Workers' Compensation & Client Profitability

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Workers’ compensation claims experience is a key component of profitability for Professional Employer Organizations (PEOs) but is too often an afterthought when analyzing individual client employers.   When calculating client profitability, it’s relatively easy to concentrate on the flow of cash received and paid out on behalf of each worksite employer.  Most payroll systems have standard reports that provide this information at your fingertips.  Yet limiting the analysis to cash flow ignores many costs that drive future performance.  Some examples to consider are the financial impact of workers’ compensation experience factors; loss development on WC deductible programs; state unemployment insurance benefit activity; and the amount of operational and human resources assistance required by each client. 

Each piece of the PEO profitability puzzle presents challenges and opportunities for the management team, which need to be separately analyzed and measured for success.  Hence, looking at each piece on it’s own is often necessary to address individual concerns.  However, it is also imperative to understand how losses in one area impact the profits in another.  Developing a comprehensive formula that incorporates each area’s contribution to profit will allow a holistic review of each worksite employer and ranked against the entire client base.  While this article will focus on workers’ compensation, many of these same principles discussed can be applied to other subsets of a PEO’s profitability analysis.

Workers’ Compensation Claims

In all types of workers’ compensation programs, claims incurred today are the most important factor in both future pricing and availability of coverage.  Even PEOs with guaranteed cost programs should pay close attention to claims and understand how underperforming accounts could materially impact their experience modifier and carrier relationships.  PEOs should remain focused on the frequency and severity of claims generated by each worksite employer, not only to understand the impact of claims already incurred, but to also predict future cost.

So how should a PEO calculate WC profit in a guaranteed cost program?  It’s best to mimic the approach an insurance carrier would take in evaluating its own insureds.  Revenue is based on the premium charged to each worksite employer and easily disseminated from the PEO’s payroll system.  Calculating costs is a much more difficult challenge given the long payment schedule of claims, reserving practices of carriers, accuracy of loss data and obtaining client level detail.  Costs associated with a workers’ compensation program would include (i) fixed costs (carrier profit, contingency, and expense) and (ii) ultimate claims expense.  Fixed cost, on a guaranteed cost program, would generally range from 35 to 40% of manual premium.  Ascertaining the ultimate claims expense on a client level is significantly more subjective.

Loss Development in Determining Your Ultimate Claims Expense

Incurred loss totals are the most often used barometer of WC performance by PEOs but relying solely on them will underestimate the ultimate claims cost.  It’s important to understand how claims change and develop over time. According to the National Council of Compensation Insurance (NCCI), over the last five years, workers’ compensation claims throughout the US grew an average of 75% after the policy expired.  While this is only a national average, it does depict the likelihood that individual claims will rise in cost and weaken client profitability. 

The traditional method of adjusting losses for growth in claims is to apply a loss development factor (LDF) against total incurred claims to arrive at a projection of ultimate claims expense.  LDFs may be obtained from a variety of sources including NCCI as well as insurance carriers.  Each LDF represents an average of the growth in value that an underlying portfolio of claims has experienced.  For example, a national average of 75% growth after policy expiration equates to an LDF of 1.75, which can be used to project ultimate cost for the same time frame.  The older a claim is, the lower the LDF will be as those claims have had more time to develop to their ultimate value.  Accordingly, as a group of claims grow older over time, the appropriate factors used to project their ultimate value should decrease to a 1.0 once all claims are closed.

Treating individual client accounts the same as an entire PEO may also lead to inequities, as the sample size of claims is too small to be statistically relevant.  A large book of claims will grow after policy expiration, consistent with NCCI LDFs, but it’s speculative to say that each small subset of that book will grow at an equal rate.  Hence, a uniform application of LDFs isn’t always the best option when addressing the subset.  A PEO should examine loss experience in total and carefully choose a profit calculation appropriate for their client base.

Possible alternatives include: (i) applying no loss development, (ii) fully developing losses using incurred (and/or paid) LDFs, (iii) development of open case reserves only, or (iv) a combination of these approaches.  Again, applying no development is foolhardy in most scenarios, but for those PEOs with limited claims experience and few client employers, loss development is not necessary for a complete understanding of each worksite.  Incurred LDFs paint the most accurate overall picture but unfairly penalize employers with closed claims.  Developing open case reserves is a compromise that will likely underestimate claim losses in total, but provide a more equitable division of loss experience between worksite employers.  Yet even this approach can be fraught with challenges, such as (i) some closed claims re-open and grow, and (ii) reserve LDFs are not typically published.  A simple suggestion for calculating reserve LDFs: multiply open case reserves for each claim by 2 and then add in all claim payments.  This will give adequate weight to claims already paid out while providing development to those claims most likely to grow. 

The goal in loss development is the same as any other component of profitability analysis, which is to assign each worksite their fair share.  In addition to underestimating claims cost, ignoring development ultimately rewards underperforming accounts at the expense of those clients who have experienced no claims.  Without loss development, a client account may appear more profitable today, leading a PEO to ignore potential problems instead of addressing with loss control or eliminating the risk.  Additionally, claims frequency (how often a worksite experiences a claim) is a key indicator of problems and should be closely analyzed for further loss prevention services.

Putting The Puzzle Together

Analyzing client profitability can be a time consuming and arduous process that will task professionals throughout a PEO.  It is important to engage resources from each functional area and allow them to collaborate together as a team.  Fortunately, the worst accounts in one area usually present problems in all areas, making them easier to identify. 

More often than not, data either will not be consistently available or impossible to format for use within reasonable time constraints.  When these problems arise, its important to be creative and learn to work with what is available.  Also, many vendors providing services to the PEO industry, such as technology companies and insurance agencies can provide assistance or even complete much of the process. 

While the law of large numbers usually applies, identifying the 20% that consistently account for 80% of cost is a moving target.  Hopefully, the worst worksite employers are effectively managed and either improve or leave within a short time frame.  Consequentially, it is important to repeat profitability reviews at regular intervals to identify trends early on and account for new clients as they are added.

When done on a consistent basis, client profit studies will allow an organization to re-focus resources to better reward the best customers and limit the impact of the worst.  This increases operating efficiency, customer retention, and most importantly profitability.