by Frank Huang | October 6, 2020
Originally published in PEO Insider (October 2020)
Reproduced with permission of the National Association of Professional Employer Organizations
One of the first goals in setting a budget is to determine what your revenue is relative to your costs. The harder part of that equation in the insurance business is usually cost because there is significant uncertainty in estimating it. PEOs are no different. The goal of this article is to cover some of the largest costs within a PEO’s workers’ compensation program and briefly suggest ways to mitigate, manage, and control those costs.
CLAIMS COSTS
Compensable claims comprise one of the largest sources of WC costs.[1] WC claim costs have three components: indemnity, medical, and expense. Each component is driven by a different set of variables, both internal and external to the PEO. For all of these reasons, mitigating claims costs is no small feat, but extremely important.
The first way to minimize claim frequency is through strong risk evaluation, followed by strong loss control and risk management at the client level.
A second way to mitigate claims costs is to reduce the number of injured workers seeking legal representation. Predictive analytics and the more recent trend in worker empathy and advocacy are among the options trending for PEOs.
A third option is to apply predictive analytics at all stages of a claim’s life cycle. From the allocation of a claim to the most appropriate adjuster at that moment to targeted final settlements, there are tools that can help improve outcomes at each stage.
Other ideas, such as return-to-work programs, medical fee schedules, and bill review, have also proved to be extremely helpful in controlling claim costs.
COLLATERAL
PEOs sometimes neglect the impact and risk of collateral on their cash flow. Depending on the program structure, collateral can be significant and additional collateral calls burdensome. NAPEO’s 2020 Financial Ratio & Operating Statistics (FROS) Survey (of 2019 data) indicated that 10 percent of all respondents saw collateral requirements increase more than 15 percent since 2019, with some increasing by more than 50 percent.
While collateral calls typically stem from adverse experience on a policy and the PEO having not set aside cash and accrued for those additional losses, a PEO can mitigate collateral costs even before the policy is bound by evaluating and negotiating the policy terms related to collateral. For example, if the carrier is using conservative loss development factors (LDFs),[2] this could produce calls for additional collateral in the near future despite claims developing normally.
REPRICING ‘COST’
One of the hardest things for PEOs to do, whether small or large, is to remove clients with destabilizing risk at the expense of revenue.[3] Much of this difficulty is driven by growth goals and/or a desired exit strategy of PEO ownership.
Much of the difficulty in culling such clients stems from the difficulty in identifying which participants materially jeopardize the stability of the program. I posed this same question to attendees at a NAPEO Risk Management Workshop earlier this year (pre-COVID-19). Half of the attendees said the appropriate metric to measure claim costs was incurred dollars, while the other half said ultimate dollars.
Figure 1 shows the amount of additional development beyond what is reported on average after 12 months. The figure indicates that claims from Indiana fare the best, with only an additional 20 percent[4] of development after 12 months, while claims in California and New York may develop another 200 percent of current reported losses on average. The national average would imply another 61 percent development after the expiration date of the policy. This additional development, if ignored, might produce a conclusion that a client is profitable when adding expected development might make the client unprofitable.
FIGURE 1. ADDITIONAL DEVELOPMENT BEYOND REPORTED LOSS (12 MONTHS OF MATURITY). THE NATIONAL AVERAGE IS 61 PERCENT.
RISK FINANCING DECISIONS
Arguably one of the most all-encompassing questions is how to finance a PEO’s WC risk. Whether you opt for a guaranteed-cost program or seek to retain risk via a deductible program, there are numerous considerations at play. An easy test is to see whether reduced WC premiums cover the losses in the deductible layer. If the PEO fails this test, it could be taking on additional claims cost that otherwise would have been financed more advantageously through a guaranteed-cost policy.
In addition to these calculated considerations, there are also intangible costs. PEO leaders should be comfortable with the size of the deductible.
IN CONCLUSION
While there are numerous sources of PEO WC program costs and even more ways to address those costs, hopefully PEOs of all sizes and serving all industries can benefit from considering the aforementioned costs and mitigation suggestions. Because each of these areas can become quite complicated, it is important to have the right expertise in each respective area. NAPEO’s “Find a Service Partner” online directory is a great place to start.
[1] This section applies to PEOs under guaranteed cost programs but carries more weight for PEOs that retain risk.
[2] There is a general understanding within the PEO industry that PEOs develop claims for less and settle them quicker.
[3] While not a focus of this article, the converse is also true—that PEOs can do more to retain profitable clients.
[4] Statistics and chart based on National Council on Compensation Insurance (NCCI) WC industry patterns of statutory (unlimited) claims costs.
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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. |
