A version of this article appeared in Risk & Insurance Magazine

The workers compensation market goes from boom to bust in cycles. Why, and how, do they happen?

Let’s start with case studies of two insurers. One collapsed from addiction to fatal management habits during the soft part of the cycle. A second, and wiser, insurer, avoided that fate and is now one of the great success stories among workers compensation insurers.

Following these case studies we will explain how the cycle works, using a compressed model of the soft market for workers compensation which started in about 1993 and ended in 2001. Finally, we will ponder briefly what causes executives to avoid taking corrective action when disaster appears on the horizon.

The table below tracks this cycle:

Workers Compensation Payments for Benefits and Medical Care and Employer Costs per $100 of Wages, 1989-2003

Premium benefits and medical
paid care paid
1992 $2.10 ................$1.68
1993 2.16 ................. 1.61
1994 2.05 ................. 1.51
1995 1.82 ................. 1.36
1996 1.66 ................. 1.26
1997 1.49 ................. 1.18
1998 1.38 ................. 1.11
1999 1.33 ................. 1.10
2000 1.32 ................. 1.04
2001 1.42 ................. 1.07
2002 1.59 ................. 1.15
2003 1.71 ................. 1.16

Source: John Burton, Workers' Compensation: Benefits, Coverage, and Costs, 2003, National Academy of Social Insurance, published 2005

Kemper: soft market fatality

Kemper Insurance once a respected and large workers comp mutual insurer, lost everything of value in under ten years. Its missteps are an extreme example of the entire market’s deterioration during the cycle’s soft phase.

In the mid 1990s top management hatched a scheme to shed its non-insurance business, dump some existing insurance lines (but keep workers comp), and grow into a specialty line powerhouse. It aimed in a few years to de-mutualize and sell stock on Wall Street. Some complicated reorganizations ensued. An AIG executive was brought on, with other big paycheck people, their incentives keyed to the company going public. The mantra soon became fast top line growth in new lines of insurance. The executive team launched over 20 new operating units, many in long tailed lines of insurance. It brought in hundreds of millions in new business almost overnight.

“You could only do that through inappropriate pricing”, noted a former Kemper executive. But, as another former executive told me, “the aroma of the premiums outweighed the stench of the losses.” The hazards of rapidly growing a large basket of long tail insurance often from nothing include the absence of actuarial history. A revealing term was used within Kemper to describe loose controls – the company “shot out all the lights.”

It wrote $3.7 billion in premium in 1997. With price discounting and changes in products, its writings slipped thereafter towards $2.5 billion. It struggled to get underwriting results and operating cash flow to break even. Then, in 2001-2002, it was hit with an almost $1.5 billion in loss reserve adjustments in product liability and workers comp claims. Kemper lost about a billion dollars in surplus between 1997 and 2001, and another $2 billion by the end of 2003. The company is now in runoff.

Zenith: a case of endurance

Zenith today is known as a virtually monoline workers comp insurer with business concentrated in California and Florida. Since the late 1970s it has been run by Stanley Zax out of Woodland Hills, California. The insurer arrived in the early1990s with roughly a half billion in revenues, half of which were auto and other non-workers comp commercial lines, and A or A- ratings.

To expand in Florida it purchased, on April Fools Day, 1998, the remains of Riscorp, an indictment-hobbled workers comp insurer out of Sarasota. Shortly a dispute rose between the new and old owners about unreported liabilities. While fighting this battle, Zenith sold off in 1999 its non-workers comp primary insurance business. By 2000 its revenues had declined somewhat, and it lost money in 2002 and 2001 due to prior year loss development. Its equity was roughly what it had been five years before.

However, concentrating on these two states, Zenith has since 2001 grown its top line revenue and profits during the hard market early in this decade. Revenues this year are trending will above one billion dollars, and equity has shot up by over 50% since 2002.
That year, Standard and Poors knocked its rating to below A-. Other rating agencies stayed with A- scores.

Zenith played in two of the most difficult workers comp markets in the nation. While growth through acquisition in Florida may not have been as easy as hoped, the firm protected itself by shedding multiple lines and focusing on its core business. In an interview in 2004, Zax revealed an intense will to maintain tight management controls. He and co-investors have brought a company valued at $10 million in the late 1970s to a current market value of about $1.5 billion through self-discipline.

What happened between 1993 and 2001?

I have built a model which takes us from 1993, the top of the cycle, to 2001, when the soft market ended abruptly. (Look at the year to year data in the table.) I am in effect compressing an eight year story into four years. Kemper performed worse then our model insurer; Zenith performed better.

Year One. Our insurer has $100 in premium revenue, $65 in losses, a combined ratio of 100, and investment earnings of $15. Profits are therefore $15. (To simplify matters, ignore taxes.) The insurer has plenty of equity, or policyholder surplus---$100 – reflecting the overcapitalized state of workers comp insurers as a whole.

Year Two. The number of injuries will decline by 3% annually, but costs per claim will grow at 8%, a net $3 increase in loss costs for the current year’s injuries. Premiums will automatically rise by $2 to reflect the incremental rise in covered payrolls. Let’s say that investment returns improve by 10%, or $1.50. Year Two, looking good, is now about to close out with an increase of profits of 50 cents to $15.50.

But loss cost inflation affects all open claims, especially in medical outlays. You have to figure in the second spinal fusion on a worker injured years ago, and increases in lifetime pain medication costs for many open claims. At the very end of Year Two, the insurer rolls up all these adjustments into a $5 increase in loss reserves. This reduces profits to $10.50, down 30% from the prior year.

It then examines the smoky deals it has made to expand market share, and calculates that instead of premiums rising by $2 they declined by $3 to $97. That drives net profit down by $5 to $5.50. Profits actually fell by over half!

Year Three. The fog surrounding loss cost inflation clears further. Current year claims costs increase again by $3, as cost inflation outpaces injury decline. The insurer tacks on an additional $5 reserve increase. Investment yields fail to rise, so investment income increases only by increasing the assets invested.

The sales force tries more intensely to beat out other insurers for a fixed amount of customers. (A few that decline to drink the market share Kool-Aid step back.) Premiums in Year Three drop $7 to $90. Based simply on payroll increases they should be $104. Insureds now enjoy a 13% savings. The insurer closes Year Three with a $3 loss – assuming that all the figures are accurately posted, rather than massaged to push some of the bad news into…

Year Four. Another year of increases in claims costs on diminishing revenue base. The chief actuary insists on a reserve adjustment of $10 for prior years. (A few years later, a third with be reversed.) Sales, though bridled, still reduces premium to $87. Loss costs plus reserve development are $84, and the combined loss ratio is 137. Insureds now enjoy a 18% reduction while the insurer reports a loss of $14.

The End. Net profits have declined from $15 to $5.50 to -$3 and -$14. The actuary wants to add to reserves. A rating downgrade? Looking at actual rating practices, one suspects that the agencies may pull their punches, especially with the big players. Insurers collectively push prices much higher very quickly, starting the hard market.

Why?

The key drivers in my estimation are idle capital; unrealistic sales plans; and, mediocre controls over claims and pricing.

In addition, there seems to have been with Kemper a pattern of denial of reality among top management. One person, such as the CEO, may be off base; why does the entire top management team behave the same?

The New York Times reported in May 2006 on a study which examined common traps that prevent executives from seeing and responding to the writing on the wall. I will quote from this article by Paul Brown, with some comments added about workers compensation insurers:

The project, business or division is hemorrhaging cash. All turnaround efforts have failed, but management continues to spend time and resources trying to turn the situation around instead of pulling the plug.

If you want to know why, reread Freud and not Drucker, argue the McKinsey consultants John Horn and Patrick Viguerie, and Dan Lovallo, a professor at the Australian Graduate School of Management at the University of New South Wales in The McKinsey Quarterly. When evaluating a failing business, there are four psychology traps executives often fall into, the authors write:

• Confirmation bias. Executives seek information to support their point of view and discount data that does not. [This is classic group think. Workers comp executives also seem often to be insulated from other industries, thus may not be able to bring into their work painful lessons experienced elsewhere. – PFR]

• The sunk cost fallacy. Managers add up all the money they have already spent and conclude it would simply be too costly to walk away. [Can sunk cost include personal investment in obtaining a position of authority? – PFR]

• Escalation of commitment. Executives decide to throw even more resources at the problem, convinced that is the way to resolve it. [Sales staffs will cling to their sales plan even in the face of disaster. One insurance exec told me that it took years for the sales force to buckle under. – PFR]

• Anchoring and adjustment. Estimates of the potential worth of the project or business are revised upward to justify all the spending. [In a workers comp environment, the costs of the tail are under dispute. – PFR]

One simple way around these biases, the authors write, is to have a senior executive who is not involved do a thorough assessment about whether it is worth continuing.

And who might that be?