NCCI Reiterates “Optimistic but Cautious” Outlook for Workers Comp

May 11, 2007

The workers compensation calendar year combined ratio stands at 96.5 percent — the best underwriting result in at least 30 years and the first underwriting profit for the line since 1995 according to NCCI Holdings Inc.’s annual “State of the Line” workers compensation market analysis.

Although the underwriting results are the best in decades, the returns after investment income and federal taxes show that returns on surplus supporting the business are not close to record levels, and only modestly above the average for the last 20 years due to the low levels of interest rates in recent years.

The 2006 workers compensation calendar year combined ratio showed a 6.5 point improvement over 2005 and a 25.5 point improvement from the current cyclical peak of 122 percent realized in 2001.

On an accident year basis, the workers compensation insurance industry had its fourth straight year of underwriting profits. NCCI estimates the combined ratio for the 2005 and 2006 accident years at
87 percent and the 2004 accident year at 88 percent. This is more than a 50-point improvement since the 140 percent combined ratio earned in 1999.

Again, while reporting positive results for both calendar and accident years, NCCI did point out the significant impact that California has on countrywide numbers. For example, excluding California’s results alone would raise the calendar year net combined ratio about 10 points, to over 105 percent.

There is a similar impact on the accident year combined ratio: excluding California from the accident year combined ratio would raise it from 87 percent to 95 percent. This somewhat dampens the overall results for the entire country, and it reminds us of the distortions caused by a single large state that is adjusting to its post-reform environment.

Workers compensation insurance prices also declined in 2006. In particular, both California and Florida experienced significant price declines as the reforms in those states favorably affected costs and improved marketplace conditions. In addition, national claims frequency trends continue to be favorable and, along with wage increases, are offsetting medical and indemnity cost increases — allowing for a generally stable loss cost environment.

In terms of private carrier workers compensation reserve position, 2006 marked another year of improvement. NCCI’s estimate of the reserve position for the private carriers as of December 2006 shows a slight $4 billion deficiency. This is a $5 billion improvement from year-end 2005.

After allowing for discounting of the indemnity reserves for lifetime pension cases, the reserve position is slightly more than adequate. NCCI’s analysis indicates that the industry has made significant progress on its reserve deficiency over the last five years and that the current cycle of strengthening reserve on older accident years is likely near an end for this cycle.

“We are pleased to report that all of the major financial performance measures for the line experienced significant improvement during 2006,” said NCCI Chief Actuary Dennis Mealy. “However, despite excellent underwriting results, it is important to note that the record low interest rates of recent years — as well as the industry’s need to strengthen its reserve position — made these types of results a necessity.”

President and CEO Stephen J. Klingel said NCCI’s short-term view of the line is optimistic, but added that the long-term outlook remains cautionary due to a series of critical issues that continue to face the business.

“As always, in a cyclical, long tail line such as workers compensation insurance, we need to be mindful of those challenges that threaten to negatively impact our business,” Klingel said. “These include skyrocketing medical costs, low investment returns, a changing political landscape, and the projection that the current underwriting cycle is likely at its peak.”

The issues he mentioned will need industry attention in the coming months for continued improvement of financial performance, according to Klingel.

Positive workers compensation market developments noted in NCCI’s 2007 “State of the Line” report include:

•The calendar year combined ratio of 96.5 percent for 2006 marked a 6.5 point improvement over 2005 and a 25.5 point improvement from the current cyclical peak of 122 percent in 2001.

•The accident year combined ratios showed more than a 50-point improvement since 1999.

•NCCI’s estimates of the reserve position of the private carriers continued to improve. The deficiency, which peaked at $21 billion at year-end 2001, declined to $4 billion at year-end 2006.

•Depopulation of the residual market continued at an increased pace in 2006 and into 2007. Overall, residual market premium dropped to $1.2 billion in policy year 2006, down from $1.5 billion in 2004. The combined ratio for the residual market pool continues to remain in the 110 percent to 113 percent range where it has been for the last several years. However, just a few states contribute a major part of the underwriting loss; many jurisdictions are at or close to being self-funded.

•The positive news on the claims frequency front continues, with lost-time claim frequency continuing its decade-long decline in 2006. On the severity side, NCCI is reporting that indemnity costs crept up a bit in 2006 after moderating for several years.
Areas of market concern noted in NCCI’s 2007 “State of the Line” report include:

•Medical costs continue to increase at or near double-digit rates. These increases have pushed medical costs to nearly 60 percent of the total losses for NCCI states in 2006. Many states continue to search for ways to control medical costs in their workers compensation systems.

•The investment gain associated with workers compensation insurance transactions (about 10 percent) is down dramatically from the late 1990s and 2000, when interest rates were higher and the stock market produced large gains. Today, combining the underwriting profit with the investment gains results in a pretax operating gain of about 14 percent, and NCCI’s modeling indicates that the workers compensation insurance industry earned little more than its cost of capital for the first time since 1998 (however, if California results are excluded, the industry may in fact not be earning its cost of capital in the remainder of the country).

•The political landscape for many states and nationally has changed considerably after the 2006 midterm elections, resulting in increased activity on the legislative front during 2007. In 2007 NCCI has already priced over 150 bills and proposals versus about 130 during the entire 2006 sessions. Given the relatively positive results posted for workers compensation insurers, some parties may feel that now is a good time to review benefit levels, administrative guidelines, and cost controls to the detriment of efficient and well-balanced workers compensation systems.

•The Terrorism Risk Insurance Extension Act expires at the end of 2007. Policies already in force have exposure that extends beyond the expiration date of the current federal backstop law. NCCI’s modeling shows that, for 99 out of every 100 modeled scenarios, the federal government would pay virtually nothing under the current law. Even when the federal government does pay, the insurance industry is also incurring a significant portion of the losses. The current Congress seems more amenable to some type of a permanent terrorism solution. However, it remains to be seen what, if any, compromise can be worked out with the Bush administration.

•Net written premiums for workers compensation, including state funds, halted a six-year rise and posted a 2.5 percent decline in 2006. NCCI’s preliminary estimate stands at $46 billion for 2006. This makes the workers compensation line the largest commercial line of insurance and the third largest overall after personal auto and homeowners.

“The workers compensation insurance industry had an excellent year of financial results in 2006,” Mealy said. “All major financial measures improved significantly. Both the calendar year and accident year underwriting results are at levels that have not been experienced in decades. Residual markets are depopulating in most states. Reserves appear to be nearly adequate overall. Frequency continues to decline.”

Mealy added that the impact of favorable results in California lowered the countrywide combined ratios 8 to 10 points, leaving the results in the rest of the country far less exemplary.

“Although the underwriting cycle is turning, stable overall loss costs and stable interest rates offer hope that this cycle will be less severe than the last one,” Klingel said.

Source: NCCI Holdings Inc.

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