It's not often that a major U.S. corporation blames lower net income on workers' compensation claim costs — and in a single state, to boot. But that's what Costco CFO Richard Galanti did in the second quarter of fiscal 2003: despite an 8 percent increase in net sales from the previous year's second quarter, net income was down 5 percent because of a pretax charge of $26 million that had been set aside to absorb projected workers' comp expenses in California.
While the Golden State represented just over a third of Costco's U.S. operations, it accounted for almost three-quarters of its workers' compensation costs, "even though the types of injuries and their frequency and severity in the state were no different when compared with the 37 other states in which we did business at the time," says Galanti.
Galanti says the average claim in California was more than two and a half times higher than the average in other states. "It worked out to an additional $30 million in just one state for just one policy year," he says. "The system was set up for abuse."
Insurers felt the pain as well. Twenty-eight companies went bust, according to the California Division of Workers Compensation, while those remaining either pulled up stakes or pulled back their capacity to write business. Their departure left the California State Compensation Insurance Fund, the so-called market of last resort for acquiring workers' compensation insurance, owning a 52 percent market share in 2003.
The lack of insurance competition, among other factors, forced many companies to reconsider whether and how to do business in California. "We saw costs rising 22 percent a year," says Robert Edwards, executive vice president and CFO at $43 billion Safeway Inc., the Pleasanton, California-based grocery retailer. "We're headquartered here, so there was no way we could just close our 530 California stores and move elsewhere. But we did think very hard about our resource allocation in the state — the return on investment from further expansion or upgrades to existing stores."
Costco faced the same dilemma. "We couldn't take our retail locations out of the state, but there was no way we could continue to invest in our stores with these costs spiraling out of control," Galanti says.
Employers were so rattled by the system's inequity that they began to cry foul. Their pleas attracted the attention of Arnold Schwarzenegger, then considering a run for the state's highest office. As improbable as it may sound, Schwarzenegger made workers' compensation reform a major pillar of his gubernatorial campaign.
Once elected, Schwarzenegger came through on his pledge, signing a series of legislative reforms beginning in 2004 and continuing to the present that have reduced average rates by almost two-thirds (from $6.46 per $100 of payroll in 2003 to $2.44 per $100 of payroll in 2007), according to the Workers Compensation Insurance Rating Bureau of California.
Costco, Safeway, Walt Disney, Marriott Hotels, and other companies proved that a recalcitrant legislature can be compelled to take action if the chorus of voices is loud enough and the message is consistent. When California lawmakers balked at reforming the system, employers bypassed them and began collecting signatures on three petition initiatives that put workers' compensation reform on the ballot for a statewide vote.
Realizing that there was a high likelihood that the initiative would succeed, legislators capitulated and worked with the governor to enact sweeping changes. In some ways they were simply catching up to the majority of other states; in other ways they were leading the charge.
Adding Insult to Injury
The workers' compensation system in the United States and other countries is predicated on a dual purpose — reducing the prospect of litigation brought by injured workers against their employers, while mitigating the need for workers to prove their injuries were the fault of employers. In practice, the system provides workers with an absolute right to free medical care for a work-related injury, in addition to ongoing payments representing lost compensation from both temporary and permanent partial disabilities. To pay these costs, employers either buy coverage or self-insure.
Workers' compensation in the United States is statutory, meaning each state has its own set of laws based on its particular industrial/commercial composition and workforce demographics. Most states sought to balance system costs against the needs of injured workers, but critics say California missed the mark considerably.
"The state was beset by 'excess utilization' — more injuries and treatments per worker than can be explained by the nature of the injury or what was happening in either the workplace or the economy," says Robert Hartwig, president of the New York–based Insurance Information Institute, a group representing insurance interests. He attributes the disparity to laws giving doctors in California sole control over an injured worker's medical diagnosis and prescribed treatment — a policy dubbed "physician presumption of correctness."
Richard Victor, executive director of the Workers Compensation Research Institute, a nonprofit, public-policy research organization funded by state governments, employers, managed-care organizations, insurers, and state labor groups, agrees. Asked what was driving California's enormous costs before the reforms, he says, "Almost everything — longer duration of disability, more-frequent litigation, more tests and office visits — you name it."
The demise of physician's presumption of correctness is seen as one of the key reforms. Today, care is based on a medical treatment utilization schedule that incorporates guidelines written by the American College of Occupational and Environmental Medicine and other groups, and sets out specific treatment protocols, backed by scientific findings, for injured employees. Other reforms include paring the previous five-year limit to receive temporary disability benefits to two years, except in cases of substantial injuries like amputation of a limb.
Except under limited circumstances, workers also can no longer choose their own doctors to treat their injuries; rather, they must select treatment from a network of medical providers established by the claims administrator. These networks must follow treatment guidelines and return-to-work procedures.
Doctors must also follow guidelines established by the American Medical Association when evaluating injuries that cause permanent partial disability. "Previously, our permanent partial disability rating system did not require objective evidence; doctors could schedule people to stay away from work to prove they couldn't do the job," explains Carrie Nevans, administrative director of the California Division of Workers Compensation, a state agency. "The new system brings science, in the form of the AMA guidelines, into the equation."
Safeway's vice president of workers' compensation, William Zachry, concurs. "In the pre-reform days, an injured worker would think, 'I am disabled, therefore I am,'" he says. "Now it is based on a true, objective finding of disability."
The various medical guidelines have combined to reduce unneeded, expensive treatments. "Outpatient surgery was rampant prior to the reforms; doctors charged whatever they could, even though in some cases the surgery could be performed in the doctor's office at much less cost," says Debbie Michel, chief operating officer of business market at Boston-based insurance company Liberty Mutual Group, one of the largest workers' comp insurers in the country. Michel estimates that outpatient-surgery facility costs are down 60 percent since the reforms.
So are trips to the chiropractor and physical therapist. A study by the California Workers Compensation Institute found that the average number of chiropractic and physical therapy visits were 50 percent and 44 percent lower, respectively, in 2004 than they were in 2002. Total costs per claim also fell 60 percent and 48 percent, respectively, over the period.
Despite these reductions, injured workers have little dissatisfaction with their treatment. According to the California Coalition on Workers Compensation, applications by injured workers appealing their workers' comp claims to state regulators are down nearly 50 percent since the reforms.
Nevans, of the state's workers' compensation division, notes that more workers are returning to work earlier than they did before the reforms, assisting employee morale and employer productivity. "Obviously, when someone is injured at work it is an emotional issue, but the reforms have allowed us as a state agency to be more objective, using data and science, not emotion and anecdote, as the basis for decision-making," she says.
The new laws also have revived insurance-industry competition. The state fund's share is down from 52 percent to a respectable 26.5 percent. Several insurers have either moved their operations back to the state or increased their willingness to underwrite risk.
Others, such as Midwest Insurance and FirstComp, are entering the market for the first time. Intensified competition has not only resulted in lower premiums, but many insurers are now willing to write unlimited coverage. Pre-reform, obtaining more than $25 million in coverage limits excess of the self-insured deductible was virtually impossible.
Although some further reforms are stalled in the state's legislature, companies say that by and large the system has been fixed. Other states faced with rising workers' compensation costs — Marriott International vice president of casualty claims Bob Steggert cites New York and Illinois as "troubled," while Hartwig points to South Carolina — can take a page from California's experience, particularly as it relates to evidence-based treatment guidelines and the use of medical-provider networks, both relatively new concepts. "Many states watch what California does," Liberty Mutual's Michel says. "Several, like Texas, are just beginning to adopt similar reforms."
Galanti, who has spent the past 25 years as Costco's finance chief, does not expect to cite California's workers' compensation costs in a quarterly report ever again. "If there is one takeaway from all we went through, it's that when a system allows for abuses to go unchecked it costs everyone more — employers, injured workers, regulators, and citizens," he says. "Ultimately, we were able to gain the trust of employees, legislators, and regulators, but not until we raised our voices loud enough."
Russ Banham is a contributing editor of CFO.