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Goldilocks Workers Compensation Reserves: Too High, Too Low, or Just Right?

Workers’ compensation is often one of the largest items in a business’ insurance budget. Relatively small claims for injuries like cuts or abrasions can impact the coverage’s cost, but more influential are the larger claims for more serious injuries. This type of loss requires the insurance company to set up a reserve, or estimate of a claim’s ultimate cost. The accuracy of a reserve has important implications for both the employer and insurer.

Businesses may feel that insurers set reserves too high, and that can happen. Over-reserving unnecessarily inflates the insurer’s liabilities and reduces its surplus (net worth.) This in turn reduces the amount of insurance the company can provide without raising fears about its financial stability. Although the experience modification formula penalizes a firm more for frequent claims than for severe ones, over-reserving does make the firm’s modification greater than it should be, resulting in higher premiums. Finally, over-reserving distorts a firm’s loss ratio, which makes the firm’s business less attractive to underwriters.

Under-reserving presents the greater threat to insurers. If the company sets the reserve too low, the claim can develop more rapidly than expected. The company may eventually find itself with a large obligation for which it is not prepared to play. Also, company managers tend to focus their attention on large claims and delegate handling of smaller ones. This means that an under-reserved claim will not receive proper management attention; the company will not apply claim control measures until it is too late for them to make a difference. Inadequate reserves can also affect a company’s financial stability ratings. Rating agencies such as A.M. Best may decide to lower a company’s rating if it finds significant under-reserving. This may cause customers to move their business to companies with higher ratings.

Certain types of claims are more likely than others to develop into high-dollar ones. Back injuries tend to be very expensive. Aging factory or warehouse laborers who have endured years of stress may need long-term treatment and, in some cases, surgery. Depending on the worker’s age, he might not return to work. Older employees who suffer injuries to their feet and legs may also have expensive claims. These employees may have pre-existing conditions, such as diabetes or hypertension, which worsen the consequences of an injury, resulting in amputations or heart attacks. Other injuries may aggravate conditions such as obesity or spinal problems, making the worker’s diagnosis more severe and increasing the disability period.

Other claims may develop into large losses because of the worker’s circumstances. Suppose a two-earner household has been paying for childcare for years, and the youngest child reaches the age where such care is no longer necessary. The parents are accustomed to a standard of living where they live on the after-childcare income. Workers’ compensation benefits with no childcare expense may be similar to a parent’s wages after paying for childcare. This gives the worker less of an incentive to return to work. Workers who are nearing retirement also have a reduced incentive to return to the job after experiencing a period of disability, as they may be mentally prepared to stop working. Conversely, seasonal employees who need income to carry them through the off-season have incentives to prolong their disability periods. So do workers whose companies are laying off employees or whose plants are closing.

Employers should work closely with their insurance agents and companies to monitor workers’ compensation claim activity. Claims that fit into any of the types described above need special attention. The art of claim reserving is one of making educated estimates based on evidence and experience. Employers should verify that their insurers’ claim reserves are both fair and realistic.