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Home | Workers Comp Blogwire | What is the connection between Market Failures and Workers' Compensation?

What is the connection between Market Failures and Workers' Compensation?

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Everyone has some idea of what an economic “market” is and how it works.  Terms like “supply and demand” are well known. For most goods and services  competitive private markets  work well;  outcomes for all parties concerned are optimized.  When private markets fail to provide expected or intended outcomes, the consequences can be severe for the parties involved and others (including you and me as citizens and taxpayers).
The limitations and failings of markets are precisely the rationale behind government intervention in the form of legislation, regulation  and the introduction of social insurance including workers’ compensation.  As one commentator put it:
The goal of government intervention is to ameliorate these potential market failures by protecting workers against work-related risks and by inducing employers to invest more resources in safety.
(Krallj, Boris, “Occupational Health and Safety: Effectiveness of Economic and Regulatory Mechanisms”,  Workers’ Compensation Foundations for Reform , Edited by  Morley Gunderson and Douglas Hyatt, University of Toronto Press, 2000) 
Government intervention may be motivated by the failure of market to provide optimal economic and/or desired socio-political outcomes.  Governments may intervene to regulate a market to counter the effects of market failures.  Such interventions typically change the information balance, lower information and transaction costs, or alter the incentives of participants in the market.  One economist researcher put it this way:
In theory, regulation is designed to address market failures that would otherwise impair economic performance and reduce social welfare.  The purpose of regulation is to correct market failures, or at least minimize their negative effects, and improve allocative efficiency. …
Insurance markets, including workers' compensation, are subject to several types of market failures that insurance regulators seek to counteract.
(Hunt, H. Allan, and Robert W. Klein. "Workers' Compensation Insurance in North America: Lessons for Victoria?" Upjohn Institute Technical Report No. 96-10. Kalamazoo, MI: W.E. Upjohn Institute for Employment Research, 1996.).
Market failures in the insurance sector (and workers’ compensation in particular) can lead to financial failures such as insurer insolvencies.  The reasons for financial failures are many but here are a few examples: 
  • excess risk-taking,
  • pricing decisions to lower premiums to gain market share without regard to the actuarially required funding level
  • insufficient reserving
  • Excessive costs (administration, monitoring, marketing, etc.)
Even in markets that are subject to some regulation, financial failures can occur and may bring uncertainty or delay to compensation recipients, employers and taxpayers.  The collapse of HIH in Australia is illustrative of these consequences (see Kehl, David, “HIH Insurance Group collapse”, E-Brief, Parliament of Australia, 29 November 2001). . 
Other market failures may occur if the price of insurance is too high or availability of coverage to some or all employers too low.  This is often a consequence of “adverse selection”.  In the case of work-injury insurance, firms will only purchase insurance if they believe there is a cost advantage to doing so.  Firms who perceive the expected cost of insurance to be less than the expected cost of injuries (administration, legal costs, settlements, etc.)  will opt out.  Over repeated insurance cycles, the pool of insured will contain firms with the most risks; the cost of insurance rises, the pool of insured shrinks. To counter this type of market failure, governments intervene and almost universally require all firms to carry workers’ compensation coverage for their employees.
If there are too few insurers willing to insure all employers, competitive pressures prevalent in well-functioning markets may decline;  remaining insurers may refuse to cover all risks and premiums may rise (among other consequences). If work-injury insurance is mandated but unavailable, new businesses may not be able to open.  The state of Maine experienced some of these market failures in the early 1990s:
The new year—1992—was only hours old when five insurance companies representing 40 percent of the private insurance market in Maine surrendered their licenses to sell workers’ compensation insurance in the state. The companies included three well established insurers: Hartford, Travelers, and American Fidelity. In making their announcements, the companies cited the high cost of paying compensation claims in Maine compared to revenues collected from premiums.
Later that year, another seven smaller companies filed plans to leave the workers’ compensation market in Maine. The state’s remaining insurers demanded that Maine provide protection from the potential liability of millions of dollars in workers’ compensation claims from employees covered by the residual pool.
(Gold,  Susan Dudley, MEMIC: A Maine Miracle, Custom Communications:  Saco, Maine, 2013)
Government interventions to deal with market failures may be limited to regulation or reporting requirements but may include creating a workers’ compensation entity ( State Fund in the US, Workers’ Compensation Board in Canada, WorkCover authority in Australia). Such entities may act as competitors in under-served markets or exclusive “monopoly” providers.  In some cases, the State Fund may be the designated insurer for certain classes of industry (government operations, for example) or assigned the role of the “insurer of last resort” (providing coverage when private markets decline the risk). 
Market failures may arise from “information asymmetries” and non-aligned incentives of parties involved in insurance markets.  Workers, for example, may have insufficient information to fully assess the inherent and latent risks they face in the workplace.  Employers struggling to fill jobs may have little incentive to fully assess or communicate those risks to either workers or insurers.  Insurers may have changing priorities motivated by financial market opportunities, market share or state of their balance sheet.  In a totally transparent environment, each party would be fully informed.  The cost to overcome these informational barriers so all parties concerned are fully informed can be impossibly high.
Market failures in work-injury insurance markets include “externalities” –the imposition of costs on third parties (typically taxpayers or other insurance or benefit programs).  Prior to workers’ compensation, the courts were the arbiters of many contested work injury cases.  Decisions favourable to an injured worker would depend on proving fault and overcoming systemic and traditional defenses.  Occasional large wins by injured workers could bankrupt an employer with consequences for many parties outside the injured worker-employer relationship.  Society had to bear the financial (and “congestion") costs of the courts to oversee disputes, the welfare of those displaced by the disruption in the workplace and the lost productivity of other suppliers, providers, and eventual customers of the enterprise concerned.
Markets also fail when transaction costs are disproportionately high relative to the other costs associated with a claim. Note the following comment regarding workers’ compensation:
Is there a strong economic rationale for workers' compensation? We believe there is. Absent some form of no-fault insurance for workplace injuries, a large number of accidents would be handled by the courts using a negligence standard. The joint costs of determining liability under these circumstances would be large, substantially larger than the indemnity and medical costs of most accidents. Only a minority of workers would be compensated for injuries if it were necessary to prove company (or co-worker) negligence, and payment would be received long after most medical expenses occurred and wages were foregone.
(Addison, John T.  and Barry T. Hirsch,  “The Economic Effects of Employment Regulation: What are the Limits?” Government Regulation of the Employment Relationship Bruce E. Kaufman, ed. IRRA 50th Anniversary Volume, Madison, WI: Industrial Relations Research Association, 1997).
Medical costs currently comprise 50% or more of the benefits (combined medical and indemnity costs) of workers’ compensation in the US (See NASI Workers’ Compensation Research for the latest report) .  In an unregulated free market, the potential for externalization of medical costs is high:
Absent workers' compensation, much of the medical costs and some of the indemnity costs from workplace injuries will be shifted to others. Indeed, an advantage of having workers' compensation rather than other forms of health insurance pay for the medical cost of workplace injuries is that it shifts costs to parties whose behavior can affect safety.
(Addison and Hirsch, ibid.)
“Cost shifting” of medical and indemnity costs is an externality (an unintended effect that amounts to a subsidy).  Note, intentional cost shifting through waiting periods or employer deductibles may also be seen as subsidization of work-injury costs but are not externalities or market failures because they are intentional.
There are other market failures including those due to “moral hazard” and also government failures, failures related to the regulation imposed by government (topics of other blog posts).
The success of interventions to overcome market failures varies by jurisdiction.  Each intervention has the same intent (ameliorating the effects of market failures, making all parties better off and eliminating the externalization of costs of work injuries to others).  There is no one “right” intervention but each intervention has its own advantages and consequences.  Only active and continuous performance measurement against the intended social policy objectives of the jurisdiction will confirm the effectiveness of a particular intervention.
The failure of private, competitive, unregulated markets to deliver desired outcomes continues to be the motivation behind workers’ compensation.  The “historic compromise” or “grand bargain” that spawned workers’ compensation was a collective decision by labour, employers and the state (acting on behalf of all of us) to overcome market failures and support a specific social policy objective:  to protect workers from work-related injury, disability, illness and death in a compassionate and sustainable way that still allows the economic activity and innovation necessary for societies to operate and thrive. 
 

About Terry Bogyo:

Terry Bogyo

Terry is an active researcher, speaker and commentator on workers compensation issues. Now retired, he was the Director of Corporate Planning and Development for WorkSafeBC. His responsibilities included environmental scanning, strategic planning and inter-jurisdictional comparisons.

Terry says of himself: I am a student of workers' compensation systems. Many years ago I discovered two things about this area. First, workers' comp and OH&S are of vital importance to people. Protecting, caring for and providing compensation to workers are important, noble and morally responsible endeavors. The second thing I learned was that no matter how much I knew about workers' comp/OH&S, there was always so much more to learn. This is an endlessly challenging area of study. My purpose, therefore, is not to lecture, but to reflect on the ideas and issues that are topical in this area... and to invite others to share in a learning experience. By adding your knowledge and insights, others with similar interests can participate in the discovery and study of this important domain.

His blog is "Workers' Compensation Perspectives".

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