Just when it seemed California might overcome its perennial workers’ compensation crisis, renewed downward pricing pressure threatens to send the market into another tailspin, according to analysts at Standard & Poor’s Ratings Services.
“The industry has barely recovered from the cutthroat pricing of the mid-1990s,” commented Steve Dreyer, a managing director in Standard & Poor’s Insurance Ratings. “Now the commissioner seems to be inviting the same irresponsible behavior that caused the last crisis.”
In May 2004, California Insurance Commissioner John Garamendi issued an advisory calling for a 21 percent reduction in workers’ compensation premium rates, compared with a year before. And he has meted out praise or condemnation to insurers, depending on their adherence to his guidelines.
American Financial Group Inc. and Liberty Mutual Holding Co. Inc. won plaudits as “industry vanguards” for price cuts of 20.5 percent and 17.5 percent, respectively, while Zenith National Insurance Corp. and the California State Compensation Insurance Fund (State Fund, or SCIF) earned Garamendi’s rebuke for cutting prices a mere 10 percent, close to the industry average.
“Each month the rhetoric gets more acerbic,” said Dreyer, who points out that the two insurers lauded by Garamendi are national players and therefore relatively insulated against adverse developments in one state. Together, they have only about 4 percent of the California market. SCIF, by contrast, operates only in California where it commands about 53 percent of market premiums.
The California State Compensation Insurance Fund
The latest chapter in California’s workers’ compensation saga dates back to 1995, when the state repealed its minimum premium rates. Years of inadequate pricing ensued, leading to the demise of some 25 insurers between 2000 and 2003.
Enter the State Fund, without which no lament on California workers’ compensation would be complete.
This non-profit carrier, established by the state in 1914, views itself as the “shock absorber” in the system. It has soaked up like a voracious sponge business abandoned by other insurers’ flight or failure. As a consequence, its annual premiums have multiplied by more than six-fold in just four years to reach $7.6 billion in 2003. Meanwhile, SCIF’s surplus (assets minus liabilities) has increased by only about 50 percent, to just over $2 billion.
These developments mean SCIF’s premiums/surplus ratio, a rough indicator of an insurer’s stability, leapt to a very precarious 3.7 for 2003 from the safe level of 0.9 in 1999. “It’s very chancy,” observed Standard & Poor’s credit analyst Jason Jones, who argues the fund has further aggravated its risk profile by veering away from its traditional client base of small employers. “State Fund has grown in a period of great uncertainty, and the policies it has taken on are very different from its old book,” he said.
Although SCIF claims it has priced its new accounts properly, Standard & Poor’s remains unconvinced. “State Fund could be in serious trouble if pricing for newer business proves inadequate,” said Jones. He also points to State Fund’s difficulties, as part of the California civil service system, in hiring qualified individuals from the private sector, and he recalls a hiring freeze at SCIF during a crucial time in the insurer’s breakneck growth, which “added to the strain on its underwriting and claims functions.”
Nor is there much comfort in State Fund’s brimming revenues of late, given that workers’ compensation is a line of business where payouts can last several years. “One danger of growth is that it can mask a problem,” Jones said. “State Fund’s recent cash flows seem fantastic, because all the premiums come in upfront, but the business written from 2001 to 2003 is still very green. When the growth stops, that’s when all the problems can catch up.”
In an apparent effort to rein itself in, SCIF finally began turning away some business in 2004, following a surge in market share to about 53 percent in 2003 from around 20 percent in the late 1990s. But Jones argues there is little this recent reformation can do to defuse any time bombs in existing policies.
The California Insurance Guarantee Association
Such concerns bring the California Insurance Guarantee Association (CIGA) into play. Established by the state legislature in 1969 to pay claims against insolvent carriers, CIGA operates three separate funds: one devoted to workers’ compensation, one to home and auto coverage, and one to other commercial insurance. To replenish these funds, CIGA is authorized to charge solvent carriers an ordinary assessment equivalent to 2 percent of their premiums written in the preceding calendar year.
But with workers’ compensation payments reaching almost $800 million in 2003, compared with a historical annual average of about $15 million from 1969 to 2000, CIGA has not only had to borrow from its two other funds just to keep up with its workers’ compensation payments but has just taken the unprecedented step of borrowing $750 million in the bond market, in accordance with recent authorization to borrow up to $1.5 billion.
For private insurers, the most worrying aspect of this arrangement is that CIGA is authorized to levy against them special bond assessments (in addition to the ongoing ordinary assessments) “at any time and without limitation” to meet its debt payments (according to the official statement accompanying the bond issuance). The commissioner’s approval is not required, nor is there any obligation on the state or its powers of taxation.
In a worst-case scenario, in which State Fund had failed, and CIGA had issued bonds up to its full allowance, its indebtedness of $1.5 billion would translate to 21.7 percent of 2003 premiums for the remaining private carriers. “Thus the insurance industry could involuntarily become a lender to State Fund,” commented Standard & Poor’s credit analyst, Steve Ader. “This would clearly present a ratings impact.”
Small wonder, then, that Edmund Kelly, chairman of Liberty Mutual Insurance Co., likened State Fund in March 2004 to a “misbehaved animal” that should be hauled back into “a supervisory cage.” Commissioner Garamendi has also shown alarm at SCIF’s condition, calling on the insurer “to right its financial ship” and braving State Fund’s defiance in litigation. His assertion in July 2003 that State Fund’s reserves were $1 billion in deficit was echoed in an audit report issued by PricewaterhouseCoopers shortly afterwards. If SCIF were a private insurer and had reflected this deficiency on its balance sheet, Garamendi asserts, its financial condition would warrant mandatory regulatory control.
Premature pricing pressures
Yet the commissioner’s appetite for lower premiums in California, even at SCIF, has not abated. “The California Department of Insurance is very much pushing insurers to cut rates,” said credit analyst Jones. “If insurers cut premiums too close to the bone and don’t allow enough time to rebuild capital, that can be very destructive. State Fund in particular needs to build up its capital base, so to see them cutting rates so quickly is very disconcerting.”
The strongest rationale for price cutting comes from two rounds of legislation—one enacted in September 2003 (AB 227 and SB 228) and the other in April 2004 (SB 899)—that aim to bring down costs in the California system. But Standard & Poor’s analysts argue it is too early to take these savings to the bank. “There’s no track record to determine the effectiveness of these reforms,” said credit analyst Laline Carvalho. “California is where we’ve seen the most bankruptcies in the past. Inevitably, some companies will take imprudent rate reductions.”
Analyst Steve Ader agreed: “The political groundswell is demanding that rates go down, but it’s surprising how far and how rapidly that has occurred. If you look at the pricing history of this market, it raises some flags,” he said. “You wonder if we’re going back to the same type of cycle.”
Recently heightened competition would seem to confirm these fears. For example, Everest Re Group Ltd. said in June 2004 that it would implement contingency arrangements to continue writing workers’ compensation coverage in California, after its agent, American All Risk Insurance Services Inc. (AARIS), moved over to national insurance giant Berkshire Hathaway Inc. The AARIS relationship provided about 12 percent of Everest Re’s premiums in 2003. Another national player, Safeco Corp., announced in July 2004 it would resume writing new workers’ compensation business in California, albeit cautiously.
Such moves may be misguided. “Outside players don’t have experience with the local market,” commented credit analyst John Iten, “so for them to come in and expect to make a profit seems very speculative.”
Perhaps the one saving grace for insurers is their scope to deviate from “pure” premium rate reductions filed with the California Department of Insurance (CDI). For example, in an investor call of July 21, 2004, American Financial Group Inc., though hailed by Garamendi as an industry vanguard for lower premium rates, reported “our prices actually were up 15 percent” in the first six months of 2004 (following adjustments based on geographic and other factors).
That assessment contrasts with the company’s 14.9 percent rate reduction filed for Jan. 1, 2004 (prior to a second reduction of 7 percent for July 1, 2004). “What insurers file and what actually occurs can be two different things,” commented Ader. “The various pricing mechanisms are muddying the waters.”
Nevertheless, “all signs point to downward pricing pressure” across the California market as a whole, according to Jones. In August 2004, for example, the California Manufacturers & Technology Association announced a partnership with SCIF that would cut member premiums by an extra six percent beyond price reductions already inherent in SCIF’s filings with the CDI. Meanwhile, talk of direct price controls continues to buzz in California’s legislative chambers.
Through the mechanism of California’s insurance guarantee arrangements, compounded by CIGA’s recent debt issuance, no workers’ compensation insurer in California can consider itself immune to the fortunes of SCIF, which remains in highly vulnerable condition. Now is not the time to be forcing premium rates lower, according to S&P’s analysts, especially with the fresh arrival of national insurers muscling into the state and intensifying competition. If State Fund were to fail, private carriers would have to pick up the pieces of a shattered system.
Copyright (c) 1994-2004 Standard & Poor’s, a division of The McGraw-Hill Companies.
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