Employee Rights and Employment Policy Journal

In the conventional wisdom, state regulators contributed to a crisis in workers' compensation in the 1980s and early 1990s by suppressing insurance rates instead of reducing high benefit claims costs. This story portrays insurance companies as the victims of "moral hazard": regulators created incentives for workers and their advocates to drive up claims costs by shifting responsibility for the costs of escalating benefits to insurers. Insurers responded to the alleged rate inadequacies by decreasing supply of workers' compensation insurance, until state lawmakers switched their cost control strategy from restrictions on insurers to restrictions on workers' benefits. Incorporating a typical refrain from neoclassical economics, this story warns that government intervention in the market on behalf of workers' rights brings harmful unintended consequences and that workers cannot escape the economic fact of a tough tradeoff between adequate benefits and business costs.

This article responds to this standard rate suppression story with an alternative explanation of the crisis as a problem of insurer moral hazard. That is, insurance companies repeatedly sought government protection from the costs of benefit financing and used this protection to drive up the costs of benefits. A closer look shows that the regulatory rate controls of the 1980s and early 1990s in many ways moved toward introducing economic rationality and political balance into a ratemaking system previously designed to further traditional insurance companies' political interests (especially their interest in minimizing competition) at the expense of workers and employers. Although aggressive rate controls did reduce the supply of workers' compensation insurance from traditional insurers, this decreased supply often resulted not from inadequate rates but from inadequate cost control on the part of traditional insurers. The conventional story of the crisis fails to recognize how alternative insurance suppliers, especially new forms of self-insurance and new state funds, used innovative cost control strategies to successfully take over a large share of the insurance market in a number of states by the mid to late 1990s. In contrast to the typical economic message, my alternative account of the workers' compensation crisis suggests that if governments structure insurance markets to reduce insurer moral hazard (holding those who finance benefits accountable for benefit costs), workers can have better benefits at lower costs to employers.