By David J. DePaolo

The following article is the third in a series on national trends in workers' compensation. Part 1 reviewed the "The Social Contract," Part 2 discussed the Unicover debacle and the third part reviewed deregulation of the market in California. This part of the series takes a look the the stock market and funny money schemes that assisted in creating the workers' compensation financial delusion.

The basis of this article series is a presentation that was given to the California Association of Rehabilitation and Reemployment Professionals at their annual conference in San Diego October 15, 2005. The presentation has also been adapted as a professional continuing education course at WorkCompSchool.com in a multi-media format including video, audio and supplementary reading materials, and has been approved for, or is pending approval for (depending on the accrediting agency) 2 hours of CE units.

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- DON'T JUST READ THIS ARTICLE, GET CONTINUING EDUCATION UNITS BY TAKING THE COURSE AT WORKCOMPSCHOOL.COM.

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Unicover was successful in one respect, it freed up a large amount of capital that would otherwise have been tied up in reserves, thus providing carriers with expanded investment opportunities. And what better investment opportunity could there have been in the late 1990s than the stock market with flaming hot Internet offerings?

Just because insurance companies are run by professional financial managers does not mean that they don't get caught up in trends. Companies are just a group of people led to a common financial cause. When you see an IPO skyrocket 200% on the first day of trading, you get caught up in the frenzy, or what investment professionals like to call "irrational exurberance."

While everyone knew it was not a sustainable model, what was not known at the time of the stock market bubble was when the show would end. The money managers of the insurance industry are like any other investor - you always regret missing that big jump in gains, that one hot stock, cashing out too early, missing the peak, etc.

As we have seen, work comp is traditionally a cash flow mechanism that works well with the time value of money rules of finance. The purpose is to generate cash via the sale of insurance for investments (less what is necessary for claims and operational costs) that can then generate a profit for the insurance firm.

The stock market in the late 90s blurred the time-money lines of demarcation because so much money was being made so fast. But that is also the single biggest problem with the stock market as an investment vehicle - its virtually instant liquidity. Gains can evaporate in an instant, and when you manage hundreds of millions of dollars, liquidity can be a problem because to get out, you have to sell cheaper than the next guy, fueling price drops. The industry as a whole became over-exposed, like many other investors, and suffered the same consequences as those who got caught in the market going in to 2000.

Another debacle that added fuel to the workers' compensation fire was a little noticed accounting maneuver by several large carriers referred to euphemistically as "Risk Loss Transfers" - an accounting technique for which companies were later brought to task by various states attorneys general and other legal oversight personnel. While these maneuvers did not by themselves create an issue with the workers' compensation market, they contributed to the ultimate financial disaster which I like to refer to as a "perfect storm."

Risk loss transfers are a reinsurance trick. By itself, such practices did not jeopardize available capital to the work comp system, but when taken with other factors, was perhaps the coup de grace, the final straw in the proverbial camel's back, etc.

Carriers were able to perform a little accounting magic by controlling off shore reinsurance companies. Where reinsurance companies are strictly regulated on territorial US grounds, other territories, most notably Bermuda, and others such as the Cayman Islands, have laws that treat insurance very liberally. Through shell companies, carriers (AIG was the most notorious for this, and was taken to task for the practice in several Fortune Magazine investigative articles) would reinsure their risk, but this risk was reverse guaranteed almost dollar for dollar - this would allow the carrier to take money off the books that was previously accounted for as reserves, and show it as free capital - ready for investment. At the point that the carrier was satisfied with its investment gains it would buy back the risk - essentially erasing the transaction.

Because there was no real transfer of risk - the full value of the risk was essentially guaranteed - regulators in the US did not view this as insurance. However, in the off shore territories, such practices were permitted.

As a Fortune magazine article recently revealed, top brass inside of AIG questioned these transactions, and were subsequently fired from their jobs and professionally buried - only recently have these schemes come in to light with the downfall of former AIG CEO Hank Greenberg and others being investigated by NY AG Elliott Spitzer, the SEC and others.

The final factor in the erasure of capital from the workers' compensation market involved shorting state guarantee funds by large carriers who misreported the book of work comp premium actually written. These charges came to light this year as NY AG Eliot Spitzer brought civil and criminal indictments against AIG, The Hartford, St Paul Travelers, and others, alleging that these companies, in the 1990s, understated their work comp premiums by hundreds of millions of dollars, thus cheating state guarantee systems out of funding for what would eventually require increases in employer policy surcharges to pay for companies that couldn't survive price competition.

The next article in this series is going to examine how all of these forces converged with the political climate to create the perfect opportunity for "reform." Article by David DePaolo. This article series is an adaptation of a continuing education course that starts with the hypothesis that the reform movement in California was the product of a national workers' compensation crisis, and that California was not alone in its reform agenda. This course also takes the hypothesis that the workers' compensation crisis that spawned reform had less to do with medical costs and utilization, and more to do with the confluence of a dubious reinsurance scheme, stock market losses, and blatant high end financial cheating. This course is pending 2.5 hours of continuing education units from various administrative agencies, and has been approved for 3 hours of CLER, 2 of which are approved for Certification. This course is available as an on line multi-media presentation at WorkCompSchool.com.

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