Last year, Santa Monica-based workers’ compensation insurance provider Fremont General Corp. was riding high in the recently deregulated market. Revenues and profits were climbing steadily as it signed up more and more clients, while its stock price reached record highs.
Executives, confident that workers’ comp payouts would remain under control, took a gamble: They decided to only buy reinsurance (insurance that insurance companies buy to protect against claims) for claims in excess of $50,000. Claims of less than $50,000 could be easily covered by cash reserves, Fremont executives thought.
The gamble failed, big time.
Workers’ comp payouts below the $50,000 cap started rising. By last August, the company was forced to pump in more than $50 million in reserve funds to cover the payouts.
The result was a sharp reversal in Fremont’s fortunes, a series of Wall Street downgradings, an unloading of shares by two of its largest institutional investors, and a slide in its stock price that wiped out more than five years of steady gains.
“Fremont guessed wrong on the amount they needed to set aside to cover their workers’ compensation claims,” said Darin Feldman, associate director of Standard & Poor’s. “They underestimated their reserves. It’s that simple.”
While Fremont is arguably the most dramatic case, it is certainly not the only company being crushed by higher workers’ comp payouts. Calabasas-based Superior National Insurance Group Inc. also has been hit and, to a lesser extent, Woodland Hills-based Zenith National Insurance Corp. In the case of Superior National, its stock has lost more than 90 percent of its value over the last five months.
In fact, the entire workers’ comp insurance industry has been under strain in recent months, the result of a squeeze between soaring costs and an all-out price war on premiums.
As for costs, insurers’ claims payouts and administrative expenses have been rising at least 10 percent annually for the last four years, defying expectations that the costs could be brought under control.
“The rise in average claim costs has been quicker than anticipated,” said Dave Bellusci, vice president and chief actuary for the California Workers’ Compensation Insurance Rating Bureau, a state entity that tracks workers’ comp claims.
Among the factors cited for the increased costs: higher state-mandated benefits for injured workers and higher medical treatment costs. Medical treatment costs are rising due to the treatments themselves costing more, but also as a result of the 1993 workers’ comp reform laws giving doctors more discretion in how they diagnose and treat worker injuries. Another contributing factor has been higher litigation costs, as insurers and their employer clients challenge diagnoses.
“Legitimately injured people are getting more benefits and more-expensive treatments for the same injuries than they were getting several years ago,” said Chris Seaman, chief executive of Superior National. “We didn’t expect this; it really was unpredictable.”
Meanwhile, with the advent of deregulation four years ago, insurers slashed premiums to grab market share, despite a steady stream of warnings from the Department of Insurance and analysts that such moves could lead to disaster down the road.
“There has been a very aggressive price war going on among the insurance underwriters,” said Norris Clark, deputy commissioner with the Department of Insurance.
For a while, many insurers dipped into their reserve funds that had been built up during the workers’ comp crisis. But over the last year, Bellusci said, the amount of outstanding claims has grown to exceed the amount of annual premiums collected from employers statewide by $3 billion nearly half the $7 billion in total premiums collected each year.
As a result, insurance underwriters have been forced to put more money into their reserves to cover the higher costs. That has sent many of them deep into the red.
Hardest hit in the state have been Fremont General and Superior National, the second- and third-largest workers’ comp insurers in the state behind State Compensation Insurance Fund.
Consider what happened to Fremont.
The company took a $75 million charge against third-quarter earnings ($25 million of that for discontinued asbestos insurance operations), resulting in a net loss of $86 million, a sharp reversal from net income of $34 million for the like period a year ago. That net loss came despite a 40 percent jump in revenues.
Several rating firms, including Standard & Poor’s, Moody’s Investor Service and A.M. Best Co. either downgraded Fremont’s insurance portfolio or placed it under review for possible future downgrades.
Fremont’s two largest institutional shareholders also reacted to the news. Merrill Lynch & Co.’s asset management division sold all 4.5 million of its Fremont shares during the third quarter, according to First Call, a securities research firm. That represents about 6.4 percent of outstanding shares. Also, Fidelity Research & Management Co. sold off about 1 million of its nearly 8 million Fremont shares during the third quarter, according to First Call.
Amid the selloff, Fremont’s stock price plummeted not once, but twice. In late August, Fremont announced it would take a charge against third-quarter earnings, triggering a 42 percent drop, to about $9 a share. It drifted in the $8-$10 range until three weeks ago, when news surfaced that its third-quarter net loss would be about $86 million, nearly $10 million more than originally forecast. The stock plunged another 40 percent, to just under $5 a share.
The primary reason Fremont has taken such a beating was its January 1998 decision to reduce its reinsurance policy to cover only claims of more than $50,000. Believing a much larger portion of its claims would be covered by reinsurance, Fremont reduced the amount of cash reserves set aside to cover claims. Then, when its level of $50,000-and-less claims skyrocketed, the company was caught flat-footed, with claims exceeding cash reserves by $50 million.
The company decided to boost reserves by $75 million, giving it a $25 million cushion. But some analysts still believe Fremont does not have a firm grasp on how much it should set aside.
“It is not reassuring to investors to realize that they are still playing a guessing game,” said Nils Wright, executive editor of the Workers’ Comp Executive, an industry newsletter. “That is a major reason why the stock price has not recovered, even though the company said it expects no future charges.”
Questions about the company were referred to President and Chief Operating Officer Louis Rampino, who did not return calls.
The situation is perhaps more dire at Superior National.
First, Superior National’s reinsurance carrier, Inter-Ocean Reinsurance Co., canceled its contract, alleging that it had been misled as to the condition of Superior National’s reserves.
In September, Superior National filed suit against the reinsurer, alleging breach of contract. The matter is still in the courts. Then, to cover a reserve shortfall, Superior National announced it would add $60 million to its reserves.
“As has been the case with everybody else, we underestimated the severity of claims that we set aside reserves for,” said Superior National’s Seaman.
Just as with Fremont, Wall Street has not taken kindly to this predicament. From a 52-week high of $30.25 a share on June 30, Superior National’s stock closed on Nov. 24 at $2.81 a share.
The solution to the woes of Fremont and Superior National lies in raising premiums to bring them more in line with costs, industry analysts said.
Toward that end, earlier this month state Insurance Commissioner Charles Quackenbush recommended that insurers institute an 18.4 percent increase in the basic workers’ compensation premium.
But under the deregulated system now in place, Quackenbush can only cajole insurers; he has no direct authority to force them to raise rates.
But the recommendation does seem to be having some effect, said the DOI’s Clark.
“We are seeing evidence that premium rates are firming up and we expect to see more increases as policies are renewed in January,” Clark said.
