Heading for a fall

There are numerous arguments highlighting that, in the long term, the compensation of employees injured or made ill in the course of their work is not something commercial insurers should expect to be able to cope with economically.

Years ago it became settled law that an employer was vicariously liable for negligent acts of an employee who injured a fellow employee in the course of their mutual employment. The insurance market itself decided that, where this occurred and the employer's insurer paid a claim under an employers' liability policy, the insurer involved would not seek to exercise subrogation rights against the negligent employee. This, in effect, meant the onus to insure rested on employers not individual employees.

That is very sensible but it was then an easy step for government to make such insurance compulsory.

Employers' liability insurance first became compulsory for virtually all employment situations about a generation ago. The Employers' Liability (Compulsory Insurance) Act 1969 was followed shortly by further legislation, namely the original 1974 Health and Safety at Work Act. The HSWA did not make liability strict but did impose a duty of care on an employer that was simultaneously very high, uncertain in its nature and capable of being interpreted to apply to injuries and, more unpredictably, to illnesses that the employer could not for all practical purposes foresee. The legislation gave the courts quite broad scope to interpret the intention of parliament, but always biased in favour of the underlying assumption that employees deserved compensation.

The legislation was passed at the height of true socialism, not in today's social democracy. This was a piece of social engineering that all by itself, even if there were no other factors at work, would ensure that the long-term return on capital for investing in EL insurance was likely to be poor. That, however, was of no concern to the government. The fact that the legislation might make it difficult for shareholders of insurance companies to make money out of this class of business did not figure on the radar. In fact, there had been a real possibility in the Wilson years that insurance companies (and banks) might be nationalised.

So, the legislative environment changed 30 years ago. But that is not the only factor in guaranteeing poor returns on the class for insurers.

The development risk

In the generation since the new legislation, technology and science, including medical science, have developed apace. We no longer question whether using drilling machinery causes vibration white finger, whether working with asbestos will result in mesothelioma, whether working in a high-noise environment induces deafness, and so on. All of these are the source of claims that were not contemplated when premiums were set historically.

Of course, new sources of claims also apply to other liability classes of business. But, with any other class of liability insurance, insurers can take steps to ensure getting the premium for the risk, specifically by issuing claims-made policies as with professional indemnity policies and/or by excluding unknown risks for which a premium had not been factored such as in products liability. But, for EL insurance, the legislation does not allow this.

EL policies are issued on a loss-occurring basis rather than a claims-made basis. Perhaps there was a time when the market could have moved together towards a claims-made basis but this would have been unpopular with the political executive. It would add to the case for nationalisation or at least may have led to the introduction of a workers' compensation regime based on strict liability as happened in other countries.

The result is that insurers (and reinsurers) ought to factor in premium to cover the fact that risks may arise in the future about which they know nothing and that they cannot exclude. The ability to do so, however, is limited.

A compulsory commodity

EL insurance is a bit like growing coffee. Think of it in the following terms. Coffee is a commodity that many people purchase. A coffee plantation takes a long time to mature and, at the time the owners calculate their costs, they have little idea what price they will receive for the end-product.

EL insurance is compulsory and, like coffee, market forces lead to it being priced as a commodity. Pricing is strongly influenced by short-term supply and demand not by the cost of supply. In fact, EL insurers may actually be worse off than coffee growers. It may be stretching the analogy somewhat, but at least coffee growers can try to differentiate their output as a premium brand or appeal to the conscience of buyers by charging a premium price claiming to use non-exploitative employment practices. EL insurers do not have this option. The product they produce really is ubiquitous; it is difficult to distinguish one EL policy from another without adding to the cost of supply of the product by extending cover much beyond the legal minimum.

However, if the demand-led price starts to look attractive, there is no barrier to entry for new insurers. Incoming insurers can factor in known new risks in a particular trade and do not have the legacy of past losses to fund. For EL insurance buyers, however, like third-party motor insurance, the purchase is a 'distress' purchase. Buyers have no loyalty and will readily switch to a new supplier that offers substantially the same product but for a lower price.

Knowing this, economic theory dictates that, as new suppliers enter the market, some old suppliers should leave. Over time, supply and demand should even out, favouring neither buyers nor sellers of EL cover beyond the fact that sellers should expect only mediocre returns on capital.

Unfortunately for insurers, there is yet another factor working against them.

Few people buy EL insurance on its own. Like most insurance students I was taught that employers', public and products liability should all be handled by one insurer for a specific risk. It does not always happen, but brokers are wary of splitting the covers (as are their professional indemnity insurers). In a perfect market, as new insurers come in, the timid insurers - or those not prepared to accept only mediocre returns - should drop out. In practice, such insurers would lose out on other classes of casualty business too and so price to retain market share longer than they should.

Hope triumphs over experience and worse-than-mediocre returns are likely inexorably to follow. In fact, it is just like baked beans in that supermarkets sell them at a loss because everyone buys them and knows the price, but no one buys just baked beans and nothing else.

Horace

Fickle Horace put Paul's fork in Polly's receptacle - is a mnemonic I learned eons ago to help me remember the principles of what types of risk are insurable (see box above,).

So the argument to say the present EL insurance market is not economically sustainable in the long term is based on not one but several interacting factors. In summary these are as follows.

The legal environment is biased against the insurer. It is not a single item of legislation or court decision but the collective effect of several that creates the bias.

Pricing is like that of a commodity, driven by short-term supply and demand and not by underlying risk. This is getting worse. As insurance becomes increasingly dematerialised and not dependent on physical presence, the barriers to entry for new players (especially offshore ones), which are already low, get lower.

The underlying risk is understood only by looking retrospectively at the long term. Should you believe there are no future shocks to come, for example, asbestos or deafness, how about those that arise from changes in the nature of employment or a new cognitive view of employment risk: damage from electromagnetic waves (mobile phones, computers and computer-controlled machinery); information-overload-induced stress; passive smoking (even providing smoking areas could be suspect - it just concentrates the passive smoking); sedentary-employment-induced obesity; heat-induced infertility (from the use of laptops); isolation-induced personality disorder (for teleworkers, peripatetic workers, robot machine minders); and constant reorganisation-actuated psychosis syndrome.

The usual ways insurers have to cope with uncertain and developing risks, namely issuing claims-made policies with specific exclusions where needed, are not available.

The nature of employment is changing and - this is the clincher - the pace of change is accelerating. Risk 'shocks' will not be mitigated by inflation and the passage of time.

How employees that are injured or made ill at work ought to be compensated has become a matter of social policy and politics and is influenced by an uncertain future for the nature of employment. The risk of injury or illness for one individual may be a particular one but is not easily quantified.

For society as a whole, the risk is increasingly regarded as fundamental.

The clock started running 30 years ago and is accelerating. And - as the mnemonic learned all those years ago reminds me - fundamental risks and those not capable of financial measurement are not insurable.

HORACE

Horace is a mnemonic for the characteristics of risks that can be dealt with economically by insurance.

Fickle - The risk should be capable of being measured in financial terms.

Employers' liability risks can be in the long term but not the short term.

Premiums, however, are determined by short-term demand, not long-term exposure to risk.

Horace - There must be an homogeneous group of risk to be insured. Ironically, it appears the few successful EL insurers have been niche players.

Put - The risk should be a pure risk, not speculative.

Paul's - The risk should be a particular risk and not a fundamental one.

This is more tricky because what is deemed a fundamental risk is a function of society's attitude and this changes over time. A clue is that, if the issue is one about which politicians get excited, the risk is more likely to be fundamental. As we have seen, politicians have got excited about compensating employees and we should now perhaps regard the risk as fundamental.

Fork - Occurrence of the event insured against should be fortuitous.

In - There must be insurable interest.

Polly's - It must not be against public policy to insure. No modern commentator would argue there was a problem here, but it was not ever thus. In the past it was seriously argued that making the employer liable for injuries caused by one employee to another was against public policy because it made it less likely that employees would look out for each other's safety.

Receptacle - The premium must be reasonable in relation to the risk. If the premium is too high in relation to the risk then selection kicks in in a big way and the only people prepared to pay the premium are those who know they are likely to have to claim. At first sight this does not present a problem for EL insurance but for some trades (roofing contractors, for example) there have been times when insureds had a choice of either being illegally uninsured or priced out of business.

Dr Michael Collins, Deputy chief executive, Broker Network Holdings.