The Big Short & Workers Comp Insurance

As I recently mentioned, I just finished reading The Big Short by Michael Lewis. It's a great read, explaining in detail how investment banks and rating agencies created various AAA rated securities that were really based on Junk-quality subprime mortgages. And I was struck by some interesting parallels with the world of Workers Compensation insurance.

One of the ways that this financial scam was enabled was that rating agencies like Moody's and S&P rated various investment securities as AAA (essentially risk free) even though they were based on mortgages of dubious quality. This happened because the rating agencies were paid by the investment banks that created these frankenstein investments, and the lucrative fees corrupted what should have independent analysis by the rating agencies.

Something kind of similar exists in the world of Workers Compensation insurance with the NCCI, I think. NCCI, the National Council on Compensation Insurance, is at the center of the Workers' Compensation insurance universe for most states. NCCI does the actuarial work to calculate rates, NCCI devises the classification system that determines what kinds of employment are assigned to which class code, NCCI devises and operates the experience rating system that calculates experience modifiers for employers--NCCI is really central to the whole system that is used in most states to figure premium charges for Workers' Comp insurance.

NCCI is often viewed as some sort of regulatory agency--except that it isn't. Most of NCCI's money comes from the insurance companies that write Workers Compensation insurance. NCCI was created by insurance companies way back in the early part of the 20th century, and to this day the majority of NCCI's Board of Directors is made up of insurance company executives.

Now, I'm not saying that I have any evidence that NCCI has been corrupted by this close financial relationship with insurance companies. What I am saying, though, is that one important lesson from this financial crisis is that you need truly independent and impartial rating agencies. Even with the best of intentions, the financial relationship between NCCI and the insurance companies creates the appearance of a conflict of interest.

Another parallel: the financial products created by investment banks were so convoluted and arcane that almost no one really understood them properly, not the banks selling them and not the investors purchasing them. That reminds me a lot of the system behind Workers Compensation insurance premiums.

Not only are the rules of classification and experience rating difficult to follow, many insurance companies have devised policies that further complicate how premium charges will be calculated, so that policyholders often have a very poor understanding of how their costs will really be calculated. Some insurance companies actually issue side contracts that change the terms of the policy, even though the terms of the policies themselves explicitly state that they cannot be changed except via endorsement to the policy.

The good news, though, is that I don't think the Workers Comp insurance market is going to implode like Bear Stearns. Given how most employers are required to buy Workers Compensation insurance, demand for the product is guaranteed. But unpleasant surprises when employers receive their audit bills also seem guaranteed to continue.