Guarded Optimism in 2007

Saturday, June 2, 2007 | 0

By Stephen J. Klingel

As we move further into 2007, NCCI has examined the available workers' compensation market data and adopted a position of "guarded optimism" regarding the outlook for the workers' compensation market this year.

In May 2006, NCCI issued a preliminary market analysis that indicated that workers' compensation private carriers posted a 102% combined ratio for 2005. This was the latest in several years of improvements in the combined ratio. By the end of 2006, our preliminary estimate of the 2005 calendar year combined ratio edged up slightly, from 102.0% to 102.6%.

This increase was driven by an increase in the loss ratio from 64.0% to 64.6%. Changes in the underwriting expense ratio from 22.0% to 22.4% -- and the dividend ratio from 1.0% to 1.2% -- were offset by a change in the loss adjustment expense ratio from 15.0% to 14.4%.

The industry also did some much needed reserve strengthening in workers' compensation over the past several years, which was the major reason why the calendar year combined ratio lagged the overall industry results.

Based on midyear reporting on a direct basis, NCCI currently estimates another slight decline in the combined ratio (back to 102%) in the final 2006 numbers.

Investment Gains

As part of our overall market examination, NCCI took a look at projected 2005 investment gain numbers in late 2006, and the final investment gain on insurance transactions as a ratio to earned premiums was estimated at 11%.

That investment gain result, along with the nearly one-point increase in the loss ratio, led to a pretax operating gain ratio of more than 8% -- two points lower than the preliminary estimate of 10%. Despite these downward revisions, the workers' compensation line continues to stand out as one of the few that had an improved combined ratio in 2005 versus 2004.

NCCI's modeling indicates that during 2005, after including the investment gain on surplus and paying taxes, the industry came close to earning its cost of capital in this line for the first time since 1998.

Our analysis continues to indicate that the workers' compensation insurance industry needs to run combined ratios at or near 100% to achieve a reasonable return on the capital supporting the business. This target-combined ratio is up slightly from recent years, but is still at nearly historic low levels.

Net Written Premium

Preliminary and updated NCCI estimates indicate that net written premium increased about 9% for private carriers in 2005. This was the sixth consecutive year of increases for private carriers. Premiums were up a more modest 2.5% when state funds were included.

NCCI also reported some $37.8 billion in private carrier net written premium. Total industry (private carrier and state fund) net written premium volume came in at $49.4 billion.

Based on midyear reporting, NCCI currently estimates 2006 will post another increase, to nearly $40.0 billion in net written premium on a private carrier basis. Due to the lack of an estimate for state fund premiums, an estimate for total 2006 net written premium is not available.

Accident Year Results

Analyzing experience on an accident year basis can provide additional insights into the underlying performance of workers' compensation and other "long tail" lines of insurance without the distortions of reserve adjustments on prior years' losses.

The workers' compensation insurance industry had another excellent year on an accident year basis. NCCI estimates the combined ratios for both 2004 and 2005 accident years to be about 90%--the best results in recent memory. This is a 50-point improvement since the 140% peak in 1999.

It was the third consecutive year of accident year underwriting profits for the line. Although the 90% combined ratios seem extremely favorable by historic standards, the record low interest rates of recent years and the industry's need to strengthen its reserve position made these types of accident year results a necessity. In recent years, our Internal Rate of Return models have indicated that underwriting profits remain necessary for the industry to earn a reasonable return on its surplus.

Much of the improvement in the accident year combined ratios resulted from three factors: significant increases in carrier pricing since 1999, lower claim frequency, and significant reforms, especially in California, Florida, and Texas.

Key Market Drivers

Key market drivers and other factors influencing the results above include:

Improved Reserving: 2005 was another year of improvement in the private carrier workers' compensation reserve position. NCCI's estimate of reserve deficiency for private carriers as of December 2005 is about $9 billion. This is a $3 billion improvement from year-end 2004. After allowing for the permissible discounting of the reserves for lifetime pension cases, the remaining deficiency was a very manageable $3 billion.

Medical Cost Volatility: Average medical claim cost trends continued their recent volatility, rising to 11.7% in 2005. Medical costs continue to grow much faster than average wages and the Medical Consumer Price Index. For NCCI states, medical losses are now approaching 60% of total losses. Workers' compensation is increasingly becoming a medical management business as policy makers, employers, and carriers strive to control these costs.

Moderating Indemnity Claim Costs: NCCI estimated that the average cost of workers' compensation indemnity claims rose a more modest 3% in 2005. This continues a moderation in the increase in indemnity claims costs that we have seen since 2002. Some of the rapid increase in costs we saw from 1997 to 2001, and the moderation we have seen recently, appear to be related to changing claim frequencies. For several years, we have observed that the frequency of smaller claims has been dropping more rapidly than larger claims.

Declining Claims Frequency: The reduction in claims frequency continues to be a major bright spot for workers' compensation. Injury rates have dropped by an average of 4.1% per year since 1996, including an estimated decline of 6.6% in 2005. While claim frequency continues to drop, however, indemnity and medical severities continue to rise, as noted above.

Improving Residual Market Results: We finally started to see some significant residual market depopulation in 2005. Overall premium dropped to $1.4 billion from $1.5 billion in 2004. The volume of business in the residual markets remains too high, particularly in Alaska, Kansas, and New Hampshire, but most markets are benefiting from the depopulation trend. This is a sign that many markets are returning to a healthy environment. Our late 2006 look at the residual market confirmed that policy year premium volume remains lower, and that the percentage of calendar year voluntary market share is also down slightly, from 13% to 12%. The 2005 combined ratio for the residual market pools came in at a relatively stable 112%.

Terrorism Backstop: In late 2005, Congress extended the Terrorism Risk Insurance Act (TRIA) for two more years (albeit with higher industry retentions), and charged a Presidential Working Group with finding a permanent solution. The modeling underlying NCCI's terrorism rate/loss cost filings demonstrates that with the increased retentions, the federal government would make a significant contribution of taxpayer funds in only less than 1% (1 of every 200) of modeled scenarios. TRIA remains critical to the survival of the insurance industry, providing a critical backstop if one of the horrific scenarios were realized. NCCI is completing work on an updated model that will contain the most recent data, modeling techniques, and the impact of the updated TRIA.

Looking Forward

The workers' compensation insurance industry had another solid year of financial results in 2005.

All major financial measures improved significantly. Both the calendar year and accident year combined ratios are at levels that allowed the industry to strengthen its reserve position and earn a reasonable return on surplus. Reserves are in the best position in a decade while frequency continues to decline. Indemnity claim cost increases have moderated.

Areas that continue to concern us include:

* Medical costs; * Challenges to reforms; * Continued uncertainties regarding terrorism exposure; and * A host of new legislators and regulators requiring industry education.

2007 is the second year in a row that NCCI has been optimistic about the market. Clearly, not all issues that pose market threats or challenges have been eliminated. Still, at this point, NCCI sees few reasons to retreat from a positive, albeit cautious, outlook.

Stephen J. Klingel, CPCU, is the president and chief executive officer of NCCI Holdings Inc. This article was published in NCCI Holdings Inc.'s 'Workers' Compensation 2007 Report' and has been republished here with the permission of NCCI. The entire report can be read at www.ncci.com.

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