Three Management Processes that Help Reduce Workers Compensation Cost
December 2001
The involvement of operations managers in
the WC cost control effort is vital to its success. Martin McGavin explains
how measurement, cost allocation, and providing management information can assure
their involvement and an environment where cost containment is an expected part
of every operations manager’s job.
by Martin
McGavin
Managing workers compensation is more a matter of desire than mastering a
complex process. When operating managers possess the desire, they will always
find a way to achieve results. This means creating the desire in operations
mangers is the long-term key to successfully controlling workers compensation
cost.
There is no doubt that the involvement of operations managers is vital to
success. They control the work environment, including the work processes and
physical hazards that lead to injuries and illnesses. They set the expectations
for those who manage the internal workers compensation process, and they control
internal personnel practices, such as return-to-work programs, that determine
the ability to mitigate claim costs.
Creating visibility for safety and claims management results and creating
the economic incentive for cost reductions will provide operating managers all
the incentive they need to take an active interest in workers compensation cost
control. Using three internal management processes will create the necessary
visibility and economic incentive. The processes are measurement, cost allocation,
and developing performance information. Each is described in detail below.
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. Figure A shows how this data can be presented.
Figure
A
A table like that shown in Figure A 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.
Figure B
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. Figure
C below shows how an employer might allocate its expected cost of workers compensation
among its six plants. Figure C assumes the estimated total cost for all plants
is $3.2 million.
Figure C
Figure C 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.
Figure D shows how each plant's loss allocation can be derived from the accounting
reserve. Figure D assumes that the revised reserve is $3 million.
Figure D
In Figure D, 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 Figure E.
Figure
E
Figure E 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.
Opinions expressed in Expert Commentary articles are those of the author and are
not necessarily held by the author's employer or IRMI. Expert Commentary articles
and other IRMI Online content do not purport to provide legal, accounting, or other
professional advice or opinion. If such advice is needed, consult with your attorney,
accountant, or other qualified adviser.