number of claims. A review for a number of quarters or for several years will indicate trends in recurring losses. If losses continually recur, management should determine why and examine safety engineering solutions that would eliminate the losses.

Loss run review also can determine whether individuals are abusing the workers' compensation program by malingering. In some cases, minor injuries are exaggerated because employees can collect between 66.67% and 80% of their salaries while they are on workers' compensation and do not have enough incentive to return to work. Employees suspected of malingering can be watched and challenged. Rehabilitation and light-duty return-to-work programs can help reduce malingering.

Loss runs also can be reviewed to assess the reasonableness of medical costs attributable to injuries. In some cases, either medical charges are excessive for the injury or there are medical costs included that are unrelated to the claimed injury. These can be removed from a claim.

An audit of the workers' compensation program and especially an analysis of loss runs can be important first steps in determining why costs are as high as they are and allowing for corrective actions such as loss prevention and safety engineering and rehabilitative programs.

ALTERNATE RISK FINANCING

The second major effort that can help reduce workers' compensation costs is the institution of alternate risk financing programs. These programs are alternatives to the conventional insurance company guaranteed cost program; they offer cash flow benefits and savings. They include

* Self-insurance.

* Incurred-loss retrospective rating plans.

* Paid-loss retrospective rating plans.

* Retention plans.

Self-insurance. With self-insurance, the company, rather than a commercial insurer, covers workers' compensation losses. The savings that may be generated by a self-insurance program are computed by comparing premiums that would have been paid with the retained losses paid. The additional costs of purchasing services that were provided by the insurer, such as claims handling and loss prevention, must be deducted from the savings. Also, because workers' compensation laws are compulsory, many states require posting a surety bond or other financial guarantee to ensure the company will meet its obligations to injured employees. Some states require the self-insurer to purchase aggregate excess insurance above a self-insured limit to ensure the company can pay all claims.

The most obvious benefit to complete self-insurance is the immediate cash flow savings the self-insuring company realizes by not paying premiums at the beginning of the coverage period. Other benefits include saving the profit portion of premiums paid to the insurer. The amount saved depends on the rate of payout of workers' compensation claims.

The greatest disadvantage of a self-insurance program is the loss of the tax deduction normally allowed for premiums paid to commercial insurers; money held by the company as reserves for contingencies can receive tax credits only in the year the funds are paid to settle claims. The deferral of tax benefits must be considered in calculating the cost benefit of a self-insured program.

The following alternatives to traditional insurance are offered by most insurance companies.

Incurred-loss retrospective rating plans. These plans are risk financing programs in which the premium is determined at the end of the policy period, based on loss experience. A premium is paid to an insurance company up front and then adjusted at the end of the policy period to reflect actual losses. Since an insured company is rewarded for instituting and maintaining effective loss control programs, the insured can control its premium costs by preventing losses.

The plans contain a maximum premium the insured company can pay, even with very poor loss experience.

Two advantages of a retrospective rating plan are

* When losses are kept low, the net cost of the program is lower than that of a standard program.

* The insurance company provides all services, such as loss control engineering, plan administration and claims settlement.

Disadvantages of retrospective rating plans include

* Loss of cash because the standard premium is paid up front.

* Due to excess loss experience, the maximum premium may be in excess of the regular premium and, consequently, make the program more expensive.

* The final premium is unknown until all losses are settled; therefore, an insured company cannot budget its costs accurately.

Paid-loss retrospective rating plans. These plans are similar to the incurred-loss plans, except for the timing of premium payments.

Although the premium is the same as that under an incurred-loss program (the normal or standard premium that would be charged for a regular policy), the premium is not all paid to the insurance carrier on inception of the policy. Only the amount necessary for insurer expenses, profit and administrative expenses is paid. The insured company keeps the remaining amount until it is needed to pay for losses.

The benefits and disadvantages of the paid-loss program are similar to those of the incurred-loss plan. An additional benefit is increased cash flow through retention of the premium portion allocated for losses.

Retention plans. Under these programs, the normal premium is paid up front. They are dividend plans offered by commercial insurers in which the insured company receives a dividend based on good loss experience and the portion of risk retained by the insured.

The insurance company charges for its services, which include administration and profit. The amount is a percentage of the normal premium it would charge under a fully insured program. The difference between this charge and the full premium is used by the insurer to pay losses. Any amount not used is returned to the insured company in the form of a dividend.

The major benefit of this type of retention plan is the insured company is rewarded for good loss experience and retention of risk through dividends. On the other hand, if loss experience is poor, the maximum paid is the normal premium that would be charged under a fully insured program. A further benefit is that retention plans give full economic incentive to loss prevention and control programs.

Some disadvantages of control programs include

* Loss of cash flow advantages because the insured company must pay the normal premium on inception of the policy.

* Charges for the insurer's services, such as profit administration, may be high.

* The dividend payable to the insured company is not fully paid until all claims are closed, which could take several years.

CHOOSE THE BEST FIT

If used properly, these techniques can be attractive alternatives to soaring workers' compensation insurance costs. Management must first consider all the available options and then choose the one that best fits it current needs.

Remember that, regardless of what program is chosen, an insured company must reduce losses through a well-organized and -managed loss control--prevention program. Reduced losses will always reduce the cost of insurance, self-insurance or alternate risk financing programs.

ALLAN H. BADER, CPCU, is president and ANGELA COTRONE is vice-president of Risk Management Services Inc. (RMS), a risk management and insurance consulting firm in Westbury, New York. RMS specializes in environmental exposures and alternate risk financing.