REGULATORY CAPTURE AND EFFICACY IN WORKERS’ COMPENSATION

• Date: 01 September 2018
• Published date: 01 September 2018
• Author: Faith R. Neale,David C. Marlett,Steven P. Clark
• DOI: http://doi.org/10.1111/jori.12183

REGULATORY CAPTURE AND EFFICACY IN WORKERS’

COMPENSATION

Steven P. Clark

David C. Marlett

Faith R. Neale

ABSTRACT

We examine changes in workers’ compensation laws from 2003 to 2011

and their effect on insurer performance as measured by loss ratios and

claim costs. We study changes to: length of temporary total loss

indemnity, penalties on employees whodonotcomplywithrehabilita-

tion efforts, employer or employee choice of physician, and limits on

attorney fees. We find differential effects among these reforms with the

most robust being changes to limits on temporary total indemnity and

penalties for workers who do not comply with rehabilitation efforts. We

measure one effect of the political environment and find that appointing

authority over the workers’ compensation board or committee signifi-

cantly affects loss costs. Lastly, we find evidence of regulatory capture in

workers’ compensation.

INTRODUCTION

Workers’ compensation insurance is an integral pa rt of business operation s in the

United States. However, ther e are substantial differen ces across states in the laws

and regulations that go vern the provision of wor kers’ compensation in surance.

These differences can be si gnificant enough to facto r into the geographical lo cation

decisions of employers, and can influence whether an insurance company

chooses to write workers ’ compensation lines in a given state. In general,

employees who are injured in the course of employment are e ntitled to

compensation for loss of income associated with t he injury (commonly called

Steven P. Clark and Faith R. Neale are at the Department of Finance, University of North

Carolina at Charlotte, Charlotte, NC. Clark can be contacted via e-mail: spclark@uncc.edu and

Neale can be contacted via e-mail: frneale@uncc.edu. David C. Marlett is in Finance, Banking,

and Insurance at the Appalachian State University, Boone, NC. Marlett can be contacted via

e-mail: marlettdc@appstate.edu.

© 2016 The Journal of Risk and Insurance. Vol. 85, No. 3, 663–694 (2018).

DOI: 10.1111/jori.12183

663

indemnity benefits).

1

Employees are also enti tled to medical care, rehabilitation, and

vocational training if th ese services are reasona ble and necessary. Throug h the

years, states have impleme nted diverse types of laws and refo rms to address

concerns when premiums o r claim costs increase si gnificantly.

2

This raises the question: are the laws effective and if so, who benefits? Workers’

compensation insurance benefits are directly and indirectly based upon state laws.

3

State lawmakers may decide to restrict coverage to benefit insurers/employers or

expand coverage to increase protection to workers. We examine recent state

lawmakers’ decisions regarding physician choice, length of indemnity period,

penalties for noncompliance with rehabilitation, limits on attorney fees, and who

appoints the head of the Workers’ Compensation/Industrial Boards or Commissions.

Stigler (1971) presents capture theory asserting regulation is sought by industry and

designed for its benefit. Capture theory views economic regulation as a product of the

political arena in which the most powerful groups of agents pursue and obtain

regulatory actions from political representatives (Sundaram, Rangan, and Davidson,

1992). Laffont and Tirole (1991) develop a model of capture theory that allows

multiple interest groups consisting of government, regulatory agencies, producers,

and consumers. In workers’ compensation, state legislatures make the laws, workers’

compensation boards/commissions and insurance commissioners regulate the

program within the confines of the law, insurers/employers are the producers,

and employees/plaintiff bar are consumers.

4

Based upon this theory, we expect

reforms that reduce coverage or benefits will decrease claim costs allowing insurers/

employers to retain a larger portion of earned premiums in relation to losses incurred

also known as the loss ratio. Conversely, we expect reforms that expand coverage will

increase claim costs relative to earned premiums and result in higher loss ratios

benefiting employees/plaintiff bar. We use two loss ratios in this study to measure

insurer profitability. The first loss ratio is direct losses incurred divided by premiums

1

The amount of indemnity benefit depends upon the severity of the injury and the length of

disability. Injured employees are typically entitled to 66 2/3 percent of their average weekly

wage subject to weekly minimum and maximum payments. Injured workers are indemnified

for lost wages in accordance with their disability status based on extent and duration of

disability. An injured employee will be classified based on a combination of temporary or

permanent and partial or total disability.

2

At the end of the 1980s, many states implemented a wide variety of reforms due to widespread

problems in workers’ compensation. Since then states have implemented reforms as needed.

3

If there is not a law that directly spells out the rule, then direct authority is given to the relevant

state workers’ compensation board or commission to administer the program and promulgate

rules for the program.

4

Plaintiff attorneys have a strong interest in workers’ compensation. In most states, the attorney

is paid a percentage of the employee’s award so attorneys desire to maximize both the award

and the benefits allowed employees. The state plaintiff bars have developed strong

partnerships in workers compensation and lobby hard against reform. The state agencies

overseeing workers’ compensation in each state are commonly referred to as workers’

compensation commissions, industrial commissions, boards, or agencies. We use the term

workers’ compensation board to refer to all of these.

664 THE JOURNAL OF RISK AND INSURANCE

earned. The second loss ratio adds loss adjustment expenses to direct losses incurred

and divides the sum by premiums earned.

THE ISSUE AND MOTIVATION

Employers subject to the w orkers’ compensation la ws must either purchase

insurance or qualify as a se lf-insurer.

5

Workers’ compensation la ws differ widely

across states but the recurring problems remain th e same; at times premiums ar e

either too high according to policyholders or too lo w from the perspective of

insurers. To calculate pr emiums, employees are first placed into one of 600

industrial-occupat ional classifications ( Butler, Gardner, and K leinman, 2014).

Each classification is assi gned a manual rate that rep resents the average loss fo r

each classification. Th e rate is then multiplied by the payroll of the wo rkers in each

respective classificat ion to determine the premi um. Generally, larger e mployers

with more loss history may deviate from the manual rate if their loss experience is

better than the average for the cl assification. The small est firms typically pay

manual rates. Regardless, whether states are imp lementing laws to provide more

coverage or to control co sts, it is important to understand the impact of these laws

on losses and premiums th at affect affordabili ty of insurance and ultim ately on

insurer performance, w hich determines an insur er’s ability or incentive to supply

the insurance.

While the literature on workers’ compensation insurance is broad, the majority of

studies that examine the effects of variation in benefits have focused on changes in the

maximum indemnity payment or the associated waiting period. This study makes

three primary contributions to the body of literature. First, our unique data set

encompasses a variety of issues allowing us to examine the effects of regulations that

have received little or no attention in previous studies. Second, we utilize diverse

samples and analyses. We examine subsamples of states and perform a quartile

analysis. Lastly, we examine the loss ratio to test the Laffont and Tirole (1991) theory

of regulatory capture to determine if there is evidence of capture as measured by

insurers’ ability to retain earned premium in relation to losses.

We estimate panel data models with fixed effects using the Driscoll–Kraay estimator.

The most robust and effective changes to laws are those regarding limits on temporary

total indemnity and penalties for workers who do not comply with rehabilitation efforts.

Decreasing time limits on temporary total indemnity are associated with lower loss ratios

for most insurers. Increasing (decreasing) penalties to injured workers who do not comply

with rehabilitation efforts are associated with lower (higher) loss ratios while increasing

penalties is associated with lower losses incurred for most insurers.

5

Some large employers decide to retain the risk in exchange for avoiding premium payments to

insurance companies. Typically this includes employers with a large number of employees,

adequate financial resources, and substantial managerial experience. Employers may choose

to self-insure to gain more control over claims and associated litigation. They also avoid

pricing fluctuations of insurance market cycles. Self-insurers often hire third-party

administrators, retain attorneys, and have medical staff available for consultations.

REGULATORY CAPTURE AND EFFICACY IN WORKERS’COMP 665