Workers’ Compensation Risk

The substance of our M&A advisory support to clients can vary greatly due to the varied nature of each deal. However, there are general similarities in form, especially as it relates to workers’ compensation (WC) programs. Two areas that are a common refrain in transactions involve unpaid liabilities and risk financing. Before delving into each, it will be helpful to cover some useful terminology and equations. (I promise this will be quick.)

Terminology

Let’s start off by looking at terminology used to describe a single, individual WC claim:

• Paid Loss – the amount paid as of a certain date to the injured worker.
• Allocated Loss Adjustment Expense (ALAE) Expense – expenses directly attributable to a specific claim (e.g. legal expenses).
• Case Outstanding Loss and/or ALAE – the claim adjuster’s estimate of the additional amount needed to settle the particular claim.
• Reported Loss and/or ALAE – the sum of Paid Loss and Case Outstanding.

Then there is this all-important piece called IBNR which can be used to describe a single claim but is more often attributed to a group of claims:

• Incurred But Not Reported (IBNR) Loss and/or ALAE – the actuary’s estimate of the additional amount beyond both what has been paid and what the claim adjuster has estimated as necessary to settle a group of claims.

Important Equations:

• Ultimate Loss and/or ALAE = Incurred + IBNR = (Paid + Case) + IBNR
• Unpaid Loss and/or ALAE = Ultimate – Paid = Case + IBNR

Unpaid Analysis

One of the core services that is asked of us in most every transaction is to estimate unpaid liabilities. Contrary to some people’s opinion that IBNR stands for “incurred but not real”^[1], IBNR is indeed real and can be a major component of the overall unpaid estimate^[2]. While actuaries apply commonly accepted actuarial methodology to estimate WC (or similarly long-tailed coverage) IBNR, there are a number of reasons why estimating unpaid liabilities for PEOs can be uniquely difficult.

One main reason is that PEO WC claims experience can be quite different from that of a traditional WC industry risk. Just as I might view a cheetah and a leopard as the same type of animal much to my son’s dismay^[3], some actuaries may look upon a PEO like a more traditional WC client and estimate future development and IBNR similarly. However, from our experience, PEO claims can behave quite differently from broader WC industry claims, even when you adjust for various exposure factors.

Another reason why the estimation of a PEO’s unpaid liabilities can be more complicated than an actuary may expect is that, while there are many similarities between PEOs and small to mid-sized insurance companies (e.g. both have similar functions of sales, underwriting, safety, claims management, etc.), the sophistication and experience within each of those functions can vary significantly depending on the PEO. For this reason, we often recommend that diligence be performed on the operations of the target firm in addition to providing due diligence on the unpaid liability. The proper coordination of these different risk functions can meaningfully impact valuation and post-transaction improvements.

Finding a partner to estimate unpaid liabilities is not a difficult task, but it is very important for PEOs and investors to find partners that will be able to understand PEO risk and risk operations in order to both properly estimate unpaid liabilities and potentially support post-transaction improvements.

WC Risk Financing

Another common topic of conversation we have with clients, whether in a transaction or not, relates to WC risk financing. Allow me a few seconds to explain what risk financing is.

When a PEO goes into business, WC and health benefits are two of the largest insurance coverages provided to their clients. For both coverages, but especially for WC, there is flexibility in whether to transfer all the insurance risk to an insurance company or to retain some or most of that risk (for reasons to be discussed below). Depending on which path the PEO decides to pursue, and the related decisions to be made, the complexity added due to the amount of risk retention can vary from small to great.

On the least complex end of the spectrum would be a guaranteed cost (GC) program. PEOs that utilize GC programs effectively pay a premium amount to an insurance company for the insurance risk they have sold to their clients. The PEO retains no risk but also retains limited profit.

As you move along the spectrum towards greater complexity thru retaining more insurance risk, there are a number of available options, including deductible plans, captive programs, and self-insurance. Each of these allows the PEO greater potential for profit in their retained layer, but also expose them to greater risk. For the sake of time, and because it’s one of the most common risk financing approaches, let’s take deductible plans as an example.  (This retention of insurance risk is what produces the loss and ALAE reserves discussed earlier.)

Similar to each of our personal auto insurance, a deductible plan allows a PEO to retain a set amount ground-up for each claim in exchange for a smaller premium paid to the carrier. The amount of the deductible itself is an important decision. If it is too large for the PEO, there may be greater volatility than desirable and it may result in a loss for the financial period compared to if a GC program was utilized. The size of the deductible, and how it has potentially changed over time, can impact the unpaid analysis and may impact a number of different areas outside the scope of this article.

Another important issue is collateral. A prominent feature of deductible plans is that carriers will pay the claims ground-up and then seek reimbursement from the PEO for their applicable deductible portion. This produces a credit risk for the carrier. In order to mitigate that credit risk, carriers require PEOs to post collateral. The type of collateral can vary, whether as working fund that is prefunded, as cash/security, or as a letter of credit. The amount of collateral required can also be a major sticking point between a carrier and PEO. Perhaps the toughest aspect about the collateral of PEOs relates to the timing of collateral calls/releases and the potential subsequent cash crunch that ensues.  As you can tell from the above discussion, the type and amount of collateral combined can add complexity to the due diligence process.

Wrapping Up

While there are many other areas to discuss with regard to PEOs and specifically transaction support, unpaid liabilities and risk financing are two of the most commonly encountered issues, such that investors and those new to the PEO industry would do well to be familiar with them sooner rather than later. Understanding these areas can help minimize unnecessary ^[4] headaches in the midst of a transaction.

^[1] Told to me by a then target and now client who was convinced that their IBNR was 0.

^[2] Based on industry WC data, IBNR at 12 months of age is 60% of what is reported. In jurisdictions such as California and New York, IBNR can grow to be double what is reported at 12 months.

^[3] Who knew that cheetah’s are almost twice as fast as leopards – 70 mph vs 37 mph, respectively.

^[4] I can’t help you with the necessary headaches.