Friday, September 11, 2009

Workers' Compensation and Unfunded Liabilities

A relatively new workers’ compensation officer asked me to explain ‘unfunded liability’ and why this would be a concern to a workers’ compensation system. The officer’s interest arose from a reading of the Ontario WSIB Annual Report for 2008 which stated:

Due mainly to the investment loss, the unfunded liability has increased to$11,469 million at the end of 2008. This is $3,375 million higher than at the end of 2007, when it was $8,094 million. The WSIB’s funding ratio has decreased by 12.9 percentage points to 53.5 per cent on December 31, 2008, from 66.4 per cent at December 31, 2007.

Funding workers’ compensation systems requires a longer view than most insurance systems. Injuries in one year may not be fully resolved within that year. In fact, many cases will require medical treatment, rehabilitation, and medical aid expenditure for decades. Permanent disability cases may also require funding for many years. Add in the cost to administer the claim and expenditures over time and it is plain that the true total cost of a claim will not be known for many years. For the workers’ compensation insurer, these future costs are ‘liabilities’.

Since payments against a claim will be made over time, workers’compensation insurers can estimate the amount of money they need today to make those payments into the future. Amounts that will be paid in the future are ‘discounted’ so they can be stated in current dollars. Using actuarial principles, past experience, and some assumptions about investment returns the insurer can place a ‘present value’ on the cost of the claim at or near the time the injury occurred. This present value is also known as the incurred cost of a claim. As long as the insurer has collected enough in premiums to cover the incurred costs of all claims, receives the investment returns expected and experiences costs over the lifetimes of the claims as expected, the insurer will have just enough money to cover all the costs associated with all the claims that arose in a given year. The idea is simple: premiums collected from current employers in a year should be sufficient to cover the cost of the work-related injuries incurred in that year.

Of course, things do not always go as planned. The costs of medical treatment may increase at a rate greater than expected. Investment returns may be less than expected. By comparing the current present value of all claims to the current value of all assets that may be used to pay those claims, an insurer can determine its funded status. If the value of its assets equals the present value of its liabilities, the system is ‘fully funded’. If there are more liabilities than assets, the system is under-funded and is said to have an ‘unfunded liability’. If the valuation of current assets is made when the market for those assets is depressed, the size of any unfunded liability will be larger than on a day when the market is elevated.

So,what if there is a large and persistent unfunded liability? Not necessarily. The situation may improve with higher investment returns, actions to achieve lower patterns of expenditure such as improved return to work outcomes and better health outcomes with lower disability. If these don't work, at some point the unfunded liability must be funded. Assuming benefits are held constant and patterns of disability do not change, the only other source available to cover the unfunded liability of past claims will be premiums or assessments paid by current employers. In effect, using premiums or assessments to offset an unfunded liability is an inter-generational transfer of the cost of work-related injuries from employers in the past to current employers.

There are other measures of financial health of a workers’ compensation system but the funded status is one of the most common in Canada. The AWCBC includes funded status in its report of key statistical measures. The 2007 results for all Canadian boards are the most recent funding ratios available without going to individual annual reports.

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