What's happening with costs and what to do about them: workers compensation coverage has gotten more difficult to obtain, and costlier, in the past couple of years. Companies need to focus on the source of costs and on financing structures.

You don't typically expect to see newspaper headlines about workers compensation, an insurance product designed to help employers fulfill their legal obligations to provide medical care and income for employees injured at work.

Lately, though, workers compensation has received considerable media attention, particularly in California--where it was part of the gubernatorial debate--and Florida. The situation in California is fairly chaotic. Average rates for many employers increased over 50 percent in the last two years, a number of insurers restricted their operations or closed down and the state workers compensation fund grew meteorically.

There is also great uncertainty about the potential effects of recent and upcoming legislation. The Florida headlines are more upbeat, since recent legislative changes resulted in a 14 percent rate rollback. The dynamics around this coverage, which ultimately are manifested in employers' costs, are not unique to these two states; a number of emerging issues across the U.S. have increased employers' focus on this seemingly routine coverage. And, in every state, employers can take some basic steps to control costs.

To gain some perspective on where we are, it's helpful to review how we got here.

* During the 1980s, employers experienced significant increases in their workers compensation costs, due in part to significant benefit expansions legislated in the late '70s and early '80s. In response to these trends, employers more actively managed their workers compensation claims and/or started to self-insure, rather than buying first-dollar coverage.

* During the 1990s, employers reaped the benefits of cost management programs implemented in the "80s. Consistent annual reductions in claim frequency and the impact of a strong economy further contributed to favorable cost trends. Insurance company results were boosted by investment opportunities, and many insurers lowered prices to attract or retain customers. In some states, most notably California, vigorous price competition induced a significant migration of employers from self-insurance back to traditional fixed-cost insurance.

* By early 2001, the workers compensation market started to "harden"--prices were increasing, and fewer insurers would quote a risk--in some jurisdictions, and the events of Sept. 11, 2001, exacerbated this trend. The workers compensation market remains hard to date.

Factors contributing to this hard market include:

* Downward trends in claim frequency began to moderate.

* Increases in workers compensation medical costs, caused by general medical inflationary trends, were magnified by cost-shifting from other, more restrictive, medical coverage (workers compensation provides first-dollar cover age that is generally unlimited). Theoretically, cost-shifting shouldn't be possible (occupational costs are covered by workers compensation and nonoccupational costs are covered by other coverages) but we hear it occurs, as when workers injured on the weekend limp in to trip on Monday.

* An increase in how long injured workers continue to claim benefits, attributed in part to the softening economy and, in some jurisdictions, less favorable employer outcomes in decisions by state industrial accident commissions that adjudicate these claims.

* Diminishing returns from managed care initiatives.

* Historically low investment yields.

In spite of these pressures, workers compensation premiums in many states are still lower than they were 10 years ago. How do we reconcile this observation with many employers' perceptions that costs are increasing?

1. Location matters--More so than for most other coverages, workers compensation is a local item, affected by the intricacies of the individual jurisdictions' claims environments and legislated benefit structure. In some states, costs are increasing through explicit benefit expansions (such as AB 749 in California); in other states the cost drivers may be more subtle (such as more liberal findings of injured worker impairment). In some jurisdictions, legislative actions have reduced costs.

2. It depends on your risk-financing structure--Some employers purchase first-dollar coverage, some choose large deductibles to retain some of their risk, and others have established formal self-insurance or captive vehicles. (Many large employers use different structures in different states.) The various risk-financing approaches are subject to different cost pressures at different times; in the recent past, the costs of some components of these programs have increased.

A self-insurer may have experienced significant increases in its excess insurance costs--which limits the cost of a single occurrence or the aggregate dollar of losses--potentially compounded by decreases in projected investment income, which typically increases funding. An employer purchasing a large deductible policy may be required to retain greater levels of loss (such as an increase the corporate retention level).

3. What are you comparing?--A "cost" comparison can be misleading. Some employers look at workers compensation costs on a cash basis, considering only the annual level of loss payments or premiums. Cash flow accounting, particularly for a newer self-insured program, will typically show increasing loss expenditures each year, reflecting that claim payments extend over multiple years. If an employer looked at costs on a true accrual basis, the same comparison may not suggest deterioration.

4. There's no free lunch--The cost of this coverage is affected directly by your company's track record--the number and cost of workplace injuries. In a large deductible program, the cost effect is direct and immediate. In a fully insured program, the effect occurs in subsequent years, when insurers include your claims experience in pricing your business.

The availability of cheap insurance alternatives allowed many employers to stop managing their own workers compensation costs. Without appropriate management oversight, some basic loss control and safety initiatives can be overlooked. The result may be short-term expense savings, but longterm increases in program costs.

5. There are new sources of claims--Workers compensation, like other casualty lines, has not been immune to the emergence of new exposures (earlier in 2003, for instance, health care systems needed to consider the impact of the smallpox vaccine). All things being equal, the emergence of new classes of exposure typically increases system cost.

6. The insurance market has shrunk--There are fewer players on the traditional insured front. Large national workers compensation writers, such as Legion, Reliance and Kemper, are no longer players. A number of self-insurance groups have begun reevaluating their long-term viability from both a financial and structural perspective, since not all employers are comfortable with the joint and several liability associated with group membership.

Given these trends, what should an employer do? The answers are surprisingly basic; for that reason they seem less exciting than a "magic bullet" solution--which we haven't found in any case.

Know your costs and what's driving them. You can't manage what you haven't measured. Spend time to understand your workers compensation trends; this will help determine the level of resources needed to manage this exposure. Key steps include tracking claim frequency, setting accurate claims reserves, and, as needed, an actuarial analysis of incurred but not reported (IBNR) claims. You should also know benchmark costs for your typical exposure.

Periodically evaluate how you finance these exposures. A risk financing vehicle that worked in the late 1990s may not be appropriate for 2003. If you've participated in a self-insurance group or other alternative risk financing vehicle, make sure you understand the program finances and are comfortable with its financial position. If you are a self-insurer, make sure your excess carrier is solid.

Focus on the key elements that ultimately affect your loss costs. While loss control sounds "vanilla," you don't have to manage a claim that doesn't occur. Once the claim occurs, it's important to quickly determine if it represents a significant exposure. As in many situations, the 90/10 rule applies: generally, 10 percent of claims produce about 90 percent of the dollars. These serious claims need management--medical services should be controlled and monitored, back-to-work programs should be considered and insurers need to be involved.

Don't forget that you ultimately own these costs. Even when you find "cheap" insurance, employers eventually pay the costs of their claims. Many employers learned this lesson the hard way after benefiting from well-priced insurance programs. When these programs were not renewed or were not available, these employers emerged into a hard market and were perceived as less than attractive risks. Conversely, those employers who continued managing their claims in spite of the competitive pricing environment achieved "softer landings."

Bob Conger (312.609.9363) is a principal and the manager of Trillinghast-Towers Perrin's Chicago office, and Ann Conway (617.638.3774) is a principal in Tillinghast-Towers Perrin's Boston office. Conger's consulting practice has a particular expertise in workers compensation, and Conway has significant expertise in loss-reserve and pricing analyses for insurers and for alternative risk financing vehicles.