Workers' Compensation: Rx for Policy Reform

Policy Reports | Welfare

No. 287
Wednesday, September 13, 2006
by N. Michael Helvacian

Do Economic Incentives Matter?

How do workers respond to incentives of the workers' compensation system?  Researchers have found that benefit increases distort their behavior in ways that increase costs.  These costs are paid by employers in the form of higher insurance premiums and by employees in the form of lower wages. 

The Effect of Higher Wage Replacement Rates.  The higher the wage replacement rate, the greater the potential economic reward for workers who file claims.  Do workers respond to this economic incentive?  The evidence suggests that they do.  In general, if the financial rewards for making a claim increase, there will be more claims, particularly lost time claims.  This is sometimes called "claiming behavior."21  Studies have found, for example, that a 10 percent increase in the wage replacement results in:

  • a 2.5 percent to 5 percent rise in the total number of claims made,22
  • a 6 percent increase in the relative frequency of lost time claims,23 and
  • a 7 percent rise in the number of people receiving benefits - due to both the increased number of claims and the longer receipt of benefits.24

Conversely, in the 1990s a number of states reduced some types of indemnity benefits.  Partly as a result of these changes, the frequency of claims and injuries declined countrywide.  The growth in employer costs for insurance also moderated. 

The effect of benefit increases on claims is different for employees of larger firms than for employees of smaller firms, according to an analysis of longitudinal data on claims for manufacturing firms from 1979 to 1984.25  The greatest increase in claims was for establishments with fewer than 100 employees, where each $50 increase in weekly indemnity benefits raised claim rates by 18 percent.  In establishments with 500 or more employees, the same increase in weekly benefits increased injury rates only 4 percent. 

Why the difference in the behavior of workers at different size firms?  Larger firms are more likely to offer short-term disability benefits apart from workers' compensation.  Thus the smaller rise in claims among employees of large firms indicates that workers' compensation indemnity benefits substitute for disability insurance, and the benefits are less valuable to employees if they have alternative short-term disability coverage. 

“Higher wage replacement increases injured employees’ time away from work.”

The wage replacement rate affects not only the number of claims filed, but also the type of claims filed.  One study found that following an increase in the percentage of weekly wages replaced by indemnity benefits in Texas there was a sharp increase in the percentage of indemnity claims compared to medical-only claims.  

Furthermore, a statutory increase in wage replacement benefits is also statistically associated with employees' remaining away from work longer than medically necessary to recover from their injuries.  For example:

  • A 5 percent increase in the minimum and maximum wage replacement benefits in Minnesota led to an 8 percent increase in the duration of disabilities for employees affected compared to those not affected.26
  • A 10 percent increase in the maximum weekly benefits for temporary total disability that only affected some high-wage employees in Kentucky and Michigan increased the average duration of disability among the affected employees by 3 percent to 4 percent.27

In addition, since workers can receive both workers' compensation permanent total disability benefits and Social Security disability payments, they have a financial incentive to claim that a disability is work-related when their total benefits will be higher than if they receive only Social Security disability.28

The Effect of Longer Required Waiting Periods.  The greatest effect on claiming behavior appears to come from increasing the number of days employees must be absent from work due to an injury before they are eligible for wage replacement benefits.  For many workers, the number of days of required waiting equals the number of days of lost pay and hence represents a cost to the worker of filing a claim.  Alan Krueger, for instance, found that increasing the statutory waiting period from three days to seven days results in a 39 percent reduction in the number of employees receiving workers' compensation benefits.29

The Effect of Permanent Partial Disability Benefits.  Permanent partial disabilities are small but significant residual impairments that are thought to be permanent in nature, such as 10 percent permanent loss of the use of a hand, or 5 percent permanent loss of the use of an arm.  Most states base PPD benefits on the impairment rating - they do not consider whether or not the employee with a partial disability returns to work at full or near-full wages, or if the disability affects the employee's future wage-earning capacity.  So a worker can receive a lump-sum PPD payment but return to work either in the same job or another one that he is able to perform despite the disability.  An increasing and large percentage of claimants with lost time from work now receive PPD benefits after receiving total temporary disability.30  PPD compensation now accounts for about 60 percent of all system costs.  In California and a number of other states, the average impairment rating is less than 15 percent loss of use.

The laws that determine the award associated with an impairment rating are often arbitrary.  For example, Virginia's statute provides that a worker who loses a thumb gets a benefit equal to two-thirds of the worker's average weekly wage up to 60 weeks; however, if only the first joint is lost, the benefit is reduced to 30 weeks.31  In some states, the percentage of wages an injured worker receives depends on whether the injured hand is the worker's dominant one.32  State agencies publish compensation schedules for partial loss of part of the body and unscheduled permanent partial benefits when the loss of function is not confined to any particular part of the body. 

The method used to determine permanent partial disability affects the cost of these claims, and varies considerably from state to state for similar injuries.33  In a six-state study, California and Texas had the highest percentage of workers' compensation cases that involved lost-time claims (more than 50 percent).  [See Table III.] 

Table II - Average Claims Costs Reported by Private Insurers Countrywide

“An increasing percentage of workers receive benefits for permanent partial disabilities.”

These two states, however, have very different methods for compensating PPD claims. 

  • In California, PPD benefits are generally paid in lump sums and attorneys are involved in negotiating the amount; the wage component of PPD claim costs averaged $42,624 in 2000.
  • In Texas, PPD benefits are generally paid as weekly compensation for wage loss, and attorney involvement is rare; the indemnity component averaged $19,180.

Fees for the plaintiff's (worker's) attorney are included in these costs, and they account for a significant component of the cost difference between the two states.34    

“Workers’ compensation benefits encourage employees to remain away from work.”

Other Factors Affecting Permanent Partial Disability Claims.  One way in which the workers' compensation system distorts employees' behavior is by encouraging longer disability in order to obtain permanent partial disability (PPD) benefits.  Three factors related to features of the state systems affect the frequency of PPD cases.  They are (1) the extent to which the state limits temporary total disability, (2) how the state treats back injuries and (3) the amount of the anticipated PPD award.  

First, the likelihood of particular outcomes for PPD claims is related to the length of temporary total disability (TTD) claims - which is in turn influenced by state benefit levels and the state's mechanism for ending TTD benefits.  States without adequate controls on the length of time a worker receives TTD also have high rates of PPD claims.  For example, Texas is among the states with the longest average duration for receipt of TTD and it also has high PPD rates.  Nearly all Texas claimants receiving weekly TTD benefits beyond three months go on to receive PPD benefits.  There is no clear reason for this outcome, except that it may be more difficult to challenge claimants who file for PPD benefits once they are out of work for an extended period.

The second factor affecting the likelihood of PPD claims in a state is the proportion of back sprain and soft-tissue injury claimaints who receive PPD benefits.  The greater the percentage of back sprain cases awarded benefits, the greater the percentage of cases in the state that involve PPD claims.  Connecticut, for example, has a low rate for back sprains and strains, but a relatively high rate for more objective fracture cases.  The overall PPD rate in Connecticut is lower than in the other states compared in Table III, except for Wisconsin.  The states that more readily award benefits for back sprains and soft-tissue injuries encourage employees to file for awards and have proportionately more PPD cases.  

A third factor is the anticipated size of the PPD award, which is often paid in a lump-sum amount, in conjunction with the degree of litigiousness and attorney involvement in the state systems. The states where attorneys are frequently used to resolve disputes and to close claims generally have higher PPD rates.  A state's litigation rate in workers' compensation cases is affected by many factors, including the anticipated size of the award, the uncertainty associated with receiving it and whether the award will be paid as a lump sum.  In many states, the size of the anticipated award is the central issue in litigating claims and in subsequent negotiations between the attorneys representing the employees and employers/insurers.  Attorneys representing workers are paid on a contingency fee basis and receive 20 percent to 25 percent of the award, which is generally paid in a lump sum.  Plaintiffs' attorneys have a financial incentive to litigate cases if they are relatively certain of a successful outcome and of the size of the anticipated award.  Attorney involvement in workers' compensation claims raises both PPD rates and claim costs.35  The proliferation of lump-sum payments or award of benefits to settle or close claims over the last two decades has caused a surge in the frequency of such cases.36 

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