I see a lot of negative talk about worker’s comp of late, mainly because pricing is coming down and reserve releases will likely be declining.
However, just because these things are true, doesn’t mean one should be negative on comp. First, while earnings can be declining, they are declining from a high plateau. Less good does not mean bad.
Second, this attitude ignores that investment yields are far more important to comp results than underwriting margins.
Investment returns are up more than 400bp over two years. That adds about 10 points to ROE! Pricing would have to come down > 10% to offset this.
I know some people will say “but it is down that much!” and, in some places, that’s true, but not everywhere. Also, even so, that means returns are still as good as the last few years and returns in recent years have been…terrific!
There’s a lot more to discuss here, so let’s get into why I’m still bullish on comp.
The Leverage Math
Before I discuss where things are headed, it’s important to level set and explain how I evaluate whether comp is attractive or not.
Let’s start with the leverage. As I noted above, investment income matters much more than underwriting.
Roughly speaking, a steady state comp book will write premium equal to its surplus (aka 1X). However, reserves will often be twice (2X) equity resulting in investment assets of 3X equity.
This mean each 1% of yield matters 3X more than each 1% of underwriting profit. If comp had very low CRs, the NII leverage might not matter so much, but historically there is very little underwriting profit.
Comp writers have been spoiled in recent years by 90 or better CRs that offset the lack of NII. In the 25 years from ’90-’14, comp was profitable for the industry, on a CR basis, just twice.
A good outcome historically would be to have an underwriting margin similar to your yield (e.g. 4% NII and 96% CR). But even in this case, 75% of your profits were coming from investments.
Just to complete the equation, this would result in a 12-13% ROE (12% p/t NII + 4% p/t U/W = 16% p/t =12.8% a/t +/- any corporate income/expense).
There is one more factor to consider. Since reserves are twice as big as new premium, reserve releases can make up as much, or even more, of the underwriting profit as the current accident year.
If you write at a 98 AY but can release 3% of your reserves, that’s going to be a 6% release relative to premium, resulting in a 92 CY.
Yields > Reserves > Renewal Prices
So, in order of relative importance, investment earnings matter most, then reserve adequacy, and finally, renewal business pricing.
We have been, for much of the last ten years, in an anomalous period where underwriting margins have been high as insurers raised prices to offset low investment yields.
This has tilted the ROE math more heavily towards current underwriting profit and away from NII, but that anomaly has likely reached its end.
In other words, as interest rates have risen, comp pricing should be falling.
Which brings me to our main topic. Why is the Fed so important to the future of workers comp? One reason you can probably guess. The other may be a little less obvious.
Higher For Longer
The Fed has committed to “higher for longer” meaning they will keep short term rates at current levels for an extended period of time.
This obviously affects longer term yields. Barring a recession, long rates should thus remain at or above 5% for the intermediate future.
Given this high visibility into reinvestment rates, insurers should be comfortable writing at breakeven CRs. After all, you can make 6-7% on 5-10 year investment grade credit.
At 3X leverage, that is a ~20% p/t ROE (16% a/t) on new business. While AYs are heading higher, they are still in the 90s. Plus, reserves are still redundant, even if less so.
Thus, there is room to lower price, while still earning very strong returns. If you are retrenching in comp now, you are missing out on a lot of future profit.
But there are more tailwinds. Because the Fed is struggling to fend off inflation, wage gains are well above trend.
With the majority of worker’s comp claims now being related to medical, these wage gains have high incremental margins.
In other words, a 5% wage hike isn’t raising $ loss cost by 5%. It’s maybe closer to 2%.
This is another ~3% improvement to the CR. If wage hikes continue to be elevated, this benefit will compound over time. This means prices can drop even further with little risk to profits.
If medical inflation takes off, this would change the calculus, but, until then, the Fed not being able to cool down wage increases is great for comp writers.
We Are All Monetarists Now
If you participate in the comp space, like it or not, you need to be a monetary policy expert as much as an underwriting expert. Unfortunately, few, if any, insurers approach the line of business that way.
The direction of interest rates and wage growth matters more than giving up a few points of rate in a certain class code.
That means, as long as the Fed is staying higher for longer, comp has some tailwinds that haven’t been seen in at least a generation.
Netting It Out
So, yes, some of the benefits comp writers have enjoyed in recent years – high pricing, large reserve releases – are going away, but they are being replaced by new tailwinds – higher interest rates and wage growth.
When you stir everything together and let it sort out, you land in pretty much the same place we’ve been the last 8 years…which is it’s a terrific time to write worker’s comp.
6% yields at 100% CR is no different than 2% yields at a 90% CR. This shouldn’t be difficult to figure out but it doesn’t seem everyone understands it.
Certainly, that can change if pricing pressure goes too far, but it would have to go north of a 105 CR before that’s a problem. I don’t think anyone is suggesting we’re close to that yet.
I get some of the comments companies make are posturing to try to talk the market up, but, in that case, I hope they’re not following through on their talk.
If they do, they’re going to be letting a lot of good business walk away.