The profitability of workers' compensation has attracted a lot of attention of late. 

In part, that’s because the insurers have been celebrating. The NCCI’s state of the line report in 2014 said that the insurance market was “in balance” after a streak of recent good fortune. Its President and CEO Steve Klingel remarked this May that the market was “calm" and warned of “turbulence ahead” but did not suggest that profits were in trouble. In 2014, the combined ratio (losses and other expenses as a percentage of premium) was 0.98, one of the best years since the mid 1980s.

On the other hand, the workers’ comp system was prominently attacked by investigative journalists who alluded to big profits of insurers. They sought to draw a connection between meager benefits to injured workers and insurer fat cats. Their point was somewhat gratuitous because meager benefits could just as well be associated with any level of insurer profits.

This is a good time, therefore to ask how profitable the workers' comp line of insurance has been through today. Breaking that question into four parts, we start with this:

How should one measure profitability?

Harry Shuford of the NCCI, in a 2014 analysis of insurer finances, wrote that “Return on surplus [i.e., equity] is the appropriate measure for judging profitability for the total P&C industry.”

His report, using figures from Best’s, showed that for the entire P&C industry, return on equity was around 10% in the mid 1980s, and has declined to somewhat over 6% today. In only one year, a negative return on equity was recorded (2001).

The National Association of Insurance Commissioners calculates workers’ comp profitability. From 1994 through 2013, what it called the return on net worth nationwide ranged above 10% six times, below 5% five times, and for the 15 years ending in 2013, averaged 6.1%. In those 15 years, among major states, there was not much volatility except for California and Illinois, and since the mid 2000s, there have been very few years among all major states with negative returns. Generally speaking, workers’ comp return on net worth is low compared to the financial services industry and for the entire business community, and it is probably more stable.

 Little as it is, what drives volatility?

To answer this, one needs to hold in mind two basic models of the workers’ comp insurer, as a financial intermediary and a risk bearer. As a financial intermediary, it takes in premiums, pays out losses over a long period of time, and earns investment income. 

There are three key trends in this investing function. First, the role of investment income as a share of insurer returns has been slowly declining. Thus, the financial intermediary model has been declining compared to the risk-bearer model.

Second, with rare exceptions, the investment performance has not varied much from year to year. Third, highly profitable insurers and poorly performing insurers have relatively similar investing track records. It’s almost as if they use the same investment advisor.

As a risk bearer, the workers' comp insurer tries to earn an operating profit or break even on operations. Operational results are heavily dependent on pricing practices and claims performance. Profits are deeply influenced by risk-bearer practices.  

What does poor performance look like?

The period of the late 1990s and early 2000s marked a sharp decline in profits, due to widespread underpricing and claims management; that is, poor risk-bearer performance.

Industrywide return on net worth in 1997 was 12.8%, when very few states experienced a return of under 10%. Five years later, in 2002, nationwide results were 2.4%; most major states had experienced at least one year’s sharp decline after 2000. According to the NCCI, pre-tax operating results sank from an 18.5% gain in 1997 to a 10% loss in 2001. What happened?

During the late 1990s, insurers aggressively cut prices, discounting by over 20% in some years. This practice contradicted claims trends. The average cost of lost time claims rose at close to a double-digit rate, year over year. The number of work injuries with over a month of lost time (those accounting for perhaps 90% of losses) remained virtually flat.

During these years of madness, claims and underwriting executives never appear to have attended the same meetings, but the CEOs could see the ditches they were digging, if they were willing to look. 

In the mid 1990s, top management at Kemper, a mutual insurer, worked up a plan to shed its non-insurance business, grow into a multi-line powerhouse and make a pile of money by demutualizing and selling stock on Wall Street. Some complicated reorganizations ensued, and the insurer launched over 20 new operating units, many in long-tailed lines of insurance.

An executive who worked there at the time said the company “shot out the lights” in order to gain market share, which clearly led to significantly inadequate pricing. Kemper wrote $3.7 billion in premium in 1997. With price discounting and changes in products, its writings declined to $2.5 billion. It struggled to get underwriting results and operating cash flow to break even. Then, in 2001-2002, it was hit with almost $1.5 billion in loss-reserve adjustments. Regulators took over the company in 2003.

California’s State Compensation Insurance Fund shared with Kemper a relentless lust for growth. In the late 1990s, SCIF began to sell aggressively. As the Fund grew, its pricing model undercut private carriers, driving them to retreat. Prices were too low to allow the Fund's surplus (equity) to keep up. It grew to a size four times or greater than a private carrier would have been permitted given its surplus. By 2002, the Fund had reached a point where just one bad year, or a few mediocre years, would have wiped out its surplus.

A.M. Best over time lowered its rating for SCIF from A- to B-. SCIF responded by dropping Best as a rater. Standard and Poor's downgraded the fund from A to BB. SCIF then cut off S & P. In a dispute over adequacy of reserves, the outside auditor quit. SCIF sued the state commissioner of insurance to ward off disclosures. At the time, the CEO wrote that the "State Fund has become a model for the industry and other states." Throughout these years, the Fund never employed a chief financial officer.

Eventually top management, tainted by scandals that a Rotary member in Ventura could understand, was replaced, and since the mid 2000s, the Fund has been in good hands, and its operations and balance sheet were reformed.

What does good performance look like?

Going back to annual aphoristic brain droppings of the NCCI’s Steve Klingel, I think that “calm" and “balance” can be taken to mean two things. First, the economic and political environment is benign, and the absence of predatory pricing by a major player such as Kemper and SCIF.

Second, workers’ comp insurers have become more successful as risk bearers. They price more carefully and they manage claims more proficiently. It’s not clear that every insurer and industry analyst recognizes this.