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SURVIVAL OF THE FITTEST
In nature, as in business, a competitive edge is necessary for survival.
From Darwin's theories of evolution to Adam Smith's theories of economics, the
underlying theme of "Survival of the Fittest" has endured.
These ideas also serve to illustrate the environment in the workers'
compensation industry over the past year. Therefore, we have adopted "Survival
of the Fittest" as the theme for this annual report. It is a fitting metaphor
for how Superior National-TM- Insurance Group, Inc. has survived in an
increasingly treacherous workers' compensation marketplace.
[BEGIN SIDEBAR TEXT]
"THE ORIGIN OF SPECIES", CHARLES DARWIN
CAN WE DOUBT (REMEMBERING THAT MANY MORE INDIVIDUALS ARE BORN THAN CAN
POSSIBLY SURVIVE) THAT INDIVIDUALS HAVING ANY ADVANTAGE, HOWEVER SLIGHT, OVER
OTHERS, WOULD HAVE THE BEST CHANCE OF SURVIVING AND OF PROCREATING THEIR KIND?
ON THE OTHER HAND, WE MAY FEEL SURE THAT ANY VARIATION IN THE LEAST DEGREE
INJURIOUS WOULD BE RIGIDLY DESTROYED. THIS PRESERVATION OF FAVOURABLE INDIVIDUAL
DIFFERENCES AND VARIATIONS, AND THE DESTRUCTION OF THOSE WHICH ARE INJURIOUS, I
HAVE CALLED NATURAL SELECTION, OR THE SURVIVAL OF THE FITTEST. VARIATIONS
NEITHER USEFUL NOR INJURIOUS WOULD NOT BE AFFECTED BY NATURAL SELECTION, AND
WOULD BE LEFT EITHER A FLUCTUATING ELEMENT, AS PERHAPS WE SEE IN CERTAIN
POLYMORPHIC SPECIES, OR WOULD ULTIMATELY BECOME FIXED, OWING TO THE NATURE OF
THE ORGANISM AND THE NATURE OF THE CONDITIONS.
FROM THESE SEVERAL CONSIDERATIONS I THINK IT INEVITABLY FOLLOWS, THAT
AS NEW SPECIES IN THE COURSE OF TIME ARE FORMED THROUGH NATURAL SELECTION,
OTHERS WILL BECOME RARER AND RARER, AND FINALLY EXTINCT. THE FORMS WHICH STAND
IN CLOSEST COMPETITION WITH THOSE UNDERGOING MODIFICATION AND IMPROVEMENT WILL
NATURALLY SUFFER MOST.
[END SIDEBAR TEXT]
TO OUR STOCKHOLDERS
SUPERIOR NATIONAL
To Our Stockholders:
On December 10, 1998, Superior National-TM- Insurance Group, Inc.
acquired Business Insurance Group, Inc. ("BIG"), becoming the ninth largest
workers' compensation insurance company in the nation, and the largest
private sector underwriter of workers' compensation insurance in the State of
California. Your Company has 41 offices underwriting in 38 states and the
District of Columbia, approximately 1,400 employees, 55,000 policyholders,
and is responsible for the safety, health, and care of more than one million
working people. I think it would be appropriate to state that by working
together toward this goal, Superior's employees, stockholders, management,
and producers made Superior's success happen, our competitors watched it
happen, and I would venture to guess that there are a number of other
observers now wondering just what happened. Superior National over the last
eight years has progressed from a minor force in the California workers'
compensation market to a national workers' compensation company and the
largest private sector workers' compensation underwriter in California, the
largest single market in the United States. We will use this, our first
full-fledged Annual Report to Stockholders, to explain how and why this
occurred.
But first, the vital statistics. As you see, 1998 was a year of records;
many, but not all, arising out of the acquisition of BIG.
- -- Premium in force increased from $144 million to $669 million for the policy
years ending December 31, 1997 and 1998, respectively.
- -- Net investment income increased from $12.7 million in 1997 to $16.2 million
in 1998.
- -- Premium in force per employee increased from $351,000 million at year-end
1997 to $485,000 million at year-end 1998.
- -- Stockholders' equity increased from $60 million at December 31, 1997 to
$224 million at December 31, 1998.
- -- Statutory capital and surplus of our combined insurance companies
increased from $102 million to $340 million at December 31, 1997 and 1998,
respectively.
Due in part to a one-time write-off during the fourth quarter, Superior
National incurred a net loss for the fourth quarter of 1998 of approximately $20
million, and approximately $14 million for the year. A review of the business
acquired through the 1997 purchase of Superior Pacific Casualty Company
(formerly The Pacific Rim Assurance Company, or "Pac Rim") indicated that the
reduction during 1998 of
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premiums generated through former Pac Rim producers, and the resulting
diminution of the expected future profitability of Pac Rim's business
franchise, required a write-off of goodwill associated with the acquisition.
The fourth quarter loss includes a charge of $34.6 million. The reduction in
premiums generated by Pac Rim producers resulted from Superior National's
application of more rigorous underwriting and pricing standards to the
acquired Pac Rim business. Superior National's tangible book value at
December 31, 1998 would have been the same with or without the goodwill
write-off.
The consolidation of BIG and Superior National operations is proceeding
according to plan. Our $142 million 1999 budget reflects a reduction of the two
companies' combined controllable expenses of approximately $56 million versus
1998. Depending on the speed with which BIG's data processing systems are
converted, expense savings may exceed our initial expectations.
Our stockholders may rest assured that Superior National is ready for the
year 2000, and, in fact, is already operating in the new era. We began issuing
policies that expire in the year 2000 in January of this year, and any
computational issues associated with the 1999-2000 transition would have
appeared already. None did. We are also confident that the equally critical
2000-2001 transition will be similarly uneventful.(1)
We who underwrite workers' compensation insurance live in interesting
times. A desperate battle for survival is being waged by an ever-decreasing
group of workers' compensation insurance companies in California, and the
relatively benign pricing and benefits environment that existed across much of
the rest of the country from 1995 to 1997 vanished during 1998. The competition
for workers' compensation business is possibly the most intense in the history
of the workers' compensation line of business, and, perhaps, in any line of the
insurance business.
The legal environment as it pertains to workers' compensation in California
is also unsettled, but perhaps improving. Trial lawyers have enjoyed several
years of courtroom victories in class action lawsuits attempting to break
California's "exclusive remedy" doctrine, under which workers' compensation
disputes are supposed to be resolved by workers' compensation judges or the
California Department of Insurance. Superior National won an important appellate
decision in early 1999, however, that may reverse the tide of adverse litigation
against the entire industry. While some of our competitors prematurely settled
some of the class action lawsuits, paying millions of dollars in settlements,
Superior National fought on, and we will continue the fight to protect the
exclusive remedy doctrine up to the California Supreme Court.
The legislature is likely to enact a benefit increase during 1999 and, at
the writing of this letter, big labor's asking price is $1.75 billion. While a
benefit increase of this magnitude is unlikely to become law, California
employers will likely be required to ante
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between $1 billion and $2 billion of additional workers' compensation premium
per annum, representing a substantial return of the savings reaped by
employers during the first four years of open rating. There is some
speculation that a benefit increase could result in a firming up of the
overall rate level, but we're not so sanguine.
A word about recent developments in workers' compensation reinsurance is
also in order. Beginning in late February 1999 a wave of publicity swept the
insurance industry regarding workers' compensation reinsurance contracts sold
mainly to life reinsurance companies through reinsurance intermediaries known
as "underwriting managers". The controversial reinsurance contracts sold by
certain underwriting managers, generically known as "buy-downs", involved the
reduction of specific excess of loss "attachment points" to levels considered
extremely low by historical standards. We have heard of "buy-downs" that
attached at levels as low as $10,000 per occurrence, with a
disproportionately low amount of premium ceded to the reinsurer relative to
expected losses. Superior National's excess of loss reinsurance contracts are
not "buy-downs" and attach at a traditional retention level of $500,000 per
occurrence. In addition, unlike "buy-downs," Superior National's large
account quota share contract applies to policies having estimated premium of
$25,000 or more, and premium and losses are ceded strictly on a proportional
basis. On April 1, 1999, the California Department of Insurance announced
that it would hold a public hearing in May of 1999 to investigate the extent
of potential losses arising out of reinsurance programs sold by certain
underwriting managers, and the degree to which California companies may be
involved. The California Department of Insurance also announced that it may
promote legislation to address issues surrounding the reinsurance of workers'
compensation by life insurance companies.
Superior National's position is that the reinsurance of its high excess of
loss exposure by life and health insurance companies is the most cost effective
way in which to protect itself against catastrophic losses. Further, this form
of reinsurance has historically been profitable for life and health reinsurers.
Superior National believes that it is in the best interest of primary insurers
and their customers to preserve the option of purchasing "carve-out" reinsurance
with life and health markets.
Superior National and all of its competitors use reinsurance in a variety
of ways. We use reinsurance to protect reserves acquired through acquisitions,
and to mitigate individual or aggregate catastrophes. Certain of our competitors
have demonstrated that, for brief periods of time, reinsurance can apparently be
utilized to support inadequate pricing. Superior National has consistently
attempted to charge adequate rates, and has avoided the use of reinsurance
simply to generate cash flow at the expense of operating margins. Ironically, we
believe the recently publicized issues surrounding workers' compensation
reinsurance, and the regulators' responses to those issues, should have the
effect of increasing price levels across the nation.
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Notwithstanding the issues facing the California workers' compensation
industry, Superior National's position and standing in the California market
is enviable. We have the advantage of a dominant market position, occupying
the "high ground" as it were, and the technology necessary to exploit that
position. Our stockholders should also continue to take their greatest
comfort in the fact that their interests are aligned with Capital Z/Insurance
Partners. Superior National's long-term relationship with these organizations
is its principal strategic asset, and the success that has historically been
associated with this partnership is expected to continue. Finally, I wish to
congratulate Superior's employees and management for the outstanding effort
they have expended to bring Superior to its prominent position in the
workers' compensation marketplace. I am optimistic that our employees and
managers will continue to bring success to our Company and its shareholders.
William L. Gentz
President and Chief Executive Officer
(1) Superior National does not feel that year 2000 ("Y2K") issues will interrupt
its normal operations significantly. However, this Y2K readiness response is not
a warranty or guarantee and is not intended to enlarge any right, obligations or
remedies between our stockholders and Superior National. Our operations are
depended upon a variety of third-party suppliers of goods and services whose Y2K
readiness is beyond our control. We will endeavor to develop contingency plans
to support the continuation of our operations in the event of failures by such
third parties, but it is possible that some disruptions may occur as a result of
such third-party failures.
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Superior National is a national workers' compensation underwriter with
branch offices doing business in 37 states in addition to California. At
present, however, $550 million of the expected $750 million of expected 1999
premium will be produced in California, and California economic and legal issues
continue to have a disproportionate effect on the Company's prospects. This,
our first full-fledged Annual Report to Stockholders, is intended to provide our
shareholders with a sense of the California competitive environment, and the
major issue affecting the California workers' compensation market today; the
increasing severity of claim and claim adjustment expenses. We will finish with
some brief commentary on the national workers' compensation market. The theme
of this report is "Survival of the Fittest," which we think is appropriate in
light of the rigors of four years of open rating competition and Superior
National's achievements during this same period of time.
COMPETITIVE ENVIRONMENT
The competitive situation is influenced principally by California's
workers' compensation laws. From the inception in 1913 of statutorily required
workers' compensation insurance in California until 1995, the California
workers' compensation system was designed to ensure ample capacity and solvency
at the expense of a certain degree of efficiency. Workers' compensation
companies in California were required to charge any policyholder the same price,
with competition for policies taking place after the policy expired on the basis
of dividend payments. Such a system encouraged insurers to provide specialized
loss control and claims services to drive down their customers' claims costs.
This system also encouraged the formation of "boutique" workers' compensation
insurance underwriters who, thanks to the minimum rate law, could compete with
large insurers possessing otherwise insurmountable economies of scale.
In mid-1992, however, in response to employers' concerns about rising
workers' compensation costs in California, the legislature passed a series of
benefit increases and rating law reforms. The increase in claims costs leading
to the reforms occurred due to a number of negative incentives enacted in 1989
that encouraged employees and the
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medical and legal professions to file fraudulent and abusive claims. The
legislature addressed the seemingly uncontrollable fraud that occurred from
1990 to mid-1992 by modifying certain of the more naive benefit laws. The
legislature further redesigned the rating law to weed out of the workers'
compensation system the small, but less efficient, "boutique" companies
encouraged under the minimum rate law.
Under such circumstances the wholesale extinction of many competitors was
inevitable. Many of the old line leaders of the California workers' compensation
industry are either no longer in business or are pale shadows of what they once
were in terms of market share, market influence, and profitability. Ironically,
many market leaders were the most vociferous advocates of open rating. With
hubris born of generations of operations under the minimum rate law, the
management of these companies seemed to have believed that because they had
always been a part of "the system," they would always continue to be part of the
system. In actuality, the longer-lived the company and its
[BEGIN PHOTO CAPTION]
OBLITERATING SHOCK WAVES, STUPENDOUS EARTHQUAKES, ENORMOUS TSUNAMI, A
RAIN OF FIRE, SMOKE, SOOT, DARKNESS, A GLOBAL DEEP FREEZE, WORLDWIDE ACID
RAIN, OZONE LOSS, GREENHOUSE WARMING - IT SEEMS A MIRACLE THAT ANYTHING COULD
HAVE SURVIVED.
[END PHOTO CAPTION]
[BEGIN SIDEBAR TEXT]
SIXTY-FIVE MILLION YEARS AGO A COMET OR ASTEROID 10 KM TO 15 KM IN
DIAMETER APPROACHED THE EARTH. IT WAS TRAVELING AT COSMIC SPEEDS SOMEWHERE
BETWEEN 20 KM AND 70 KM PER SECOND AND FOR THAT REASON, CARRIED WITH IS AN
ENERGY ON THE ORDER OF 100 MILLION MEGATONS OF TNT, FAR MORE ENERGY THAN
CONTAINED IN ALL THE WORLD'S NUCLEAR WEAPONS AT THE HEIGHT OF THE COLD WAR.
AN ALMOST IRRESISTIBLE FORCE WAS ABOUT TO MEET AN IMMOVABLE OBJECT.
IN ONE LOCATION RECENTLY STUDIED BY GEOLOGISTS, OF THE 111 SPECIES OF
LAND-DWELLING VERTEBRATES PRESENT, 35 SURVIVED, A SURVIVAL RATE OF 32
PERCENT. NONE OF THE 20 SPECIES OF DINOSAUR HAD MADE IT; THEIR PERCENTAGE
SURVIVAL RATE WAS 0. BUT WHAT ABOUT THE MAMMALS? THE COMPLETE EXTINCTION OF
THE FASCINATING DINOSAURS HAS OBSCURED THE DEVASTATING BLOW STRUCK TO THE
SMALLER AND LESS INTERESTING MAMMALS. ONLY 1 OUT OF 28 MAMMAL SPECIES
SURVIVED! ANOTHER STUDY FOUND THAT WHILE 88 PERCENT OF LAND DWELLERS BECAME
EXTINCT, ONLY 10 PERCENT OF THE FRESHWATER ASSEMBLAGE DID SO. WHAT COULD
EXPLAIN THIS DISTINCT DIFFERENCE IN SURVIVAL RATE? IT AROSE BECAUSE THE
DINOSAURS AND OTHER LAND DWELLERS WERE AT THE TOP OF A FOOD CHAIN BASED ON
LIVING PLANTS, SOME 80 PERCENT OF WHICH BECAME EXTINCT, WHEREAS THE WATER
DWELLERS WERE PART OF A CHAIN MORE DEPENDENT ON ORGANIC DETRITUS LEFT BEHIND
IN LAKES, STREAMS, SOIL AND ROTTING LOGS. OUR MAMMALIAN ANCESTORS MAY HAVE
SURVIVED BECAUSE THEY WERE PART OF, OR WERE ABLE TO BECOME PART OF, THE
DETRITUS-BASED FOOD CHAIN.
"NIGHT COMES TO THE CRETACEOUS, DINOSAUR EXTINCTION AND THE
TRANSFORMATION OF MODERN GEOLOGY," BY JAMES LAWRENCE POWELL, USED
WITH PERMISSION OF THE AUTHOR AND W.H. FREEMAN AND COMPANY.
[END SIDEBAR TEXT]
management, the more ill-suited was its culture and management to adapt to
the challenges of open rating. The list of companies competing in the
California workers' compensation market at the end of 1994 who no longer
exist as independent players, no longer exist at all, or are out of the
business of underwriting workers' compensation in California, is lengthy.
During the first few months of 1999, several of the remaining owners of
California specialty workers' compensation companies have announced their
interest in selling.
Regardless, Superior National is fortunate to be operating in perhaps the
least regulated line of insurance in the nation, which represents a drastic
change from the heavy regulation that prevailed prior to 1995. Since January 1,
1995, few constraints exist with respect to the products we can offer, the
prices we can charge, the policy forms we can use, or the commissions we can
pay. Strict regulatory controls exist with respect to benefits and vendor
payments, however, and the California Department of Insurance is clearly ready
to take action against workers' compensation underwriters who fail to measure up
to high standards of solvency and business ethics. The California Insurance
Commissioner is nevertheless on record describing the California workers'
compensation market in general as healthy and profitable.
Given the decimation of much of the top tier of private sector companies
competing in the California workers' compensation market, a case could be made
that the long term effects of open rating will lead to a less competitive
environment. The 1993 reform legislation placed a limit on the potential market
share of any private sector workers' compensation underwriter, excluding the
California State Compensation Insurance Fund ("State Fund"), to less than 20
percent of the market. Thus, the current workers' compensation law contemplates
the possible distillation of the market down to as few as six private sector
underwriters and the State Fund. As a result of the minimum rate law,
California consumers will soon be in a position to reap the economic benefits
that sometimes originate from an oligopoly.
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Ironically, open rating was a primary catalyst to elevate Superior
National. This is self-evident given the position of the Company today
relative to both its continuing and diminished competition, but has been
quite a surprise to the California workers' compensation market. There were
several reasons why Superior National has prospered when so many others have
not.
First, it would have been impossible for Superior National on its own
to destabilize the market as thoroughly as open rating destabilized it,
regardless of the extent of our product innovation, technological
sophistication, or operating discipline. The traditional leaders of the
California workers' compensation market were well entrenched with generally
satisfied customers and complacent distribution systems. Innovation could only
go so far to pry those customers and distribution systems loose. The California
open rating law was, perhaps, the most destabilizing event to occur in the
primary insurance markets in decades. Open rating cleared the traditional market
leading insurers out of the way with the force and finality of a wrecking ball.
[BEGIN PHOTO CAPTION]
Due to the lack of natural enemies on the island of Mauritius, the aptly
named dodo bird lost its ability to fly. Thus, it was easy prey to the
Portuguese sailors who landed on the island in 1598 AD. The dodo greeted the
sailors with a child-like innocence. In return, the dodo was hunted just for
fun until it was fully extinguished in 1681.
[END PHOTO CAPTION]
Second, open rating leveled the playing field, literally overnight.
Effective January 1, 1995, the number of years a company had underwritten
workers' compensation in California meant nothing. The liberality of a
company's dividend scales and the reliability of its dividend payment history
became irrelevant. Political influence, trade association contacts, and
producer relationships all diminished in importance. All that mattered for most
policyholders was price. The multitude of factors that were outside of our
control prior to open rating were reduced to just the one factor of price.
Superior National charged more, on average, than its competition and suffered
significant declines in premium from 1995 to 1997 as a result, but the issue
after 1994 was only whether or not our price was competitive.
Third, and perhaps most important, Superior National's corporate culture
was able to adapt to open rating better than its competitors. Beginning in
1991, management had of necessity instilled a culture emphasizing urgency and
no mistakes, a "backs-against-the-wall" culture quite unlike that of our
competition. Thus, the disorientation and shock so clearly in evidence with
many competitors had less effect on Superior National. Open rating was
business-as-usual: a daily battle for existence against a very hostile
universe. Things had never been safe and stable for Superior National, and
the Company was spared the wrenching experience of having to instantaneously
adjust its view of the competitive universe, something most of the industry
was ultimately unwilling or unable to do.
Whatever the reasons for the emergence of Superior National as the largest
private sector player in the California workers' compensation market, we have
clearly proven our fitness to survive against great odds. The organization that
ranks first among private sector underwriters in California today was, a mere
eight years ago, a minor player on the periphery of the workers' compensation
industry. Even as late as 1994 it would be safe to say that no one would have
picked
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Superior National to emerge as the principal beneficiary, and most successful
consolidator, in the California workers' compensation market.
Today, when the Company's competitors consider Superior National, they are
confronted with a difficult problem:
- -- Superior National is one of the largest private sector workers' compensation
companies that has ever existed in California in terms of aggregate direct
written premium. The Company's ability to access and influence the California
market exceeds that of any of its private sector competitors.
- -- Superior National's access to public and private capital markets is both
proven and formidable. The Company's strategic business relationship since
1991 with Insurance Partners and Capital Z Partners has borne fruit beyond
the most optimistic expectations. International Insurance Investors,
Insurance Partners, and now Capital Z Partners, are names that the
stockholders will be familiar with by virtue of their consistent financial
and reinsurance support, and increasing stake in the Company's ownership.
This relationship represents one of Superior National's principal strategic
assets, and it is a unique asset that many of our competitors cannot match.
- -- In the recent past California workers' compensation companies that
attempted to assert market leadership through drastic increases in market
share often lacked discipline. Superior National, however, has an
experienced and disciplined management team that has survived significant
adversity, and is supported by one of the finest computer systems that has
ever been developed in the
"WEALTH OF NATIONS," ADAM SMITH
THE MARKET PRICE OF EVERY PARTICULAR COMMODITY IS REGULATED BY THE
PROPORTION BETWEEN THE QUANTITY WHICH IS BROUGHT TO MARKET, AND THE DEMAND OF
THOSE WHO ARE WILLING TO PAY THE NATURAL PRICE OF THE COMMODITY, OR THE WHOLE
VALUE OF THE RENT, LABOUR, AND PROFIT, WHICH MUST BE PAID IN ORDER TO BRING
IT THITHER. SUCH PEOPLE MAY BE CALLED THE EFFECTUAL DEMANDERS, AND THEIR
DEMAND THE EFFECTUAL DEMAND; SINCE IT MAY BE SUFFICIENT TO EFFECTUATE THE
BRINGING OF THE COMMODITY TO MARKET. IT IS DIFFERENT FROM THE ABSOLUTE
DEMAND. A VERY POOR MAN MAY BE SAID IN SOME SENSE TO HAVE A DEMAND FOR A
COACH AND SIX, HE MIGHT LIKE TO HAVE IT; BUT HIS DEMAND IS NOT AN EFFECTUAL
DEMAND, AS THE COMMODITY CAN NEVER BE BROUGHT TO MARKET IN ORDER TO SATISFY
IT.
WHEN THE QUANTITY BROUGHT TO MARKET EXCEEDS THE EFFECTUAL DEMAND, IT
CANNOT BE ALL SOLD TO THOSE WHO ARE WILLING TO PAY THE WHOLE VALUE OF THE
RENT, WAGES AND PROFIT, WHICH MUST BE PAID IN ODER TO BRING IT THITHER. SOME
PART MUST BE SOLD TO THOSE WHO ARE WILLING TO PAY LESS, AND THE LOW PRICE
WHICH THEY GIVE FOR IT MUST REDUCE THE PRICE OF THE WHOLE. THE MARKET PRICE
WILL SINK MORE OR LESS BELOW THE NATURAL PRICE, ACCORDING AS THE GREATNESS OF
THE EXCESS INCREASES MORE OR LESS THE COMPETITION OF THE SELLERS, OR
ACCORDING AS IT HAPPENS TO BE MORE OR LESS IMPORTANT TO THEM TO GET
IMMEDIATELY RID OF THE COMMODITY. THE SAME EXCESS IN THE IMPORTATION OF
PERISHABLE, WILL OCCASION A MUCH GREATER COMPETITION THAN IN THAT OF DURABLE
COMMODITIES; IN THE IMPORTATION OF ORANGES, FOR EXAMPLE THAN IN THAT OF OLD
IRON.
WHEN THE QUANTITY BROUGHT TO MARKET IS JUST SUFFICIENT TO SUPPLY THE
EFFECTUAL DEMAND AND NO MORE, THE MARKET PRICE NATURALLY COMES TO EITHER
EXACTLY, OR AS NEARLY AS CAN BE JUDGED OF, THE SAME WITH THE NATURAL PRICE.
THE WHOLE QUANTITY UPON HAND CAN BE DISPOSED OF FOR THIS PRICE, AND CANNOT BE
DISPOSED OF FOR MORE. THE COMPETITION OF THE DIFFERENT DEALERS OBLIGES THEM
ALL TO ACCEPT OF THIS PRICE, BUT DOES NOT OBLIGE THEM TO ACCEPT OF LESS.
EXCERPT FROM "OPEN RATING," HON. CHUCK QUACKENBUSH, CALIFORNIA INSURANCE
COMMISSIONER, CALIFORNIA WORKERS' COMPENSATION ENQUIRER, JULY 1998
FOR DECADES, WORKERS' COMPENSATION INSURANCE RATES WERE LIKE YOUR FAMILY
FURNACE, YOU SET THE THERMOSTAT AND IT PRETTY MUCH RAN ITSELF. ONLY THE
PEOPLE DIRECTLY INVOLVED IN THE SYSTEM KNEW OR CARED ABOUT IT. IT WAS A TIME
FOR A BASIC CHANGE IN RATE REGULATION. THE 1980S AND 1990S HAVE SEEN THE
WORLDWIDE TRIUMPH OF THE IDEA OF FREE MARKETS. FROM WASHINGTON TO MOSCOW,
FROM PARIS TO BEJING, A SPEAKER CAN ASSERT THAT GOVERNMENT CONTROL OF PRICES
EVENTUALLY LEADS TO STAGNATION AND INEFFICIENCY AND EXPECT TO SEE MOST HEADS
NODDING IN AGREEMENT. BY 1993, THE IDEA OF GOVERNMENT IMPOSED MINIMUM RATE
FOR ALL INSURERS SEEMED LIKE A TRITE COG IN THE COMP MARKET'S ENGINE,
HAMPERING THE STATE'S OVERALL COMPETITIVENESS BY INFLATING EMPLOYERS' BOTTOM
LINE.
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STILL IT MAKES A LOT OF PEOPLE UNCOMFORTABLE, INCLUDING MANY INSURERS, TO
THINK OF GIVING UP GOVERNMENT RATES. AFTER ALL, IT WAS ARGUED THAT WORKER'S
COMPENSATION IS NOT LIKE ANY OTHER LINE OF INSURANCE. IT HAS TO BE BOTH
AVAILABLE AND AFFORDABLE. ALLOWING WORKERS' COMPENSATION TO UNDERGO THE
CYCLES OF ALTERNATING HARD AND SOFT MARKETS SEEN IN OTHER LINES COULD WREAK
HAVOC IN CALIFORNIA'S ECONOMY.
AFTER MUCH THOUGHT AND DISCUSSION IN THE LEGISLATURE AND THE GOVERNOR'S
OFFICE, WE DECIDED THAT 80 YEARS OF FORCING INSURERS TO WEAR TRAINING WHEELS
WAS ENOUGH. IT WAS TIME TO LET THE CLEAN AIR OF COMPETITION BLOW THROUGH THE
INDUSTRY AND CLEAR OUT THE COBWEBS.
THIS IS GOVERNMENT AS IT SHOULD BE - FACILITATING THE FLOW OF MARKET
INFORMATION, NOT DICTATING RIGID DRACONIAN RATES TO THE BUSINESS COMMUNITY.
ALLOWING PRICE COMPETITION HAD A HUGE IMPACT. THE IMMEDIATE EFFECT OF
THE "BIG BANG" OF OPEN RATING WAS A SHARP DROP IN COLLECTED PREMIUM. IN
1994, CALIFORNIA'S WORKERS' COMPENSATION CARRIERS COLLECTED OVER $9 BILLION
FROM THE STATE'S EMPLOYERS. BY 1997, THE INDUSTRY WAS COLLECTING ABOUT $5.4
BILLION. THE BIG WINNERS WERE CALIFORNIA EMPLOYERS AND EMPLOYEES. THE
BILLIONS THAT WERE SAVED ON WORKERS' COMPENSATION PREMIUMS WERE AVAILABLE FOR
MORE INVESTMENT AND EXPANSION, PRODUCING MORE JOBS FOR OUR GROWING POPULATION.
IT WOULD BE NAIVE TO THINK THAT THIS DROP IN PREMIUM DIDN'T PRODUCE SOME
DISLOCATION. IN THE FIRST YEARS OF OPEN RATING THERE WAS A RUSH AMONG SOME
INSURERS TO GAIN MARKET SHARE, SEEMINGLY REGARDLESS OF CONSEQUENCES. THE
COMPANIES THAT WERE CALIFORNIA-ONLY WORKERS' COMP CARRIERS FOUND IT VERY
DIFFICULT TO MAINTAIN THEIR INDEPENDENCE. MOST WERE TAKEN OVER BY LARGER
COMPANIES. WORKER'S COMPENSATION INSURERS WHO WHERE ACCUSTOMED TO PASSING
THROUGH ALL THEIR COSTS IN THE MINIMUM RATE CONTEXT ARE BECOMING LEAN AND
FLEXIBLE. I RECOGNIZE THAT THIS TRANSITION IS NOT EASY FOR MANY INSURERS,
BUT I REMAIN CONFIDENT THAT THE FREE MARKET WILL REWARD THOSE WHO DO A GOOD
JOB AND GIVE GOOD VALUE TO THEIR CUSTOMERS.
OPEN RATING HAS GIVEN CALIFORNIA PROBABLY THE MOST DEREGULATED WORKERS'
COMPENSATION INSURANCE RATING SYSTEM IN THE NATION. IT'S SAFE TO SAY THE
INSURANCE INDUSTRY IS STILL WORKING OUT THE BUGS. SOME CARRIERS HAVE FIGURED
OUT HOW TO DO IT WELL WHILE MAKING MONEY, OTHERS ARE STILL STRUGGLING TO FIND
THE RIGHT BALANCE. IT HASN'T BEEN ENTIRELY EASY, BUT IN THE LONG-TERM, LESS
GOVERNMENT REGULATION WILL BENEFIT EVERYONE. MEANWHILE, THOSE OF US IN
GOVERNMENT WILL TRY TO DO WHAT WE'RE HERE FOR - TO PROTECT CALIFORNIA'S
CONSUMERS BY INSURING THAT EVERYONE PLAYS BY THE RULES.
[BEGIN PHOTO CAPTION]
"...those of us in government will try to do what we're here for - to
protect California's consumers by ensuring that everyone plays by the rules."
[END PHOTO CAPTION]
workers' compensation business. Superior National's command and control
systems enable it to create opportunities faster and achieve greater
productivity than its competition.
In summary, Superior National's California competitors are faced with
unprecedented size, incontrovertible access to capital, and a lean and
disciplined management team, backed up by one of the industry's premier data
processing systems.
CLAIMS & PRODUCTION COSTS
In 1996 we began to describe in our reports to stockholders an
unanticipated trend towards increasing severity in the California workers'
compensation market. The average cost of an indemnity claim (a claim involving
time lost from work) in California is increasing approximately 5 percent to 10
percent per year. That represents a 22 percent to 46 percent compound increase
in the severity of claim and claim adjustment expense over four years depending
on how mathematically optimistic the observer wishes to be. At the same time
severity has been dramatically increasing, premium has decreased 40 percent over
the same time. The decline in premium has been mitigated by the fact that the
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frequency with which claims occur is down 20 percent, which may cancel the
increase in severity.
If the average gross cost of sales of the workers' compensation product
is significantly higher, let's say 15 percent to 20 percent, today than it
was four years ago, the industry is in an unusual position relative to most
of the rest of American industry over the past ten years. The enormous
improvements in productivity and the decline in commodity prices that have
virtually eliminated inflation in recent years appear to have bypassed the
workers' compensation industry. Needless to say, a free market does not look
with charity upon inefficient products or industries. Yet there seems to be
a lingering feeling among some of the remaining California workers'
compensation underwriters that the market should reimburse them on a
"cost-plus" basis fundamentally the same as under the minimum rate law.
We believe the market is demonstrating a fundamental economic lesson
through the price competition wrought by open rating. Assume first that the
California workers' compensation market is a model of "hands off," free
enterprise economics. Assume further that workers' compensation companies
are willing and able to provide an unlimited supply of guaranteed cost
insurance to potential customers. In general, customer demand for guaranteed
cost workers' compensation insurance reflects perception of the value of the
product relative to substitutes. Those substitutes include full or partial
self-insurance, the "risk free" alternative of purchasing workers'
compensation insurance through the State Fund, or, perhaps, leaving
California for a less costly business environment. The demand for workers'
compensation insurance is a reflection of the value the risk-taking
underwriter provides relative to substitutes.
Customers are willing to pay only what they believe our product is
worth. One of our competitors has publicly complained about the difficulty of
persuading customers "OF THE NEED TO PAY APPROPRIATE PREMIUMS IN AN EXTREMELY
COMPETITIVE ENVIRONMENT!" No amount of persuasion will convince a customer
to pay more than they think something is worth. In the aggregate, California
businesses do not believe workers' compensation insurance is WORTH $10
billion. They have clearly informed the industry over the past four years
that the workers' compensation product IS worth $6.5 billion. Since it is
extremely doubtful that the legislature will re-institute minimum rate law
"price controls," the California workers' compensation industry has no choice
but to figure out how to make money with $6.5 billion of premium.
The economics of the California workers' compensation market is
analogous to the economics of gold mining. Regardless of the costs that are
incurred to find gold, remove it from the ground, process it into bullion,
and then transport it to storage, the market decides the price of gold on the
basis of a multitude of factors, NOT ONE OF WHICH INCLUDES THE GOLD MINE'S
COST OF PRODUCING, PROCESSING, AND TRANSPORTING GOLD. If the market price
for gold falls to levels below the average cost of production, only mines
with unique geological, geographical,
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or technological advantages will be profitable. This is no less true in the
workers' compensation insurance business. Any increases in severity and
expense must be redressed by each insurance company on its own terms. Those
who develop a competitive advantage, perhaps through the innovative use of
technology, will prosper.
There have been a number of assertions made by industry representatives,
rating agency analysts, and trade associations since 1995 as to why the
California workers' compensation market has decreased in size so dramatically.
One of the most popular statements consistently employed by the rating agencies
is that the market has declined due to intense price competition designed to
maintain or gain "market share". Open rating pricing was never driven by market
share considerations. Even Superior National's relatively dominant 7.5 percent
position in the California market is nothing like the position enjoyed by
dominant players in other industries who control 20 percent to 30 percent of a
market. What would a market share strategy bring to a company anyway? There is
no brand loyalty to be gained. Further, the total market share that may be
enjoyed by a single company is legally limited to 20 percent. It is hard to
support any assertion that open rating price competition was ever about market
share.
Another assertion has been that the brokers and agents who "control"
the policyholder/customer are driving down rates by playing workers'
compensation insurance companies against each other.
[BEGIN PHOTO CAPITON]
Uncertainty begets opportunity, and Superior National has historically been
able to capitalize on both.
[END PHOTO CAPTION]
Even ignoring the obviously counter-productive effect that reduced premiums
have on commissions, this argument does not stand up to careful scrutiny.
First, the customer is not "controlled" in any meaningful way by insurance
salesmen, as much as they might like to believe otherwise. The competition
between retail insurance agents and brokers for customers is every bit as
intense, and price and value driven, as is the competition between insurance
companies. Second, the proposition implies an auction-like process, which if
it existed would be an interesting precursor of a workers' compensation
insurance exchange, however, there is very little in the way of multi-insurer
negotiation occurring in the quoting process.
[BEGIN PHOTO CAPTION]
For the time being, the California workers' compensation market will continue
to be a fasinating laboratory for free enterprise economics.
[END PHOTO CAPTION]
What is happening is really very simple. The insured is telling the
producer what he's willing to bid, and THE WORKERS' COMPENSATION COMPANIES
ARE HITTING THE BID. And why? In its own peculiar fashion, the workers'
compensation industry appears to be saying, "We can't charge any more than
that, because, if we do, the customer will merely resort to a substitute."
We believe the importance of controlling production (i.e., claim and claim
adjustment expenses) requires some introspection on the part of the workers'
compensation industry. Much of the industry's claims infrastructure is with
difficulty adapting to the realities of a system that does not reimburse its
costs on a "cost-plus" basis. The legal and regulatory environment surrounding
workers' compensation claims processing and settlement is daunting in its
complexity and in terms of the penalties that befall the unwary or negligent.
The competition
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faced by the average workers' compensation claims examiner is formidable.
The healthcare providers and attorneys who prosecute workers' compensation
claims employ aggressive treating, billing, and settlement practices
reinforced by a judiciary that is still adjudicating claims as if the
protection provided to the industry under the minimum rate law still existed.
For the time being, however, the California workers' compensation market
will continue to be a fascinating laboratory for free enterprise economics.
The California workers' compensation experiment may also be unique in the way
that the California legislature and regulators are looking to the creation of
an oligopoly to advance the cause of consumerism. The experiment has so far
worked to Superior National's advantage as nothing else could have over so
short a period of time. We, perhaps uniquely in this industry, are content
to continue to live with a "status quo" where nothing is certain, and nothing
stays the same. Uncertainty begets opportunity, and Superior National has
historically been able to capitalize on both.
NATIONAL WORKERS' COMPENSATION MARKET
The national workers' compensation market is as varied as the 45 states
with competitive workers' compensation laws. Most of the national market is
regulated with price stability and solvency in mind. Regardless, the benign
pricing and benefits environment that existed from 1995 to 1997 disappeared
during 1998, and a search for ways to decrease claims costs to counteract
significant reductions in premium volume has begun.
Several of the panaceas promoted by workers' compensation insurers over
the past five years have generally failed to produce meaningful, if any,
results. The "managed care" revolution fizzled, and the Holy Grail of 24-Hour
Cover remains elusive. To the extent that managed care was ever a valid
concept with respect to the practice of occupational medicine, it has
manifestly failed to produce claims savings. Claim severity is on the rise
throughout the United States, and the negative publicity surrounding the
managed care activities of certain health maintenance organizations is
certain to impact managed care activities associated with occupational
medicine as well. At best, the workers' compensation insurers are gaining
very modest processing savings by purchasing claims control services from
vendors as opposed to doing the same work themselves.
Five years ago "24-Hour Cover" products (combined group health and workers'
compensation policies) were projected to provide a combination of huge sources
of new premium and reduced claims costs. Halting steps towards 24-hour cover
insurance were taken by some workers'
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compensation companies, often in partnership with accident and health
insurance underwriters. At the end of the day, however, the cost of 24-hour
cover products seemed to invariably be higher than that of the health and
workers' compensation insurance unbundled. Further, a wide gulf exists
between the workers' compensation and health insurance industries in the way
their respective products are developed and marketed. Thus, the
communication and cooperation, required of both parties to make a 24-hour
cover product work, has been elusive.
[BEGIN PHOTO CAPTION]
A wide gulf exists between the workers' compensation and health insurance
industries in the way their respective products are developed and marketed.
[END PHOTO CAPTION]
The hyper-competitive workers' compensation environment that has existed
in California during the past four years is beginning to spread across the
country. The consolidation pressures upon which Superior National has
capitalized in California will inevitably reappear elsewhere, and Superior
National will be prepared to capitalize on those opportunities as well.
SUPERIOR NATIONAL-TM- INSURANCE GROUP
Superior National's fundamental strengths are the three competitive factors
previously described:
- -- Superior National's size, and its ability to access and influence the
California market, exceeds that of any of its private sector competitors.
- -- Superior National's access to public and private capital markets, gained
principally through its strategic relationship with Insurance Partners and
Capital Z Partners is proven and formidable.
- -- Superior National has an experienced and disciplined management team that
has survived significant adversity, and is supported by one of the finest
computer systems that has ever been developed in the workers' compensation
business.
We believe this combination of strengths and advantages should operate
to assure the future success of Superior National. Superior National
survived and prospered through four years of an extremely difficult
environment in California, and we now expect to be able to duplicate this
demonstration of our fitness across the United States as well. If the
fittest are indeed those who survive and prosper, our stockholders may rest
assured that it is our goal to keep Superior National in excellent physical
condition.
"EVOLUTION AND ETHICS," THOMAS H. HUXLEY
THERE IS ANOTHER FALLACY WHICH APPEARS TO ME TO PERVADE THE SO-CALLED
"ETHICS OF EVOLUTION". IT IS THE NOTION THAT BECAUSE, ON THE WHOLE, ANIMALS
AND PLANTS HAVE ADVANCED IN PERFECTION OF ORGANIZATION BY MEANS OF THE
STRUGGLE FOR EXISTENCE AND THE CONSEQUENT 'SURVIVAL OF THE FITTEST',
THEREFORE MEN IN SOCIETY, MEN AS ETHICAL BEINGS, MUST LOOK TO THE SAME
PROCESS TO HELP THEM TOWARDS PERFECTION. I SUSPECT THAT THIS FALLACY HAS
ARISEN OUT OF THE UNFORTUNATE AMBIGUITY OF THE PHRASE 'SURVIVAL OF THE
FITTEST'. 'FITTEST' HAS A CONNOTATION OF 'BEST'; AND ABOUT 'BEST' THERE
HANGS A MORAL FLAVOUR. IN COSMIC NATURE, HOWEVER, WHAT IS 'FITTEST' DEPENDS
UPON THE CONDITIONS. LONG SINCE, I VENTURED TO POINT-OUT THAT IF OUR
HEMISPHERE WERE TO COOL AGAIN, THE SURVIVAL OF THE FITTEST MIGHT BRING ABOUT,
IN THE VEGETABLE KINGDOM, A POPULATION OF MORE AND MORE STUNTED AND HUMBLER
AND HUMBLER ORGANISMS, UNTIL THE 'FITTEST' THAT SURVIVED MIGHT BE NOTHING BUT
LICHENS, DIATOMS, AND SUCH MICROSCOPIC ORGANISMS AS THOSE WHICH GIVE RED SNOW
ITS COLOUR, WHILE, IF IT BECAME HOTTER, THE PLEASANT VALLEYS OF THE THAMES
AND ISIS MIGHT BE UNINHABITABLE BY ANY ANIMATED BEINGS SAVE THOSE THAT
FLOURISH IN A TROPICAL JUNGLE. THEY, AS THE FITTEST, THE BEST ADAPTED TO THE
CHANGED CONDITIONS, WOULD SURVIVE.
AS I HAVE ALREADY URGED, THE PRACTICE OF THAT WHICH IS ETHICALLY BEST -
WHAT WE CALL GOODNESS OR VIRTUE - INVOLVES A COURSE OF CONDUCT WHICH IN ALL
RESPECTS, IS OPPOSED TO THAT WHICH LEADS TO SUCCESS IN THE COSMIC STRUGGLE
FOR EXISTENCE. IN PLACE OF RUTHLESS SELF-ASSERTION IT DEMANDS
SELF-RESTRAINT; IN PLACE OF THRUSTING ASIDE, OR TREADING DOWN ALL
COMPETITORS, IT REQUIRES THAT THE INDIVIDUAL SHALL NOT MERELY RESPECT, BUT
SHALL HELP HIS FELLOWS; ITS INFLUENCE IS DIRECTED, NOT SO MUCH TO THE
SURVIVAL OF THE FITTEST, AS TO THE FITTING OF AS MANY AS POSSIBLE TO SURVIVE.
IT REPUDIATES THE GLADIATORIAL THEORY OF EXISTENCE. IT DEMANDS THAT EACH
MAN WHO ENTERS INTO THE ENJOYMENT OF THE ADVANTAGES OF A POLICY SHALL BE
MINDFUL OF HIS DEBT TO THOSE WHO HAVE LABORIOUSLY CONSTRUCTED IT; AND SHALL
TAKE HEED THAT NO ACT OF HIS WEAKENS THE FABRIC IN WHICH HE HAS BEEN
PERMITTED TO LIVE. LAWS AND MORAL PRECEPTS ARE DIRECTED TO THE END OF
CURBING THE COSMIC PROCESS, AND REMINDING THE INDIVIDUAL OF HIS DUTY TO THE
COMMUNITY, TO THE PROTECTION AND INFLUENCE OF WHICH HE OWES, IF NOT EXISTENCE
ITESLF, AT LEAST THE LIFE OF SOMETHING BETTER THAN A BRUTAL SAVAGE.
BOARD OF DIRECTORS
C. LEN PECCHENINO
CHAIRMAN
RETIRED EXECUTIVE
BRADLEY E. COOPER
SENIOR VICE PRESIDENT
CAPITAL Z PARTNERS, LTD.
WILLIAM L. GENTZ
PRESIDENT AND CHIEF EXECUTIVE OFFICER
SUPERIOR NATIONAL INSURANCE GROUP, INC.
STEVEN D. GERMAIN
GENERAL COUNSEL
ZURICH CENTRE GROUP LLC
ROGER W. GILBERT
RETIRED INSURANCE EXECUTIVE
STEVEN B. GRUBER
MANAGING DIRECTOR
OAK HILL PARTNERS, INC.
THOMAS J. JAMIESON
PRESIDENT
JACO OIL COMPANY
GORDON E. NOBLE
CHAIRMAN AND CEO
COMMODORE INSURANCE SERVICES
CRAIG F. SCHWARBERG
RETIRED FINANCE EXECUTIVE
J. CHRIS SEAMAN
EXECUTIVE VICE PRESIDENT AND
CHIEF FINANCIAL OFFICER
SUPERIOR NATIONAL INSURANCE GROUP, INC.
ROBERT A. SPASS
DEPUTY CHAIRMAN
CAPITAL Z PARTNERS, LTD.
CORPORATE INFORMATION
HOME OFFICE
Superior National Insurance Group, Inc.
26601 Agoura Road
Calabasas, CA 91302
Telephone (818) 880-1600
Fax (818) 880-8615
www.superior.com
SECURITIES LISTING
The common stock of Superior National Insurance Group, Inc.
is traded on the Nasdaq under the symbol SNTL
ANNUAL MEETING
June 17, 1999
Superior National Home Office
26601 Agoura Road
Calabasas, CA 91302
FORM 10-K
A copy of Form 10-K for the year ended
December 31, 1998, as filed with the
Securities and Exchange Commission, is enclosed.
TRANSFER AGENT
US Stock Transfer Corporation
1745 Gardena Avenue, 2nd Floor
Glendale, CA 91204
INDEPENDENT AUDITORS
KPMG LLC
725 South Figueroa Street
Los Angeles, CA 90017
LEGAL COUNSEL RIORDAN & MCKINZIE
300 South Grand Avenue, 29th Floor
Los Angeles, CA 90071
SHAREHOLDER RELATIONS
Robert A. Lentz & Associates, Inc.
3535 Fishinger Blvd., Suite 140
Hilliard, OH 43026
DESIGN: Square One Advertising, Inc.
San Diego, CA
TEXT: J. Chris Seaman
Branch Offices
Birmingham, Alabama
Little Rock, Arkansas
Phoenix, Arizona
California
Calabasas
Diamond Bar
Eureka
Fresno
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<PAGE>
Monterey
Novato
Orange
Oxnard/Ventura
Pleasanton
Rancho Cordova
San Diego
San Jose
Santa Maria
Woodland Hills
Denver, Colorado
Florida
Altamonte Springs
Boca Raton
Jacksonville
Atlanta, Georgia
Boise, Idaho
Chicago, Illinois
Indianapolis, Indiana
Overland Park, Kansas
Baton Rouge, Louisiana
Saint Louis, Missouri
Florham Park, New Jersey
Albuqerque, New Mexico
New York, New York
Charlotte, North Carliona
Oklahoma City, Oklahoma
Tigard, Oregon
Willow Grove, Pennsylvania
Brentwood, Tennessee
Texas
Irving
Houston
San Antonio
Salt Lake City, Utah
Brookfield, Wisconsin
SUBSIDIARIES AND AFFILIATES
Business Insurance Group, Inc.
California Compensation Insurance Company
Combined Benefits Insurance Company
Commercial Compensation Insurance Company
Infonet Management Systems, Inc.
Pacific Insurance Brokerage, Inc.
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SN Insurance Administrators, Inc.
SN Insurance Services, Inc.
Superior (Bermuda) Limited
Superior National Capital Holding Corporation
Superior National Capital Trust 1
Superior National Insurance Company
Superior Pacific Casualty Company
Western Select Service Corp.
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