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Workers' Compensation Insurance Pricing.

Workers' Compensation Insurance Pricing

As evidenced by publication of Workers' Compensation Insurance Pricing, the National Council on Compensation Insurance (NCCI), in coordination with the Huebner Foundation of the Wharton School, continues to offer the form of research support that readers of the Journal seek from industry. The book represents the third compilation of papers presented at the Annual Seminar on Economic Issues in Workers' Compensation.

Workers' Compensation Insurance Pricing devotes an introductory chapter to a general discussion of workers' compensation programs, followed by a summary of the papers. The summary provides a framework for linking together the papers. Papers presented comprise the remaining chapters.

The focus of the book is the pricing process of workers' compensation insurance, loosely represented by the familiar three-pronged regulatory requirement of adequate, not excessive, and not unfairly discriminatory rates. However, the three prongs are titled (1) estimation of costs, (2) equity in pricing, and (3) insolvency.

Workers' compensation costs estimates, upon which premiums are based, depend on the interaction of numerous incentive effects. The initial three papers in the book address some of those interactions, with the first providing an econometric model of effects associated with changing benefit levels and use of experience rating. Butler and Worrall (1) continue to offer improved statistical methods to analyze workers' compensation data. Here they work toward decomposition of observed claim patterns into differences caused by random effects, caused by structural incentives of the system, and caused by heterogeneity of workers/firms.

Workers are assumed to return to work when the market wage is greater than their reservation wage. Increased benefit levels, which raise the reservation wage, therefore, are likely to yield higher claim frequency and duration. The effect may be magnified if increased benefits cause employers to reduce wages. In contrast, exprience rating ought to reduce claim costs by rewarding employers with lower premiums for fewer and less severe claims.

Through utilization of recently developed maximum likelihood estimates, Butler and Worrall test these hypotheses. They find that both experience rating and benefit/wage levels significantly affect claim frequency and duration. Their data indicate that a 10 percent increase in benefits yields a 15 percent increase in costs. These estimates are consistent with results found elsewhere and have significant implications for policy decisions.

Also concerned with policy decisions, Lambrinos and Johnsons (2) suggest the development of "disability-related categories" (DRCs) as a mechanism to contain workers' compensation disability costs. DRCs would serve the same function as diagnostic-related groups (DRGs) in the health care system. DRGs provide a system of prospective payment with the intent of abating some of the disincentives associated with retrospective payment systems (wage loss). Those disincentives have been mentioned in the discussion of the preceeding paper.

Under the suggest system, the data base of disability claims (excluding permanent total because of the small sample size) would be partitioned according to major categories. The latter might be linked to the functioning of body organs. A distribution of lost work days would be estimated for each category, from which payment schemes would be developed. For example, the "scheduled" benefit per disability could be determined as the mean plus some level of standard deviation. Lambrinos and Johnson believe that "DRGs may reduce workers' compensation expenditures by eliminating work disincentives and reducing the costs of administering claims." (p. 52) They believe, assuming that the number of lost workdays is reasonably predictable, that the system also improves equity. To address the equity concerns caused by special circumstances, the authors suggest the extension of benefits for outlier durations. A potential roadblock to success is the worker's incentive to extend loss duration to the outlier limit. A strict asministration of the system is needed, therefore, if policy goals are to be met.

Schlesinger and Venezian (3) address a third concern to policy makers by considering the incentive conflicts involved in assessing liability for workplace (occupational) disease. Compensation for losses caused by occupational disease often is more troublesome than is compensation for losses caused by traumatic events. Two prominent causes of the trouble are the long-term exposure often involved in occupational disease and the possibility of exposure in non-work settings. Questions concerning responsibility for losses when these elements exist are particularly difficult to answer.

Given the absence of a first-best-solution, Schlesinger and Venezian suggest a compensation system that minimizes total costs of occupational disease. These costs are defined by Danzon as injures, injury prevention, risk bearing, and overhead costs of litigation and asministation. (4) An additional cost mentioned here is the cost of inappropriate compensation.

Perhaps a good approach would be one of "comparative institutional analysis," as suggested in various articles by Komesar. (5) Komesar proposes determination of the least-cost approach to answering a legal question by considering all available institutions rather than minimizing cost conditioned on the use of a given institution.

Having discussed incentives effects in the workers' compensation system, concerns over equity in pricing are considered in the next three chapters/papers. First, Worrall and Butler (6) take up the controversial issue of whether experience rating reflects employer actions to control the seriousness of workplace injuries. The difficulty of assessing this question arises from the conflicting forces associated with employer/employee objectives. Benefit increases, for example, may be associated with decreased incentives for employees to be safe. They also may be associated with increased incentives for employers to provide safe workplaces. Or, alternatively, if benefit increases cause greater reductions in wages than increases in costs from injuries, the employer may be less inclined to provide a safe environment.

Worrall and Butler find that employee incentives dominate claim results. They also find that experience rating (using size as a proxy) has an effect on claim frequency, which is stronger for more serious injuries. Thus, holding benefits constant, a 10 percent increase in size is associated with a 4.95 percent decrease in permanent partial and a 1.55 percent decrease in temporary total disability injury rates.

Similarly, Harrington (7) finds that firm size is negatively related to standard loss ratios. He suggests this result is due in part to economies of scale and in part to incentives associated with experience rating. Appel and Borba (8) conclude that the findings offer evidence that the experience of large employers ought not be accorded too great a weight in the development of statewide workers' compensation manual rates.

Looking at ratemaking from the regulatory viewpoint, Hunt, Krueger, and Burton (9) find that the shift in Michigan to open competition has resulted in a significant reduction in workers' compensation costs to employers. Their work compares actual premiums to simulated premiums, controlling for various confounding effects. For the period 1983-85, Michigan employers experienced annual cost reductions of 25 percent, 30 percent, and 10-15 percent. The authors caution, however, that evidence in other states does not appear to be as positive in Michigan. Further, the authors suggest that the lasting impact of open competition in Michigan may not be reduced costs but rather quicker adjustments of market prices to market conditions. To test such a hypothesis, data over an entire (or several) underwriting cycle(s) is needed.

One concern about open competition, of course, is the solvency of firms whose prices are unregulated. Cummins (10) addresses a somewhat different solvency issue, which is the mechanism of guaranty fund assessments. Recent experience with the FDIC and FSLIC are similar in nature in that assessments are not based on costs (risk), causing the incentive effects to be distorted. That is, insurers are overly encouraged to be risk-takers because the costs of risk taking are borne by other firms on a post-insolvency basis. Cummins proposes a pre-insolvency risk-based method of assessment. His model, a derivative of the Option Pricing Model, assumes that changes in assets/liabilities of insurance companies are represented by a diffusion process. Further, the guaranty fund, in return for its promise to cover insurers' liabilities, is modeled to have an option on each insurer; this option is exercised when liabilities exceed assets. If assets exceed liabilities, a new option is "sold," with a new premium charged based on the current riskiness of the insurer. Riskiness is comprised of asset risk, liability risk, investment return, premium inflow, claim outflow, and the incidence of new claims.

Estimated past premiums, using Cummins' model, are reasonable approximations of actual guaranty fund assessments, providing support for his method. A major deterrent to the use of the model, of course, is the highly theoretical nature of it. Just as in the banking and savings and loan industries, regulation may be limited by knowledge.

A similar type of concern might be found with Doherty's (11) suggested use of the Option Pricing Model (OPM) to price reinsurance contracts. Either due to lack of knowledge, or due to ties to traditional pricing processes, use of the OPM may be long in coming for the reinsurance market. Yet, financial economists have recognized for some time the option-like characteristics of the (re)insurance product. Rather than rely on estimates of loss distributins, reinsurers may find the use of OPM more amenable to their computational needs. As is true with all papers found in this book, Doherty's approach is creative and forward-looking. The entire group of readings ought to be studied by anyone interested in the workers' compensation field.

(1) Richard J. Butler and John D. Worrall, "Labor Market Theory and the Distribution of Workers] Compensation Losses."

(2) James Lambrinos and William G. Johnson, "Disability-Related Categories: An Alternative to Wage Loss Benefits."

(3) Harris Schlesinger and Emilio C. Venezian, "Compensating Victims of Occupational Diseases: Can We Structure an Effective Policy."

(4) Patricia M. Danzon, "Tort REform and the Role of Government in Private Insurance Markets," Journal of Legal Studies 13 (1984): 517-549.

(5) See, for example, Neil Komesar, "In Search of a General Approach to Legal Analysis: A Comparative Institutional Alternative," Michigan Law Review 79 (1981): 1350-1392.

(6) John D. Worrall and Richard J. Butler, "Experience Rating Matters."

(7) Scott E. Harrington, "The Relationship Between Standard Premium Loss Ratios and Firm Size in Workers' Compensation Insurance."

(8) David Appel and Philip S. Borba, "Costs and Prices of Workers' Compensation Insurance."

(9) H. Allan Hunt, Alan B, Krueger, and John F. Burton, Jr., "The Impact of Open Competition in Michigan on the Employer's Costs of Workers' Competition."

(10) J. David Cummins, "Incorporating Risk in Insurance Guaranty Fund Premiums."

(11) Neil A. Doherty, "The Pricing of Reinsurance Contracts."

Edited by David Appel and Philip S. Borba (Kluwer Academic Publishers, 1988), 182 pages.

Reviewer: Joan T. Schmit, Ph.D., University of Wisconsin
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Author:Schmidt, Joan T.
Publication:Journal of Risk and Insurance
Article Type:Book Review
Date:Dec 1, 1989
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