Wednesday, April 23, 2014

Just a Financial Intermediary

National Council on Compensation Insurance's Chief Economist, Dr. Harry Shuford, published a great read for anyone in workers' compensation about the cyclicality of the industry.

It is in NCCI's Workers' Compensation 2014 Issues Report, which is a precursor to the organization's great Annual Issues Symposium (May 8 & 9 at the Hyatt Regency Grand Cypress, Orlando, FL).

Most of us understand that workers' compensation seems to go up and down every 7 to 10 years.

We attribute this wave of activity to reforms, the economy, new claims trends, and various other external factors.

And some of these assumptions are correct - workers' compensation IS externally impacted by all sorts of various events and issues over which the industry has little to no control.

Shurford reminds us though that insurance is a financial intermediary.

For all of the fancy terms we throw around to explain how and why insurance behaves like it does, the bottom line is that money comes in, an attempt is made to leverage that money for an investment return, and some of that money is siphoned off to pay claims and expenses. Anything left over is profit.

This is no different than what banks do.

The difference, as Shuford so correctly points out, is that banks generally deal with fixed rates of returns (loans they make on their deposits) so there is a clear link between the money taken in and the returns a bank can generate.

Insurance on the other hand is a bit more difficult, in particular workers' compensation insurance, because a big part of the outflow - claims - is much more volatile and unpredictable; ergo the rate of return on any given dollar can be significantly influenced by size and scope of the claims portfolio.

Still, there is no magic to the up and down cycle in workers' compensation insurance - the fact is that the entire property & casualty insurance market behaves nearly synchronously.

And it's very basic - when money is hard to make in the investment markets money needs to be ushered in through direct sales of the product. This is called underwriting. The basic job of underwriting is to determine how much money is needed from the customer to support the product or service provided and still be able to generate an investment return that will satisfy shareholders.

The average rate of return on invested capital in the P&C business is about 10%, and the workers' compensation industry follows this average very closely.

Moreover, when examining the cycles, Shuford correctly points out that the work comp line really isn't much different that the P&C line, which follows closely what goes on in the general economy.

As he explains, using some PhD-type terms, when the business cycle gets strong, interest rates tend to rise, which is good for the P&C industry so long as "new money" is available to invest in that trend.

The problem, however, is that most insurance investment programs use bonds because they are generally pretty safe and backed by government or big business. When rates on bonds or other safe investments go down (as in the current economic cycle) the "embedded money" (that which was previously invested) that comes to maturity has to be reinvested at the new low rates.

Ergo, "new money" must be brought in generally through premiums and sometimes invested capital from other sources (e.g. Wall Street).

Premium growth can happen only one of two ways: 1) volume; or 2) pricing.

Volume can increase by either expanded payroll of existing customers, or by taking business from a competitor.

Pricing is competitively sensitive, but if everyone is in the same boat and that boat is sinking (i.e. new investment rates are low), then everyone will start bailing - i.e. increased pricing.

The big variable in this whole scheme, and that which we generally tend to focus on in workers' compensation, is claims expense.

Claims expense can put the employer, worker and carrier at odds with each other, or can align interests, in different and surprising ways.

What is in the best interest of the carrier may not be in the best interest of the employer.

And what is in the best interest of the employer may not be in the best interests of the worker.


I think Shuford put it best in his article: "Claim costs ... are remarkably uncertain and vulnerable to economic, regulatory, and environmental shocks."

He forgot emotional shock too - the fact that claims involve the lives of real people and the emotions that, sometimes irrationally, drive the decision making process.

This explains why we in workers' compensation tend to get so wrapped up in claims - because for the most part, we can't really control claims. We try to do so with all sorts of laws, regulations and control processes to manage claims, but it's much harder to manage emotions.

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