The California workers comp market is a mess. One huge workers comp insurer has gone belly-up, and rating agencies are casting a dubious eye on others. As the industry struggles to remain afloat, the future could hold higher premiums for California employers, who must buy workers comp insurance under state law.

The current marketplace debacle stems from a workers comp price war started in 1995, when California switched from a "minimum rating" workers comp system to an "open rating" system. Instead of adhering to state-mandated minimum premiums, insurers were free to price workers comp as cheaply as they dared.

The result: Fierce price competition, leading to a prolonged pricing nosedive, what insurers call a "soft market." Workers comp premiums became so low that insurers took huge financial hits, yet were unwilling to pass losses along to workers comp consumers in the form of higher premiums.

"Companies that tried to raise premiums lost a lot of business," explains Ed Woodward, president of the California Workers Compensation Institute. "It was a feeding frenzy, and California was seen as a good place to do business. Nobody realized that the market would be soft for so long."

Prices drop, but costs rise

Massive workers comp price competition hit California in the same year (1995) that claims costs began to rise — a dangerous combination.

"From 1991 to 1994, workers comp costs dropped 40 percent. Fewer claims were filed, and everyone thought it would just get better," Woodward says.

Instead, claims made after 1994 were of greater severity, which meant higher costs per claim for insurance companies. The average claim cost rose from $17,500 in 1994, to $30,000 in 1999. Insurers still picked up the tab, though, and premiums stayed at record lows.

"The difference in claims stems from two factors: a change in the economy from a service-based economy to one where insurers may have miscalculated their probability of loss. And severity of losses has gone up, but pricing has not changed to replace that," says Darin Feldman, analyst at Standard & Poor's.

Why didn't insurers bite the bullet and raise workers comp prices? It wasn't only a question of competition. Workers comp is "long tail" coverage, meaning that claims made in one year may not be paid until subsequent years.

"It takes years to analyze data from claims and losses," says Woodward, "You don't know immediately whether changes in cost are an aberration or a trend."

Market meltdown?

Ultimately all of this led to a recently-estimated $4.7 billion deficiency in the reserves of California workers comp insurers, which could put some companies out of business. Average loss ratios reached "the mid-1.40's," according to Woodward, which means that for every $1 taken in, $1.45 was paid out by insurers. (A more desirable ratio would be close to 1.00).

"Something had to give," says Doug Whidtfeldt, vice president of the Association of California Insurance Companies (ACIC). In March, 1999, something finally gave: Superior National Corp., the state's largest workers comp insurer, was seized by California's Department of Insurance (DOI). The DOI cited Superior National's "hazardous financial condition," including insufficient reserves, in taking control of Superior National's four California subsidiaries. Superior National filed for Chapter 11 bankruptcy protection in May 1999.

Standard & Poor's has since assigned "creditwatch" ratings to several other workers comp specialty insurers in California, expressing doubts about their ability to withstand the market's $4.7 billion deficit. Although that deficit is spread among all companies selling workers comp insurance in California, specialty insurers, who sell only workers comp coverage, are likely to suffer most.

"Workers comp is just one line of business for national players, so their portion of the reserve deficiency won't have the same impact as it does for specialty companies that we put on creditwatch. It's a much larger exposure for them," says Feldman of S&P.

Sticker shock

Workers comp premiums in California are finally rising, which could lead to sticker shock for employers accustomed to have-it-your-way pricing. The Insurance Commissioner, Chuck Quackenbush, recommends that workers comp insurers raise premiums by 18.4 percent, in order to mitigate some losses and cover costs. However, Woodward says, "Insurers will be kinder to employers with good loss records, and good safety practices. Those employers won't be hardest hit."

Woodward predicts that insurers will implement managed care, and other cost-control measures, to ensure that rising premiums aren't offered by spiraling expenses.

Whidtfeldt, of the ACIC, says insurers are calling for statutory reform to aid cost-control: "We need to see legislation that allows insurers to challenge medical findings if they disagree with prescribed treatment. That might cut costs. Also, the system for calculating permanent benefits makes it hard to calculate what costs will be to insurers. We need to promote consistent, objective results," he says.

For now, employers and workers comp insurers can only wait to see which companies survive the crisis, and how much employers will pay to bail out the survivors.

"We haven't made a forecast as to who will remain involved in California," says Feldman. "I do think we'll see a push to diversify away from California. That's not to say nobody will operate there, but those who survive are likely to branch out."