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Principles for Workers’ Compensation Benefits and Insurance
Principles for Workers’ Compensation Benefits and Insurance
April 19, 2000
The workers’ compensation system compensates workers for work-related injuries, thereby reducing hardship to workers and their families and reducing spillovers of injury costs from injured workers to taxpayers and other potential payers. This system also generally provides employers with strong incentives to reduce the cost of injuries. Compared to tort liability, well-designed workers’ compensation systems achieve reasonable deterrence, provide more certain and rapid payment to injured workers, and require lower dispute resolution and administrative costs. However, whether these systems provide the right types and amounts of benefits, as well as the affordability of various levels of workers’ compensation coverage, have often been subject to intense debate.
These issues are illustrated by experience in the 1980s and early 1990s, when rapid growth in workers’ compensation claim costs produced considerable turmoil in many states. Cost growth was accompanied by deteriorating financial results for insurers, who argued that many state regulators refused to allow rate increases commensurate with expected loss growth. Consistent with binding regulatory constraints on rate increases in the presence of rising costs, the countrywide size of the workers' compensation insurance residual market increased sharply, with the residual market share of premiums growing to over 50 percent in a number of states.
Growth in residual markets and expected operating deficits on residual market business increased voluntary market rate levels needed by insurers to cover expected costs for the overall workers' compensation insurance market in a given state. Higher voluntary market rates to finance residual market deficits encouraged more low-risk businesses to self-insure, further reducing the size of the voluntary market. Escalating growth in the residual market and inability to shift residual market deficits to a shrinking voluntary market caused a virtual collapse of the workers' compensation insurance market in a few states.
Beginning around 1990, numerous states adopted workers' compensation reform legislation to reduce claim costs, and many states changed their systems of voluntary and residual market price regulation to depopulate the residual market and improve safety incentives. These changes were associated with slower loss growth, improved financial results for insurers, smaller residual market shares of the overall insurance market, and declining residual market deficits. By year-end 1998, the countrywide residual market share was comparable to the low level of the early 1980s.
Recent data, however, suggest renewed growth in workers’ compensation claim costs and deterioration in insurer underwriting margins. Moreover, some observers, including organized labor and Consumer Reports magazine, argue that some of the 1990s benefit reforms went too far and primarily benefited employers and insurers at the expense of injured workers. Specific allegations include unreasonable delays before workers receive benefits, premature termination of benefits for some workers, and inadequate measures to help injured workers return to work.
The proposed "solution" is to expand benefit levels and relax eligibility criteria. Adoption of such changes would further increase costs and put upward pressure on workers’ compensation insurance premiums. Whether regulatory responses to another strong cost surge in workers’ compensation would mimic the 1980s’ experience is an open question.
This statement sets forth five related principles that the Shadow Committee believes should play a significant role in the on-going debate about the design of workers’ compensation systems and the regulation of workers’ compensation insurance. These principles are:
- In the long run, workers bear the costs of workers’ compensation benefits and administrative costs. Both theory and evidence indicate that workers bear most if not all of the costs of workers’ compensation systems, primarily in the form of lower wages. Arguments that workers can receive richer benefits without paying the cost should be rejected.
- Employers and insurers bear the risk of unexpected short-run changes in workers’ compensation claim costs. The exposure to risk of short-run cost changes provides one incentive for employers and insurers to control losses and otherwise manage such risk. In the long run, however, effective loss control is in the interests of workers who bear the ultimate cost of losses.
- Because employees ultimately bear the cost of benefits, appropriate restrictions on benefits are in the interest of workers. Given that workers pay for workers’ compensation benefits, benefit levels and eligibility should carefully reflect what employees are willing to pay for ex ante, i.e., before a given worker knows whether he or she will be injured. An immediate implication, which is consistent with basic theory and evidence on optimal insurance and compensation for injuries, is that workers’ compensation benefits generally should (a) provide partial recovery for lost wages and perhaps medical expenses, (b) exclude payment for non-pecuniary loss, such as pain and suffering, and (c) provide less generous benefits for injuries that are expensive and difficult to verify and therefore more prone to fraud.
- Debate over specific benefits and eligibility rules should focus on whether they are either too stringent or too generous compared to what workers are willing to pay. Well-informed workers, for example, will not be willing to pay for more generous benefits if they produce large cost increases by lowering incentives for workers to prevent losses or return to work following injury. Permanent partial disability benefits are a particular concern because the injuries are inherently difficult to evaluate and are prone to costly disputes between workers and employers/insurers. While the optimal design of permanent partial benefits is not presently known, these benefits represent a costly and problematic area where careful research and re-examination of state systems might produce changes that would benefit all workers, who ultimately pay the costs.
- Workplace safety is promoted by well-functioning workers’ compensation markets where rates closely reflect expected claim costs and thus loss control decisions by employers, employees, and insurers. Price and service competition among insurers is the best method of achieving a close alignment between rates and expected claim costs and thus strong incentives for efficient loss control. (Our Statement Number 2 dealt with this issue in general.) Rate regulation should be avoided because it distorts incentives for safety, and regulators should not attempt to make insurance more affordable through rate regulation. Regulatory rate suppression reduces the availability of coverage, produces cross-subsidies from low-risk to high-risk employers, dulls safety incentives for higher-risk employers, and reduces insurers’ incentives to provide loss control services. Because it raises claim costs, rate suppression is ultimately self-defeating.