Friday, June 7, 2013

Insurance and Deployment of Capital

I get asked to talk about trends in workers' compensation all of the time. Usually what's on folk's minds is trends in claims and claims processing because most of the legislative and regulatory action concerns cost controls.

Sometimes, though, cost control legislation and regulation isn't the topic of the day when it comes to trends, because sometimes there are forces acting outside of the claims department that have trending influence on the industry.

One of these influences is the general economy and how it affects investments.

Workers' compensation, as I've said many times here and which will be familiar to regular readers, is a cash flow business. A dollar comes in the door from the employer and as it migrates its way through the system to the injured worker, parts of that dollar bill are trimmed off for various reasons.

Some of those reasons are to pay for administration, some of it is to pay taxes and government fees, some of it is to pay vendors for services or goods - in the end there are a few cents left over for investment.

When investment returns are low and the insuring entity (either insurance company be it private or state run, or self insured program) is not seeing the net gains reasonably necessary to keep people interested in the game, then more money needs to come in the door.

I know this is a very basic view of the workers' compensation financial game, but I think it fairly explains how this all works.

Some may take issue with whether this is efficient, whether the insuring entity seeks unreasonable or unfair gains on the investment money, and whether more should be diverted to the injured worker and/or returned to the employer.

I'm not raising any of those issues - it is what it is and in the grand scheme of life, motivating someone to risk capital in an insurance scheme means that there needs to be a return on that investment that motivates continuing investment.

And that is the system that has largely been in place for 100 years.

Workers' compensation insurance rates and pricing seems to trail the general economy by 18 to 24 months. This is not a hard and fast rule, it is just a general observation I have noted in my 30 years of participating in this industry.

Like the general 7 to 10 year cycle of the industry - it is just an immutable fact but something for which I lack either the knowledge or skill to define.

Regardless, if the trend in rates and premiums is any indication, then the overal U.S. economy is gaining strength.

Because the trend in rates and premiums is up. Not in dramatic fashion, but the days when an employer could open up the insurance bill and be pleasantly surprised by a discount from the previous year are over.

Like it or not, a big part of rate structure is dictated by Wall Street. Most of the big insurance companies are publicly traded corporations. Those that aren't public companies invest in Wall Street, albeit in the less volatile bond market.

Nevertheless, as the cash flows through the system, and makes its way to Wall Street, it's up to the financial wizards to make that cash work sufficiently to keep investors motivated.

The recession introduced a prolonged period of low interest rates. Low interest rates are really good for consumers - the drivers of the economy.

For example, I refinanced my house this past year (what a chore that was!) to get an interest rate that even my parents were jealous of, 2.85% - in 50 years mortgage rates have never been that low.

Contrast that with interest rate in my passbook savings account which has held steady at around 0.05%.

Nobody can make money on that interest rate. Current inflation, which is mild, is still around 3% - so every month I don't use that money to buy something I'm losing out to inflation. I save money by using debt, and lose money by saving - how perverse is that?

Most insurance type investments are in bonds. Bonds are safer, less volatile, and typically generate sufficient returns to satisfy the bean counters at the end of the day.

But bonds have life limits - essentially they are loans and the purchaser is buying the interest rate return on those loans modified by a risk factor of non or late payment over a set period of time which means the overall investment return is stable and reasonably reliable.

When the life of a bond extinguishes, then that investment must be replaced. Remember that my passbook savings rate of 0.05% can't keep up with inflation. So the insurance-based investor isn't going to keep much cash around because the losses are too great.

But the new bonds are reflecting these low interest rates too, because bonds have to compete with traditional debt financing (remember my mortgage, which is traditional debt, is 2.85%).

So the bonds that are being purchased to replace expiring bonds have significantly lower rates of return.

If the insuring/investing entity can not get an adequate return in bonds to keep investors settled, then other sources of money have to be found.

That's why rates and premiums have to go up, nationally.

This is essentially what experts at the Standard & Poor’s Annual Insurance Conference said this week.

S&P’s base-case forecast is for the 10-year Treasury bond (a popular investment vehicle for insurance) rate to remain low, but to increase to 2.1% in 2013 and 2.6% in 2014, from 1.8% in 2012. That's not a whole lot of return folks.

So the forecast is that rates will continue to increase, albeit modestly - we won't see any short term shocks. Cash needs to come into the system to make up for the low investment rates of today. At least the forecast is that there won't be any shocking increases. Mild increases are okay - people can manage that.

The bright side, if you're on Wall Street, is that insurance is a good investment. The big companies are behaving well financially with their own investment practices and claims (i.e. expenses) management.

Arun Kumar, a managing director of global credit research for J.P. Morgan, said at the conference that, from an investor point of view, the insurance industry is one of the best positioned in the fixed-income market.

“It is one of the better performing in terms of where the bond valuations are. Pricing is definitely positive for the sector, capital is at an all-time high, and if you look at credit ratings, notwithstanding a few names, most of them have been generally stable. Even AIG I think is stable at this point, and Hartford is getting there,” Kumar said.

A friend of mine explained this game very well:

"Insurance companies are not in the business of providing insurance – that is, collect premiums sufficient to pay for losses and costs, along with a reasonable profit. Hell, anyone can do that.

"Insurance companies are a vehicle for ‘deploying capital’. There are trillions of dollars circling the Globe, looking for a place to safely invest at the highest yield possible. There is no vehicle like work comp insurance that meets that need (Stocks, Bonds, and Mutual Funds are all ‘high risk’ investments with the potential for loss). It is regulated (forcing compliance on every employer in the United States). It guarantees a profit (return on investment) to those that participate."

Is there risk? Of course. Life itself is a risk. But if we put all of this together, the trend is that rates and premiums are going up modestly and the insurance industry, and in particular workers' compensation, is managing just fine.

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