FINANCIAL MANAGEMENT
REDZ18
Unit7-WorkersCompensationandAlternativeRiskFinancing.pdf
Trieschmann, Hoyt & Sommer
W orkers’ Compensation and Alternative Risk Financing
Unit 7
©2005 Thomson/South-Western
Source Material
• Trieschmann J., Sommer, D. & Hoyt, R. E. (2004). Risk
Management and Insurance 12th Edition. KY: South-
Western College
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Workers’ Compensation Insurance
• W orkers Compensation covers loss of income and medical and rehabilitation expenses that result from work-related accidents and occupational disease. – It is the single largest line of commercial insurance.
• W orker’s Compensation developed in the latter half of the 1800s in Europe and in the early 1900s in the United States
– because of hardships placed on workers by common law.
• Under worker’s compensation, a worker receives a guarantee of compensation.
• The employer is protected from employees seeking damages for work-related injuries.
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Major Reform
• The National Commission on State W orkmen’s Compensation laws was created to determine the extent to which state laws provided adequate, prompt, and equitable compensation to injured workers. – Generally, studies raised doubts about the effectiveness of workers’
compensation as it operated in the United States at the time the studies were made.
• Since then state legislatures have passed numerous reforms to comply with the commission’s recommendations, including: – Full coverage for medical care and rehabilitation
– Adequate income replacement
– Coverage of all workers
– Cost-of-living adjustments
– Improved data systems
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Insurance Methods
• There are three methods by which an employer can
provide employees with the coverage required by law
– Purchase a worker’s compensation and employer’s liability
policy from a private commercial insurer
– Purchase insurance through a state fund or a federal agency
set up for this purpose
– Self-insure
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Private Insurance
• The standard workers’ compensation and employer’s liability policy has two major insuring agreements – Coverage A
• To pay all claims required under the workers’ compensation law in the state where the injury occurred, including: occupational disease benefits, penalties assessable to the employer under law, and other obligations.
– Coverage B
• To defend all employees’ suits against the employer and pay any judgment resulting from the suits. Employee suits are surprisingly frequent because methods are constantly being found to bring an action against the employer in spite of the intention of the statutes to discourage such suits.
• While there is a contract between the employer and the insurer, the insured deals directly with the employee and is primarily responsible to the employee for benefits. – Thus, even if the employer should go out of business, the injured employee’s security is
not jeopardized.
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State Funds and Federal Agencies
• In 20 states, an employer has the choice of using a private insurer
or a state fund as the insurer of workers’ compensation.
• In five states, the employer does not have this choice;
– Must insure in an exclusive state fund or, in three of those states, may
self-insure
• In addition to state funds, federal agencies provide for workers’
compensation coverage.
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Self-Insurance
• In most states, under specified conditions, an employer is permitted to self-insure the workers’ compensation coverage.
• Self-insurance is generally not permitted in Canada.
• Self-insurers are generally large concerns with adequate diversification of risks and financial resources that enable them to qualify under the law.
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Evaluation of Insurance Methods
• Data from National Academy of Social Insurance shows that: – Private insurers incurred 55 percent; Self-insurers 23 percent; and Federal and state funds 22
percent of the cost of workers’ compensation in 2001
• Private insurers are preferred by most employers in states where they’re permitted to operate. – It offers the employer an opportunity to insure in one contract all the liabilities likely for damages
arising from work-connected injuries.
– Private insurers offer more certainty in handling out-of-state risks.
• W hile the expenses of state funds are somewhat lower than those of private insurers – The difference is not as great as rough comparisons often have you believe
• Self-insurance has the handicap that it is necessary for the insured to enter the insurance business – Which is essentially unrelated to the insured’s main operations.
– Also, contributions to a self-insurance fund are often not tax deductible
• Experience rating and retrospective rate plans enable large firm to use a private insurer’s facility in transferring as much or as little of the risk as is desired at a modest cost
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Major Features of State Laws
Employment Covered
• Compensation laws do not cover all workers. – For example, domestic labor and farm labor are often excluded.
– Employers with only a few employees are excluded under compulsory laws.
• Only about 9 out of 10 workers are covered.
• Liability suits are necessary if an excluded worker is to recover anything; – even though a basic purpose of compensation legislation was to eliminate this condition
as a prerequisite for employee recoveries.
• It is a small employer who is excluded from compensation laws and who is most likely to be the object of such suits. – This often means that:
• A successful suit will bankrupt the employer.
• If the employer is more or less judgment-proof, the injured worker will recover nothing.
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Features of State Laws
Income Provisions
• Compensation laws recognize four types of disability for which income benefits may be paid:
– Permanent total disability
– Temporary total disability
– Permanent partial disability
– Temporary partial disability
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Income Provisions
• For permanent total disability benefits, most states permit lifetime payments to the injured worker who is unable to perform the duties of any suitable occupation.
– In the remaining states, typical limitation is between 400 and 500 weeks of payments;
• and there is often a limitation on the aggregate amount payable.
• There is a common limitation that income benefits cannot exceed about 2/3 of the worker’s average weekly wage or some dollar amount.
• W eekly benefits for temporary total disability are usually the same as for permanent total disability;
– except that often there is a lower maximum aggregate limitation and a shorter time duration for such payments.
• Most workers’ compensation laws specify that lump sums may be paid to a worker as liquidating damages for a disability;
– such as the loss of a leg or an eye that is permanent but does not totally incapacitate the worker.
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Features of State Laws
Survivor Benefits
• In the case of fatal injuries, the widow or widower and children of the worker are entitled to funeral and income benefits;
– subject to various limitations.
• The maximum benefits to the widow or widower are generally less than they would have been to the disabled worker.
– If the survivor has children, these benefits are comparable to what the worker would have received for permanent total disability.
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Features of State Laws
Medical Benefits
• Most workers’ compensation laws provide relatively
complete medical services to an injured worker;
– including allowances for certain occupational diseases.
• In all jurisdictions unlimited medical care is provided
for accidental work injuries;
– and broad coverage for occupational disease is provided.
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Features of State Laws
Rehabilitation Benefits
• Both physical and occupational rehabilitation benefits are provided by
most states.
– The quantity and quality of the services are subject to wide variation.
• Rehabilitation programmes include :
– light-duty or modified-duty programs intended to reintroduce the worker to the
workplace following industrial injury.
• Federal Vocational Rehabilitation Act includes:
– federal funds to aid states in vocational rehabilitation of individuals who are
injured in the workplace.
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Features of State Laws
Benefits
• In terms of benefits, there is
great variability between the
states.
• The table shows descriptive
statistics for some states.
• Besides the various state plans,
a Federal Employees
Compensation plan covers
federal employees.
– It has the highest benefit of
any plan.
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Experience Rating
• Experience rating plans are widely used in workers’ compensation insurance.
• The general theory is that an employer has some control over the loss ratio and is entitled to a credit for good loss record; – or should pay a higher rate if the loss record is poorer than average.
• The details of the plan are very complex. – General procedure is to determine, for each occupational class, some expected
loss ratio against which the insured’s actual loss ratio is compared.
• Not all losses suffered by an insured are counted. – The plan uses a stabilizing factor so that unusually large losses cannot operate to
increase the small employer’s rate unreasonably.
– For the large employer, the employer’s loss experience becomes more important as its expected losses become greater.
• Experience rating in workers’ compensation gives employers an incentive to do whatever is within their control to prevent accidents.
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Retrospective Rating
• This is entirely a voluntary agreement between the insured and the insurer.
• If the employer’s payroll is such that a standard of premium of $1,000 or more is incurred; – it is considered that the firm is large enough to develop experience that is partially
credible.
• Standard premium is defined as what the employer would have paid at manual rates after adjustment for experience rating; – but before any adjustment for retrospective rating.
• In practice, an employer likely to use retrospective rating is generally considerably larger than this. – For example, one accident could easily cause a loss in excess of $1,000.
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Retrospective Rating
• There are various plans of retrospective rating. The choice for the employer is dependent on the level of risk the employer is willing to assume.
• The basic retrospective rating formula is given by:
R = [BP + (L)(LCF)]TM
• R = retrospective premium payable for the year in question
• BP = a basic premium designed to cover fixed costs of the insurer
• L = losses actually suffered by the employer
• LCF = loss conversion factor designed to cover the variable cost of the insurer
• TM = tax multiplier designed to reflect the premium tax levied by the state of the insurer’s business
• The basic premium declines as the size of the employer increases and it differs with the type of plan used.
• LCF and TM are constant percentage regardless of size of the employer.
– The formula is subject to the operation of certain minimums and maximums
• Both of which decline as the size of the employer increases except where the maximum the employer pays is the standard premium.
Calculation of Retrospective Rating
• If basic premium is 100,000, Loss Conversion Factor is
10% and the Tax Multiplier is 5%. What is the
retrospective rating if the employer suffers a loss of
$250,000?
• R = [BP + (L)(LCF)]TM
• R = [100,000 + (250,000)(1.10)] x 1.05
• R = (100,000 + 275,000) X 1.05
• R = 375,000 X 1.05
• R = $393,750 20
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Workers’ Compensation and Self-Insurance
• Workers’ compensation is one of the most frequently self- insured coverages in the risk management area.
• Characterized by relatively high-frequency and low-severity losses.
• In recent years, the motivation to self-insure a portion or all of this exposure has increased; – due to rapidly rising premium levels.
• W hen premiums are high, the cash flow benefits of self-insurance are greater.
– Thus, self-insurance becomes more attractive.
• The basic factor that lead to a firm self-insure revolves around lower costs.
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Factors Favoring Self-Insurance
• Lower Administrative Expenses – W hen a firm establishes a self-insured workers’ compensation program, it eliminates
most of the premium paid to an insurer.
• Cash Flow Benefits – Cash flow benefits are probably greater than the cost saving aspects of self -insuring
workers’ compensation.
– Under a traditional insured plan, the insured pays the premium • And at some later date the insurer pays all the claims
– In the aggregate, this arrangement provides the insurance company with a large amount of money that can be invested in income-producing securities until the claims are paid.
– W hen a firm self-insurers, it holds the money until the claims are paid. • Since it takes several years to pay all the claims from a given year’s loss exposure
– the self-insurer has the use of some of the funds for a fairly long time.
– Thus, there’s a perpetual sum available for investment in securities or in the self - insured’s own operations.
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Factors Favoring Self-Insurance
• Claims-Conscious Management
– Management often becomes more claims conscious when it is paying
directly for workers’ compensation losses.
• W hen insurers are paying the claims, only an indirect effect is seen by operating
managers.
– When firms self-insure, they pay the claims as they occur.
• As such there is no delay in seeing the increased costs when accident rates start
to increase.
– As a consequence, workers’ compensation losses often decline when
a firm initiates a self-insurance program.
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Factors Against Self-Insurance
• Size of Firm – A company must be financially capable of retaining self-insured losses.
– It must have a large enough exposure so that it can predict much of its losses.
– Generally, a firm with an annual premium of less than $250,000 will not self-insure.
• Stability of Workforce – Concerns how much turnover the firm has and how rapidly it is expanding.
– Newly employed people, as well as younger employees, have higher accident rates than more mature workers.
– New plants tend to have higher accident rates than established ones.
– W hen a firm closes a plant, a much greater number of employees file claims.
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Factors Against Self-Insurance
• Tax Consequences – Under a self-insured program, one cannot take a tax deduction until the funds
are actually paid. • For example, a worker may become disabled an is entitled to a $700,000 liability. The company
cannot make any tax deduction until funds are paid to the employee.
– This rule discourages self-insurers because any loss reserves would have to be funded by after-tax dollars.
• Availability of Services – When a firm self-insures, it must provide or purchase services that were formally
provided by the insurance company.
– These services include loss control activities, claims adjusting, data processing, and program administration.
– A firm can usually buy these services from companies that specialize in such activities; sometimes at unattractive prices; rendering insurance the solution.
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Excess Insurance
• Most companies do not completely self-insure the workers’ compensation exposure. – Because of the catastrophic nature of certain types of workers’ compensation
losses such claims as long-term disability or death may add up to hundreds of thousands of dollars.
– To prevent such circumstances, self-insurers purchase excess insurance.
• Two basic types of excess insurance: – Specific
• The self-insurer absorbs the first x dollars on any loss (a deductible) such as the first $75,000.
– Aggregate excess
• The policy operates like an aggregate deductible.
• Typically, the aggregate limit is at least the level of what the workers’ compensation premiums would have been if insurance had been purchased . For example, if insurance premium would have been $200,000, then excess insurance would not pay until the company retains losses of $200,000.
Self-Insurance Workers’ Compensation
• When a worker is injured at the site of or during the
course of employment, then he or she is entitled to
medical care, rehabilitation treatment, a weekly payment
of wages, and possibly an award for permanent injury.
• Any dependents will receive weekly payments if the
employee is killed on the job.
• In return for this guaranteed treatment and partial income
replacement, the worker gives up his right to sue. The
employee may be able to sue others but not the
employer. 27
Self-Insurance Workers’ Compensation
Payment Pattern
• Majority of the payments under worker’s compensation are for medical care.
• Workers’ compensation medical care is one of the few medical services that
is not subject to managed care review.
– Employers especially, believe that this factor contributes to the increased medical costs
for workers’ compensation as there is no party trying to control the costs. As such the
medical community can charge more and order more treatment than occurs under
managed care, or that patients do not return to work as quickly as they otherwise would
because their medical expenses are being paid and they are receiving weekly
paychecks.
• In terms of payout period, most of the medical care occurs in the first two
years on expenses such as hospital, medical doctor, prescription drugs, and
physical therapy charges.
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Self-Insurance Workers’ Compensation
• The other major component of workers’ compensation
losses is for the employee’s loss of income.
– Payment can be weekly while the employee is recovering from
his or her injury and/or a payment for some type of partial
permanent injury.
– A partial permanent injury occurs when some part of the body
receives permanent injury (such as back injury) but the worker
can still return to work.
• The employee is awarded some extra weeks of compensation for this
injury which begins after the employee returns to work.
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Self-Insurance Workers’ Compensation
Cash Flow Model
• A six-year payout period can be used to demonstrate but
sometimes payments continue until the employee dies.
• If $1,000 in payments were to be made to an employee,
this would be the pattern:
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Year 1 2 3 4 5 6
Percentage
paid out
30 25 20 15 6 4
Year 1 2 3 4 5 6
Percentage
($)
300 250 200 150 60 40
Self-Insurance Workers’ Compensation
• A cumulative payment schedule can be show over a six
year period assuming each year additional cash flow
accrues to the firm.
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Year 1
($)
Year 2
($)
Year 3 ($) Year 4 ($) Year 5 ($) Year 6 ($)
Year 1 300 250 200 150 60 40
Year 2 300 250 200 150 60
Year 3 300 250 200 150
Year 4 300 250 200
Year 5 300 250
Year 6 300
Total 300 550 750 900 960 1000
Float (accrued-paid) 700 1150 1400 1500 1540 1540
Self-Insurance Workers’ Compensation
• In many self-insured plans, employment and losses
increase, which means positive cash flow continues and
the float increases.
• During periods of decline or downsizing, the opposite
occurs.
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Potential Problems of Self-insurance
• Problems include, but are not limited to – Financial ability to retain losses
– A large enough exposure base to be able to predict losses accurately
– Actual management of the plan
– Establishment of a loss prevention and protection program
– Management of a risk management information system
– Availability of excess-of-loss insurance
– Top management commitment to the plan
• A self-insurance program will fail if loss control is not a well- established priority.
Retrospective Insurance
• If the firm does not want to use self-insurance or captive insurance, using
retrospective insurance is one of obtaining some of the best aspects of both
worlds: good cash flow and less administrative detail.
• Under retrospective insurance, the firm purchases insurance and receives all
the benefits of being insured.
Details of a Retro Plan
• A firm pays the standard premium (manual premium times experience
modification factor).
– The experience modification factor is the means by which the rating adjustment takes
into consideration the actual loss of the firm. If the losses are higher than expected then
rates will go up and vice versa.
• No volume discounts are given as the firm is a part of a guaranteed cost
plan. 34
Retrospective Insurance
• A minimum and a maximum premium may be charged. In addition, the
premium is tax deductible.
• The annual premium is paid over a 12-month period which provides added
cash flow benefits.
• At the end of the policy year, the earned premium is determined by the
insurance company and adjustments are made.
– That is, after about 9 months, a retro adjustment is made to the first year
premium and subsequent adjustments are made every year thereafter.
• If there are no losses in a year, the insurance company still earns the
minimum premium.
• If losses are unusually large, the premium is subject to the maximum
premium limitation and the insurance company pays for all losses above the
maximum. 35
Problems with Retros
• Because the standard premium is a function of the
manual premium, various loadings are added to the
premium such as assigned risk assessments that can
amount to 20 percent or higher,
• Also, premium taxes must be paid, as well as marketing
and administrative costs of the insurer and the insurer’s
loading for taking on the risk.
• The cash flow benefits are usually not as good as in a
self-insured plan.
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A Creative Alternative
• A large deductible plan can be used with a retro plan.
• The insured pays the losses that are within the deductible
and takes the tax deduction as the benefits are paid.
• When losses become greater than the deductible, the
insurance company pays the loss.
• A large deductible will see a small premium and the
insured receives the benefit of a retro, avoids regulatory
assessments and has many of the cash flow benefits of
self-insurance.
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