Most employers assume they must choose between traditional insurance or self-insurance for workers comp. Martin McGavin examines the "unbundling" option, how it works, and its advantages and disadvantages.
Most employers weighing their workers compensation program options assume that they must choose between buying a traditional insurance policy or self-insurance. Buying a traditional insurance policy means using the insurance company claim department to manage claims and possibly losing much control over claims management decisions. Self-insurance offers greater control of the claim process, but requires taking more risk and assuming the administrative burden for vendor management, the initial application process, and periodic reporting to state agencies.
There is another alternative employers should consider: "unbundling," a strategy that allows employers to purchase insurance from an insurer and all claims management services from other vendors. Many employers find unbundling preferable to either a traditional insurance program or self-insurance.
How Unbundling Works
In unbundling, the employer purchases a policy that does not include any claims management services. The insurer provides all other policy management services including filing coverage with the state, reporting claim data to the National Council on Compensation Insurance (NCCI) or other reporting agencies and with the applicable state government. The insurer also issues certificates of insurance if the employer needs them for customers or vendors.
The employer negotiates a separate deal for claims management services with another vendor. The claims management vendor may be another insurance company or a third-party claims administrator. The selected claim vendor then carries out all day-to-day claims management functions including paying claimants and filing claim-related paperwork. The claim vendor also provides the insurer with the data needed for financial analysis, underwriting, and for complying with reporting requirements.
In most cases, unbundling requires the employer to assume most of the risk for covered claims. This is typically accomplished through a large-deductible policy. A program of this sort, where the employer is responsible for paying claims but the insurer acts as the carrier in all other respects, is also known as "fronting."
Fronting appears to be risk-free for the insurer, but it is not entirely so. The carrier is still the insurer of record and, by filing the coverage with the state, it guarantees that all claims will be paid. This means that the insurer must pay the employer's claims if the employer encounters financial difficulties and is unable to make claim payments. The insurer must also pay if losses are unexpectedly high and exceed the agreed-to deductible.
Despite the potential problems, many insurers like unbundled programs because they can be profitable with little risk if underwritten properly. The insurer can mitigate its risk in two ways. First, it will almost certainly require collateral from the employer for the payment of claims, usually in form of a letter of credit. This provides the insurer an asset to draw on if the employer's financial condition deteriorates and it cannot pay losses.
Second, an insurer can minimize the risk of catastrophic losses exceeding the employer's retention by reinsuring part or all of its risk for losses exceeding the deductible. With these safeguards in place, an insurer stands a good chance of making a profit. The underwriter can price the business so that the premium will include the cost to fully reinsure the excess, all of the insurer's administrative costs, and a profit. Then, the business will be profitable barring an unforeseen situation, such as the failure of an excess insurer.
Still, many insurers are reluctant to write unbundled programs despite the mechanisms for minimizing risk. Sometimes this is because the insurer's claims operations are a major profit center, and unbundling would mean losing the profits generated by the claims management operation. Other insurers are simply reluctant to allow another company to adjust claims where their name is on the policy and, therefore, their standing and reputation are on the line.
Who Can Unbundle?
An employer must meet three basic qualifications to unbundle. First, its annual premium must be significant enough to interest the specialty risk department of an insurance company that writes this type of program. There is no definitive number, but an employer who generates enough premiums to consider self-insuring is probably large enough to consider unbundling.
Second, as mentioned above, an employer must be willing to take some risk. Insurers will likely only write an unbundled program for employers that are willing to retain the liability for all expected losses and probably some losses in excess of those that would normally be anticipated. Moreover, an employer may find that some coverage it took for granted in a traditional program is not available in an unbundled program.
For instance, an insurer may not be willing to offer aggregate excess insurance in an unbundled large-deductible program. Aggregate excess insurance assumes liability for all future payments once the total payments made on all claims during a policy period reach a preestablished limit. An insurer may only offer specific excess in an unbundled large-deductible program. Specific excess pays only if an individual claim exceeds the preestablished limit.
Finally, an employer considering an unbundled program must be in a strong financial position. Claim payments for injuries occurring during the policy period are likely to continue for several years, and an insurer will not issue a large-deductible policy to an employer who may not be around to make the payments.
Unbundling versus Self-Insurance
Unbundling—assuming it is achieved with a high-deductible insurance program—is most often a substitute for self-insurance. Employers considering self-insurance will find that an unbundled program offers nearly the same claims management flexibility without all the administrative burden of complying with state self-insurance application and reporting requirements. State reporting requirements can be a significant exercise, especially for employers operating in multiple states. Moreover, an employer may not meet the minimum requirements for self-insurance in all the states in which it operates, meaning it must continue a partial insurance program covering the states where it does not qualify for self-insurance or apply for special exemptions, if possible, creating even more of an administrative burden.
Another major difference is that the method for calculating fees, taxes, and assessments may be different for insureds and self-insureds. These charges are loaded into the cost of every workers compensation insurance policy, and states also collect them from self-insureds. However, the method for calculating the charges for self-insured employers is often different that that for calculating assessments for insured employers. For instance, many assessments are made against insured employers based on a percentage of standard premium. The same assessments may be made against self-insureds based on a percentage of losses. The latter method is usually very favorable to self-insureds with lower-than-average losses.
Taxes, fees, and assessments are a significant component of overall workers compensation cost in many states. An employer should be aware of these costs and should certainly compare the cost of these charges as part of an insured versus self-insured program.
The comparison of an unbundled program to self-insurance differs if an employer is already self-insured. Then, the employer has already gone through initial process of obtaining self-insurance authorization and is doing only periodic filings. Having already done the initial work of qualifying, an employer may find that it makes more sense to remain self-insured. Also, it is often the case that the employer must continue periodic reporting as long as self-insured claims continue to be paid. Claim payments could continue for years, so the employer may obtain no relief from regulatory filings even after it surrenders its self-insurance authority for future claims.
Finally, a self-insured employer must bear in mind that it may be very difficult to return to self-insurance if the insurance market changes and terms are no longer favorable. If so, the employer would need to repeat the initial application process. In some cases this can take months, leaving the employer no choice in the short run but to renew coverage under terms that it does not find favorable.
Weighing the Advantages and Disadvantages of Unbundling
As mentioned above, the primary advantage of unbundling is greater control over the claim process. Therefore, unbundling is mainly for those employers who believe they can significantly reduce their losses by working with a highly effective claims management partner who can provide specialized services. Unbundling allows an employer to find such a partner because it allows the employer to work with any independent claims administrator acceptable to its insurer or even self-administer its claims in some circumstances.
An unbundled program also greatly diminishes the chance that an employer will be forced to deal with "runoff" claims if it changes insurers. "Runoff" is the term given to claims that continue to be managed by the claim department of one company long after an employer has shifted its new business to another company. In a traditional insurance program, claims almost always remain with the insurer if the employer moves to another company after the end of the policy period. In many cases, claims remain open for years after an employer changes insurers. Many employers feel that their claims are ignored, or at least are not a priority for a claim department, once they are no longer a current customer.
This does not usually occur with unbundled programs. If an employer is forced to change insurers, it can usually continue the relationship with its independent third-party administrator providing it remains in an unbundled program. If the relationship with the third-party administrator continues, there will be no "runoff" claims.
These claim-handling advantages may make unbundling seem attractive, but employers must recognize that there are many disadvantages. First, the employer will need to conduct a search and hire its own third-party administrator. This means not only managing the proposal and selection processes, but also negotiating the claim contract, including any performance guarantees, and administering it on an ongoing basis.
The employer will also need to make provisions for funding claim payments because it will be funding them directly. The employer will also tie up some if its capital in the form of collateral for future claim payments. The employer will also find that the market for potential insurance partners is significantly restricted because many insurers will not write unbundled programs. Finally, an unbundled program may carry more risk because it may require the employer to take a higher deductible than it ordinarily would, and the employer may not be able to obtain aggregate excess insurance in an unbundled program.
Unbundling is an alternative to traditional insurance for employers who want the claims management flexibility of self-insurance without the entire administrative burden. Still, while not as burdensome as self-insurance, unbundling requires more administration than traditional insurance and may require taking more risk. Unbundling is for employers who believe the internal cost of additional administration and the increased risk will be more than offset by reduced losses achieved through improved claims handling.
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