Three Management Processes that Help Reduce Workers Compensation Cost

Measurement

Providing concise data that enables top management to easily and quickly identify workers compensation performance variations is perhaps the greatest single step a risk manager or loss control manager can take to create a climate for cost control. Senior mangers will instinctively use this data to drive poor performers to equal the results of better performers.

Employers should develop a set of measures and prepare a monthly report for senior management comparing the results of all operations. The report should include both safety and cost measures. Safety should be measured in terms of injury rates. It is best to use Occupational Safety and Health Administration (OSHA) record-keeping criteria for determining which injuries to report because almost every operation is already required by OSHA to gather the data. Using it avoids a duplicate record-keeping effort.

Cost should be measured in terms of incurred losses. Incurred losses include both the paid to date and the reserve for the estimated future cost of claims.

Both injuries and workers compensation cost should be expressed in rates to account for the difference in the size of operations. Comparisons that are not experience based do not always provide for meaningful comparisons. For example, it means little to say that 2 operations had 20 injuries each during the year, and both incurred $15,000 in workers compensation costs. One of the operations might have 30 people, which means its results were not that good, and the other might have 1,000, meaning its results were spectacular.

The number of injuries should be converted to a rate using the standard OSHA formula (incidents X 200,000/hours worked) that yields the number of incidents per 100 employees per year. Cost can be reported in terms of cost per hour.

Although this data may seem complicated, it can be reduced to a table that is simple for management to use. The following table shows how this data can be presented.

A table like shown above enables senior managers to quickly analyze the performance of all operations and to identify poor performance. A senior manger looking at this table could quickly see that the Duluth operation incurs injuries at five times the rate of its Peoria plant, and that it incurred more than 10 times the cost.

Senior managers drive performance by identifying improvement opportunities and then driving change. Instinctively, a senior manager looking at this data would realize that significant savings could be achieved by driving the Duluth Plant to match the performance of the Peoria Plant. For that matter, even greater savings could be realized by driving all plants toward performance in line with Peoria. That is what management will expect to occur.

Creating this expectation in senior mangers, which in turn is relayed to operations managers, will create the drive needed to assure that operations mangers are actively involved in cost control efforts.

Cost Allocation

Cost allocation is another way to encourage operations managers to be involved in safety and claim activity. Operations managers are accountable for the profitability of their operations and allocating actual workers compensation costs back to them will effect their profitability.

The reality is that all business must charge workers compensation costs back to their operating units in some way. The critical success factor is how the charge is made. If it is merely an overhead load or an average rate, it sends the message that workers compensation costs are like property taxes—they cannot be avoided and they are beyond management control. Instead, workers compensation cost should be charged back in a way that reflects performance.

Not only is performance-based cost allocation necessary to create the proper management incentive, but it is also essential to accurately assess the profitability of operations. Suppose, for example, a company has over-capacity and is deciding whether it should cut back production at its Duluth or Peoria plant. Naturally, it will want to cut back at whichever plant produces least profitably, all other things being equal.

The profit comparison for the two is shown in Figure B below. The chart shows that the Duluth Plant is more profitable, earning $1,750,000 compared to the Peoria Plant's $1,500,000—before workers compensation cost is factored in. After the cost of workers compensation is deducted from each plant's earnings, the Peoria Plant is much more profitable. Failing to include actual workers compensation cost would have caused this company to make an incorrect decision on which plant should reduce capacity.

Although this example is somewhat theoretical, there are many real and immediate consequences of not allocating actual workers compensation cost based on experience. For one, it may result in the plant manger at a plant that is actually less profitable earning a bigger bonus than a plant manager at a more profitable operation.

Designing a Performance-Based Cost Allocation Program

There are three rules to follow when designing a cost allocation program: keep it as simple and easy to understand as possible; make certain it quickly tracks performance, and make certain the incentives it creates for operations match the employer's overall incentives.

Cost allocation programs must be simple so operations managers can see the cost-benefit impact of the decisions they make. This is one of the weaknesses of the experience-rating scheme used by most insurers for small risks. The rating method is so complicated, that employers managing workers compensation have little idea what impact their decisions will make on future cost.

For example, an employer making a decision about whether to offer light duty in a particular case will have no idea what impact returning the employee to work will have on future cost. The employer will generally know that light duty will reduce costs over time, but it cannot make a cost-benefit analysis on each case-management issue.

Larger employers have the freedom to design more responsive internal cost allocation processes that are much simpler. The goal of the program should be that the operations manger making day-to-day decisions will know the cost of those decisions and can act accordingly.

For example, an operations manger will know that it will incur indemnity costs if it fails to provide a light duty assignment to an injured worker. The manger can then balance any cost associated with providing the assignment with the cost of sending the employee home.

Second, internal allocation processes should react quickly to actual performance. Allocation programs that do not assess actual cost back to operations for 2 or 3 years dramatically reduce the incentive to manage costs. Most operations managers are too caught up in day-to-day issues to worry about cost that might surface in 3 or 4 years. Also, operations managers tend to change assignments frequently and may realize that workers compensation costs generated during a year may never catch up to them.

Finally, cost allocation programs must match the operation's incentives with those of the company. This means that any cost allocation process must be carefully studied to assure that it is not creating any unwanted artificial incentives.

For example, suppose a company decides to charge back the actual amount paid on claims to every location on a monthly basis. A plant manger working under this system must decide whether to settle a claim. The proposed settlement amount is $100,000. If the claim is not settled, there is a good chance the employee will receive a lifetime award of benefits. This would be payable at the rate of $35,000 per year for the next 20 years. If the employee won such an award, the company would need to immediately establish a reserve of $700,000 over the employee's lifetime. This would reduce the company's earnings by a like amount. The employee's case is not expected to be decided until the following year.

The prudent thing for the company to do in this situation might be to settle for $100,000 rather than risking the $700,000 award. The incentive the cost allocation system has created for the operations manager would make settlement a poor decision. Settling would result in an immediate $100,000 payment that would be quickly charged back to the operation. This would have a substantial adverse effect on profitability in the current year. Refusing to settle would push any cost back at least a year until the case was decided, and even if the employee prevailed in the following year, and payments were ordered, they would only total $35,000 per year. Thus, the operations manger's choices are a $100,000 payment in the current year or $35,000 per year starting in the following year. The only rational decision for the plant manger is not to settle.

Conceivably, a company's claim manager or risk manager could monitor all claims and intervene whenever an operation's manager seems to be acting in conflict with the company's best interest. But, overriding the decisions of operations mangers would diminish their ownership in the process and make them less likely to participate, defeating the purpose of the allocation mechanism. It is better to avoid such conflicts by aligning the incentives of operations management with those of the company.

Loss Development Issue

Most employers that develop simplified cost allocation programs do so because of the complications created by loss development. Loss development is the continued growth in the cost of claims after the end of the policy year and after all claims are reported. A typical employer may see its cost of claims double after the end of the policy period, even if almost all claims are reported by year-end. The doubling is largely the result of increases in the expected cost to settle a handful of claims that turn out to be much more serious than the claims adjuster or the employer expected.

The problem that loss development creates is that an employer does not know its actual cost of claims at the end of the policy period. Charging back the known cost at the end of the year would create a false impression of performance. For example, if losses at the Duluth plant are $500,000 at the end of the policy period, and the employer estimated the plant's profitability based on the year-end losses, it could be significantly overstating the plant's profit. If losses double after the end of the year, as is typical, the Duluth plant's cost will ultimately reach $1 million and the plant will actually be much less profitable than assumed.

Unfortunately, this means an employer must use some estimate of loss development when allocating costs to operations. This requires a more sophisticated understanding of workers compensation by both operating management and senior management. It also makes it a little more difficult to understand the process, conflicting with the goal of avoiding a complicated process.

Still, this is not a complete change in processes because an employer must develop some estimate of workers compensation cost during the year so it can create the appropriate accounting reserve. All that is required is to find a way to distribute the accounting reserve to all operations in a way that reflects actual performance.

Suggested Cost Allocation Process

Assuming an employer keeps a reserve for workers compensation cost, it can be allocated effectively following three steps. First, the employer should develop experience-based budgets for all of its locations. This can be done by allocating the anticipated cost of workers compensations based on historical cost. The table below shows how an employer might allocate its expected cost of workers compensation among its six plants. It assumes the estimated total cost for all plants is $3.2 million.

The table above shows that the Duluth Plant has generated an average of $750,000 in workers compensation cost over the last 5 years, accounting for 33 percent of the average cost for the entire company. Therefore, the Duluth Plant must budget for 33 percent of the total $3.2 million expected cost of claims for the upcoming year or $1,048,493. Conversely, the Peoria Plant has caused only 2 percent of the company's cost and must only budget $76,889. It will clearly be much easier for Peoria to be a profitable operation because it is much more efficient at managing its workers compensation exposure.

The second step is to adjust the cost charged to each plant based on results during the year soon after the year has ended. The employer will likely review and revise its total accounting reserve for workers compensation after the end of the year, perhaps with the assistance of an actuary. It will then update its accounting reserve. The revised reserve can be allocated to the plants in a similar fashion to the budget.

The table below shows how each plant's loss allocation can be derived from the accounting reserve. It assumes that the revised reserve is $3 million.

In the table above, the new reserve of $3 million is allocated based on the percentage of total losses a plant accounted for during the year. For example, the Duluth Plant incurred $630,000 of the total losses for the company or 38 percent. Therefore, Duluth is allocated 38 percent of the total $3 million reserve, or $1,150,335. This is more than the plant's original budget of $1,048,493, so an adjustment of $101,842 would be required. This would be additional expense that would reduce the profitability of the Duluth Plant.

The new loss allocation for all the remaining plants is below the original budget, so all would receive additional income when their reserves were reduced. For example, Livonia budgeted $908,694, but its revised forecast is for losses of $776,019. Its reserve can be reduced by $132,674, meaning it can book additional income of that amount.

This method does not immediately get exact cost back to the operations that generate them, but it does result in an experience-based charge that is derived primarily from a plant's actual results, and that can be assessed very quickly after the end of the year. Operations mangers will learn that they will pay their actual cost plus an assessment for every dollar in losses they incur. This creates a very strong incentive to prevent injuries and manage the total cost of losses, an incentive that matches the company's overall incentive.

The third step in the process is to repeat the adjustment process every year until all claims are closed. At that point, there will be no more estimated cost, and each plant will have been charged exactly what it incurred.

Management Information

The final process is to regularly provide information to managers that will enable them to monitor performance and identify issues that need attention. At minimum, operations managers will need claim listings showing the amount paid plus reserved on all claims charged to their locations. Without this, they cannot see which claims require attention and increased management efforts, such as more aggressive attempts to return an injured employee to work.

Managers also need information on the nature of injuries. Prevention will play a large role in cost control, so managers need information on the type of injuries that are resulting in claim frequency and severity. Simple loss summaries that show the nature of injury, the part of body injured, and the cause of injury, sorted by the frequency and cost of claims, can help management focus prevention efforts.

Finally, managers need some periodic advice on how their performance tracks against their budget or profit plan. A monthly report that compares incurred losses to the budget will be very helpful to operations mangers. The drawback to such reports is that they can be deceiving if operations managers do not understand loss development. Employers could attempt to overcome this by training managers on loss development and hoping they remember, but a better way is to include some rudimentary loss development calculation in the performance-to-budget report. An example of such a report is shown in the table below.

The table above shows a summary of performance for calendar year 2001 as of July 30, 2001. At that point, losses were $350,000 compared to a budget of just over $1 million. This could give the impression that the plant is performing well and is in a position to receive additional income when its reserve is adjusted.

The column headed "Estimated Ultimate Losses" more clearly indicates performance. It assumes that losses will continue to be reported at the same pace through the second half of the year as they were in the first half. This means losses will double. Also, it assumes losses will double thereafter as is typical. This means the $350,000 will likely reach $1.4 million ($350,000 doubled twice).

This is a very rudimentary projection, but it alerts the plant manager to a possible performance variance—which is all a budget variance report is supposed to do. It is also true that operations managers may not initially understand loss development even if it is reported in this fashion. The advantage of showing it in the report is that it forces operations managers to gain an understanding.

When an operations manager sees a report projecting a variance of more than $350,000, as is the case in Figure E, he or she will be forced to develop an understanding of the problem in order to correct it. Conversely, an operations manager who is trained on the concept of loss development may quickly forget it and then misunderstand all the management data received.

Conclusion

The involvement of operations managers in the workers compensation cost control effort is vital to its success. Utilizing three processes—measurement, cost allocation, and providing management information—can assure their involvement. These processes will create an environment where cost containment through prevention and claim management is an expected part of every operations manager's job.