COVID-19, PEOs, and the Workers’ Comp Market

by Frank Huang | March 24, 2020

In late December, I wrote an article on coming workers’ compensation (WC) trends for the broader WC market as well as the PEO WC market. At the time, I thought to myself that my approach was reasonably conservative and that it would have to take something completely out of left field for my prognostications to be materially off.

Prognostications? Meet COVID-19.

(My weekly work routine? Also meet COVID-19.)

Entering week two in my new make-shift home office, I’ve been getting emails and texts from clients who are thinking about the future and, like me, wondering how this will all play itself out in the WC industry. Specifically:

  • How will a COVID-19-driven recession impact WC costs?
  • How may a COVID-19-driven recession impact the broader WC market versus the PEO WC market?
  • What similarities does a COVID-19-driven recession have with past recessions?

Let’s take a look.

Impact of Recession on Broader WC Market Costs – Frequency

When analyzing WC costs, it’s common to separate the analysis into frequency and severity components, as often it can provide additional insights that looking at the combined whole doesn’t provide.

In this case, history has shown us that frequency tends to decrease in times of recession. Recall that frequency is the ratio of the number of claims relative to an exposure base, such as payroll.  As such, frequency could theoretically increase if payroll declines at a faster rate than the number of claims. But the general thought is that claims decline faster than payroll during a recession largely because of last-in-first-out employment changes. That is, less tenured, less experienced workers are typically the first to get laid off during a recession. On average, these workers have higher propensity to have a WC claim than the average worker, who presumably has more tenure and more experience. In fact, a 2008 analysis by NCCI’s then-Chief Economist, Harry Shuford, showed that those less experienced workers were 46% more likely to have a WC claim.

The declining trend isn’t all one-sided.   There are unique drivers during a recession that may force frequency up. For example, workers may fear unemployment or the risk of their employer having to close up shop.  This fear may lead the employee to file a WC claim to earn higher and longer-lasting wage in lieu of going on unemployment.

It is also important to note that pre-coronavirus frequency trends were already downward, driven largely by greater use of technology and improvements in, and emphasis on, worker safety conditions. Thus, the impact of a recession will likely continue the downward frequency trend.

Impact of Recession on Broader WC Market Costs – Severity

While the impact on WC frequency during a recession has ample precedent, the impact on WC severity is less clear.

Indemnity costs may increase in recessionary times as workers file claims to avoid unemployment and may stay on WC disability for longer due to the better wage and lack of work replacement. And for these claimants to continue receiving indemnity payments, they will need to incur additional medical expense through more treatments or doctor visits.

Adding to the uncertainty is the impact of wage which statutorily impacts indemnity costs. Because wages may decrease or not increase during recessionary periods, indemnity costs will move in the same direction.

Overall, WC costs are likely to benefit from lower frequency, but this will be partially, or even completely, offset by changes in severity.

Different Impacts on Broader WC Market vs PEO WC Market

While many of the above trends and drivers are likely to mirror themselves in the PEO WC market, there are some key differences that may result in a materially different outcome.

PEOs primarily serve small and medium-sized businesses (SMBs) which are disproportionately impacted relative to larger firms during a recession[1], whether driven by reduced cash flow, a tightening credit environment, or decreased/disappearing demand.

Industry data from the 2008 recession also reveals other ways in which PEOs may be impacted:

  • Revenue growth slowed and even decreased as much as 5% through a combination of clients decreasing in size and fewer clients in total
  • Client retention decreased 4 pts on average from peak to trough
  • Operating income per WSE decreased and didn’t begin increasing again until 2-3 years post-recession.
  • Positive note: Margins remained unchanged per WSE.

While PEOs may be harder hit than the broader WC industry, there is evidence to show that the PEO industry rebounds quicker post-recession than the broader WC industry.

How This Recession (Depression?) May Be Different, especially for the PEO Industry

Unlike recent recessions which were driven by financial and credit markets, this recession is identified with unprecedented self-quarantining and social distancing and the fastest declination of market prices since the Great Depression. The nature of the coronavirus and its subsequent social distancing has led to disproportional impacts on jobs that cannot be done from home, be they construction and manufacturing (as noted above), food and hospitality, airline and travel, B&M retail, et al. PEOs, who generally are more heavily weighted in these harder hit exposures than the overall economy’s exposures, will tend to suffer more than the economy as a whole.

The biggest unknown to us is the magnitude of this upcoming recession. The industry has a bit of experience related to recessions lasting 18 months (see below) and unemployment rates around 10%. However, how will the industry behave if the recession and/or unemployment is worse than expected? While recent unemployment forecasts (1,2) do not appear to materially exceed 10%, a recent (not-yet-public at the time of this writing) DHHS report suggests that the duration of self-quarantining could last more than 18 months. If the recession mirrors this length of time not including the time it takes for the economy to rebound, then this recession could potentially turn into only the second US depression in the last 100 years.

The potential impact of a recession/depression will not be evenly felt amongst all PEOs. While an estimated 50% of the PEO industry is represented in the top 5-10 largest firms, the other 50% of all PEO firms are materially smaller. With less capital and access to credit than the largest firms, many of these 800+ smaller PEOs may not survive the economic downturn and decrease in clientele, especially if a material concentration of their book is in the hardest hit industries. This may result in M&A opportunities by larger firms which have been driving a recent trend of consolidation, or by outside private equity firms.

Conclusion

While there is plenty of uncertainty about the future, a COVID-19-spurred recession seems likely to impact WC costs in the broader WC market, as well as the PEO WC market. WC costs are likely to benefit from a decrease in frequency. Severity, on the other hand, may offset this decrease in part or in whole depending on a variety of factors discussed above.

PEOs are likely to see similar WC trends in their WC programs but those with greater concentration of business in harder-hit industries, such as manufacturing and construction, may be at greater risks of material devaluation. This may be an opportunity for larger PEOs or private equity firms looking to grow through acquisition.

[1] See Figure 8 of NAPEO’s 2016 “State of the PEO Industry” White Paper

 

Frank Huang has more than 15 years of actuarial consulting experience serving a wide range of clients, including serving as ADP’s Chief Actuary.  Learn more about our PEO consulting practice here.