Tuesday, May 21, 2013

Workers' Compensation Finance 101

I wrote yesterday about the "front end" of workers' compensation - bringing money in - and the "back end" of the system - paying money out.

Some challenged me that I had things backwards; that claims should be the front end because that is the ultimate focus of work comp.

Front end or back end - I don't really care which order you place the two. The point that I was making is that there are two distinct processes involved in the worker's compensation game that are extraordinarily complex and require a good degree of coordination, forecasting and soothsaying in order to operate reasonably efficiently.

Another point that I was making is that workers' compensation is a cash flow system.

By this I mean that money comes into the system through employer assessments; and money flows out of the system by benefit distribution.

Along the way all of us (i.e. those whose jobs are to perform some element of administration) take a little money out for our services and products.

Hopefully when all of the math is done, everyone along the path of the cash has received fair pay for their work and the net result is efficient use of a limited resource in a net sum zero game where no one takes an unfair advantage of the cash flow.

The reason workers' compensation administration is inexorably focused on costs is because it is an expense item on the balance sheet of the employer and each step of the way, from policy procurement and inception to benefit delivery, involves paying someone or for something to make the event happen and the system work.

Workers' compensation is never on the asset or income side of the balance sheet regardless of the value provided to either employer or employees. Much like an employer sponsored health or retirement plan, despite the obvious competitive advantage to the employer in attracting qualified employees, coverage is a cost. Except work comp is a mandatory cost.

The costs start at the very beginning of an employer's participation with obtaining insurance.

Employer seeks broker or agent for insurance needs, and of course one of those needs is the mandated coverage for employment related injury or illness claims. Brokers and agents don't work for free, so there is a fee attached to their service. Sometimes it is a commission, sometimes it is a flat procurement fee, sometimes it is a blend of the two - but regardless, a few cents out of every policy dollar is extracted immediately.

Cash then flows to the insurance company (or if the employer is self insured to the administration company or administrating department). The job at this juncture is to aggregate the employer's policy cash with cash from other sources (i.e. employers or is self-insured, departments) so that there is some investment leverage.

At this stage there are administration expenses - wages of insurance workers to handle paperwork, calculate risks, determine investment market status, gather statistics, provide telephone service, etc. A few more cents get extracted from the dollar to pay for these necessary elements, and a couple more cents are set aside to put into the investment kitty.

The investment portion of the workers' compensation cash flow is not without cost - there are brokerage fees, document administration fees, asset management fees, salaries, commissions and bonuses along the way.

Then a claim comes along. When this happens more than a few pennies are set aside. This is called reserves. The reserve pool consists of money that is to cover the various costs of administering the claim and to support the payment of benefits.

As the claim makes its way through the system little bits of that reserve pool are released back into the general economy in the form of indemnity and payment for medical services and products, and sometimes other ancillary services or products (such as rehabilitation).

Sometimes the flow of the claims dollar encounters some obstacles which diverts the flow - a Medicare issue or child support order. A few more pennies are shed from the dollar's migration through the system.

This is where a lot of the perceived friction in workers' compensation comes along and gets emotions a little more tested because the value does not appear to flow back to the employer or the injured worker. The dollar sheds like a dog in Spring and it sometimes is difficult to account for all of the hairs. Sometimes all we see is a big mess, and sometimes we are allergic to the material shed.

But probably (my guess) by the time the dollar gets to this stage it has already sloughed off at least half of its purchasing power, so things get a bit miserly at this stage.

Eventually the dollar makes its way out of the claims process. By this time many people have had their way with her. The dollar has been yanked through policy procurement commissions and fees, wended its way through the carrier management and administration process, diverted for investment, and filtered to pay for that claim.

If everything works right, there isn't much left over from that cash flow, and if there is then the employer gets the last penny or so in the form of a policy dividend.
And don't forget about taxes - the government has expenses in the administration of workers' compensation: insurance department salaries and costs to monitor carrier and self-insured behavior; dispute resolution system administration costs; research and public policy formulation; and of course the political costs too.

Taxes are extracted all along the cash flow, from policy surcharges to carrier fees and investment gains.

Sometimes there are elements extracting pennies during the dollar's flow through the system that are unreasonable, don't provide any return value or are simply stealing. When this happens there are other processes and services that extract a few pennies to pay for enforcement, with or without repatriation or collection.

Since no one likes to experience a pay cut, any time there is an attempt to reel in the cost of workers' compensation there is protest and/or rebellion from some interest group that is affected - but as you can see, there are many, many opportunities to save money as it goes down the work comp river of cash.

When all the math is done, if there is a deficit then the employer has to pay more for the same product than last year. And if there is a credit then presumably the employer pays less.

There are a lot of moving parts to workers' compensation, each with an attendant cost. Because it is so complex we can not, in general, deal with all of the costs of all of the parts at once so we pick and choose according to our understanding and how "soft" a particular cost element is.

So there you have it - Workers' Compensation Finance 101. This is why we need really smart people to run this thing!

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