From the January 2004 issue of Entrepreneur

Over the past year, California businesspeople have grown increasingly infuriated over a variety of perceived economic problems. High taxes. Politicians' indifference to corporate issues. Deteriorating physical infrastructure. Ultimately, this anger became so strong that it partially led to the termination of Gov. Gray Davis and the installation of Governator Arnold Schwarzenegger.

But despite companies' myriad complaints about the Golden State, when Scott Hauge, president of CAL Insurance & Associates Inc., a San Francisco insurance firm targeting the small-business market, did a survey of roughly 1,200 Californian entrepreneurs earlier this year, he found their biggest problem wasn't taxes or roads-it was the skyrocketing cost of workers' compensation. Workers' comp premiums in California rose by more than 100 percent in the past two years alone, and insurers paid out nearly $20 billion in comp claims in California last year. "It's the number-one issue [for small companies]," Hauge says.

California is a bellwether for the nation. In many states, workers' comp premiums have soared in recent years. These costs fall hardest on entrepreneurs, who have limited resources and often don't have many insurance options. In some places, workers' comp has become so expensive that it's putting small companies out of business or prompting them to skirt the law. Others are fighting back, trying to keep workers' comp costs down or fighting for reform.

It Begins
Workers' compensation, a program begun in the early 1900s that forced employers to give health insurance and cash benefits to employees hurt on the job, has always been a significant expense for entrepreneurs-particularly those in manufacturing, where serious injuries are more common. According to the National Academy of Social Insurance, a research organization, workers' comp is the third-largest source of support for injured workers, surpassed only by Medicare and Social Security.

But over the past five years, workers' comp has become an even bigger expense. Jack Hannan of the Workers' Compensation Insurance Rating Bureau of California, a nonpartisan research agency in San Francisco, says that before recent legislative reforms in Sacramento, workers' comp insurance premiums in California were likely to rise by about another 12 percent in 2004. In Florida, workers' compensation premiums rose by nearly 14 percent annually as of April 2003; while in Missouri, premiums rose by about 15 percent annually. The Insurance Information Institute, a research organization, estimates the average cost of workers' comp nationwide has increased by 50 percent since 2000. "Rates are stratospheric," says Richard Millman, 52, president of Millman Lumber, a 100-employee lumber wholesaler in St. Louis.

Worse, in industries with higher accident rates, workers' comp can become almost a second payroll. Michael Hamman, 56, a general contractor in San Francisco with three employees, pays 54 cents in workers' comp premiums for every salary dollar his carpenters earn. "For roofers, you pay 99 cents," he says. "I'm going broke."

A storm of factors is pushing workers' comp premiums through the roof. "The driver of workers' comp is health-care costs," says William S. Custer, an expert on workers' compensation at Georgia State University in Atlanta. As health-care costs have gone up, workers' comp costs have risen, he says. And in the '90s, states like California and Missouri deregulated the workers' comp market, allowing private insurers to set their own rates. Competition for workers' comp business became fierce. To win market share, many insurance companies tried to undercut their rivals; several went out of business. With fewer companies in the market, there is now less competition, higher rates and less monitoring of workers' comp fraud. Fraud drives premiums up because insurers have to increase their cost reserves to cover potential fraud. In fact, in California, the number of fraud cases prosecuted by district attorneys fell by more than 30 percent between 1999 and 2000, and again in 2001 and 2002.

Meanwhile, increased litigation has also impacted workers' comp costs. Over the past decade, many states have loosened rules on where lawyers can advertise. As a result, experts say, lawyers can easily target people hurt on the job and take claims to court rather than settling them out of court with the employer and insurer, which is what workers' comp originally intended. These are only a few of the factors creating a crisis in workers' comp.

Fighting for Their Lives

Entrepreneurs are trying anything and everything to manage rising workers' comp costs. "I'm not buying new capital equipment, and I'm trying not to lay off employees I've had for a long time," says Hamman. He says he isn't taking on new hires, yet still fears that if workers' comp continues to rise, he may go out of business.

Other small companies are adopting similar strategies. "Some have held back salary increases or say they're not going to add employees," says Hauge. At worst, he says, entrepreneurs are entering the underground economy-not carrying workers' comp or giving cash payoffs to injured employees and not reporting the claims to insurers, both of which are illegal.

Others are shopping around. Colleen Galli, president of InfoPac International Inc., a Burnsville, Minnesota-based Internet integration firm, says, "We are aggressive in our [insurance] shopping, and we try to buy from our own clients." Buying from local insurers who use her IT services, Galli says, gives InfoPac leeway to negotiate a better rate, because she can give them a deal on IT services.

Like other employers, Galli also tries to inculcate into employees the idea that everyone in the company must work together to keep workers' comp costs down because no one benefits if the company incurs huge workers' comp losses. "We try to get the message across that we're all on the same page," says Galli, 47.

Meanwhile, other entrepreneurs are removing themselves from workers' comp (laws don't require employers to cover themselves), increasing employees' contributions to other types of health insurance, and considering self-insurance for workers' comp or joining other small companies to create group self-insurance plans. But self-insurance can be risky, and group insurance makes every entrepreneur in the group liable for others' problems. "If you're going into self-insurance, be careful," warns Eric Oxfeld, president of UWC-Strategic Services on Unemployment & Workers' Compensation, a national business association. "You might be able to get a lower upfront cost [because you're not dealing with an insurer]. But a catastrophic cost can hurt you more."

Other entrepreneurs are trying to keep their workers' comp rates low by upgrading safety precautions. Paul Darley, president and COO of W.S. Darley & Co., a Melrose Park, Illinois, emergency equipment manufacturer with about $50 million in annual sales, hired a safety director in 1999. "Before that, workers' comp costs had been going through the roof," he says. "At the time, I didn't feel we were large enough to support a permanent safety director."

Darley was wrong: The new director proved he was worth his salary. He implemented safety programs, instructed employees in safety compliance, installed new equipment to reduce the amount of manual labor, and even combed through W.S. Darley's old accident reports to look for patterns. "It showed employees we were taking a serious interest in their health-and it became a collaborative effort," Darley says. "We put into place reward programs for hitting milestone dates without an accident." When Entrepreneur spoke with Darley in October 2003, his company was celebrating 800 days without a serious workplace accident. Says Darley, "[Our] workers' comp premiums were a fraction of what we paid four years ago."

Small firms can improve workplace safety by inviting an expert from the insurance company to assess their work environment, says Oxfeld. "Many insurers will provide free inspections if asked," he says. Oxfeld also suggests that employers increase scrutiny of drug use and abuse-particularly of prescriptions covered by workers' comp.

Other entrepreneurs feel they can't do anything about workers' comp costs individually. And to some extent, they're right. Millman, who has shopped for better rates and improved safety in his workplace, still watched helplessly as his workers' comp expenses increased precipitously. "Workers' comp is an uncontrollable expense," he says.

Laying Down the Law

To address the workers' comp crisis, state legislatures have begun to pass reform bills. Missouri stimulated competition in the workers' comp insurance market by forcing the state workers' comp insurer to compete with private carriers, and Oregon pioneered the use of managed-care controls in workers' comp health insurance. In the past year, Florida passed a reform to reduce 2004 workers' comp rates by nearly 14 percent, by defining injuries more objectively and preventing lawyers from receiving hourly workers' comp litigation fees. In October 2003, California passed a reform to control medical costs by increasing fraud penalties, encouraging generic drug use and promoting workplace safety. And at press time, Gov. Schwarzenegger proposed to slash $11 billion from California's workers' comp system to decrease insurance premiums.

Still, Eric Oxfeld of UWC-Strategic Services on Unemployment & Workers' Compensation says it's too early to say how effective the reforms will be. And some entrepreneurs are concerned that clauses in reform bills will mean more costs to them. "One problem with the legislation [in California] is every [business] now has to have an injury and illness prevention program in writing," says Scott Hauge, president of CAL Insurance & Associates Inc. "The cost of this will be $1,000 to $1,500 per company."

Taking a Stand

Many beleaguered entrepreneurs believe political action can help reform workers' compensation and decrease costs. "Workers' comp is killing me, so I've become a vocal thorn in [the government's] side," says Hamman. "I'm optimistic that this issue will create alliances of small businesses."

Entrepreneurs who have pushed for workers' comp reform have focused on a few key issues. Working with national trade organizations, or forming local small-business alliances, as Hauge has done by creating San Francisco Small Business Advocates, they have pushed for reform of workers' compensation litigation. One issue: In many states, workers' comp attorneys are paid by the hour, which encourages litigation over minor issues, according to the Insurance Information Institute. Entrepreneurs have advocated for states to restrict lawyers to a fixed rate for workers' comp litigation, set more objective means of assessing workplace injuries, and limit lawyers' ability to advertise so that more money is spent on injured parties.

What's more, entrepreneurs have pushed for reforms that introduce ways to control workers' comp medical costs, encourage competition in the insurance market and cut down on fraud. Some have suggested that states introduce caps on the number of visits workers' comp recipients can make to medical specialists, add co-pays and deductibles to workers' comp, let employers choose workers' comp physicians, and use other elements of managed care. Even in California, the situation has begun to improve. "California enacted workers' comp reform [in October 2003]," says Oxfeld. "It was the result of businesses in California uniting to pressure the legislature. Things can change. Legislators do listen."

What Caused the Crisis?
  • Rising health-care costs: According to Eric Oxfeld, president of UWC-Strategic Services on Unemployment & Workers' Compensation, costs rose because workers' comp insurance doesn't include solutions to expensive health care, such as co-pays and deductibles, which traditional medical insurance uses. And since workers' comp provides unlimited lifetime medical care, employees are tempted to claim all medical problems under workers' comp.
  • The aging work force: Older employees get hurt and sick on the job more often, increasing workers' comp costs. According to the National Academy of Social Insurance, injured workers aged 45 to 64 were bedridden for an average of five weeks, compared to about three and a half weeks for those aged 25 to 44.
  • Lack of competition: According to the Insurance Information Institute, 15 of the 39 insurers that failed in 2002 were in the workers' comp insurance business. "Now we put out 10 bids to cover us and only get two [responses]," says expert William S. Custer with Georgia State University in Atlanta. That's because so many insurers are out of business.
  • 9/11: September 11 decimated the balance sheets of reinsurers that provide insurance for insurance carriers. Reinsurers passed on costs to insurance companies, who passed them on to clients. September 11 also showed office workers could be at just as much risk as manual laborers. As a result, some insurance firms raised workers' comp premiums for professional businesses, making them equal to those paid by manufacturing firms, which traditionally paid more for workers' comp.

Joshua Kurlantzick is a writer in Washington, DC.