Performance audit, State Compensation Fund

              December 1988 Report No. 88- 10
The O f f i c e o f t h e A u d i t o r General has conducted a performance a u d i t of
the State Compensat ion Fund i n response to a June 2, 1987, r e s o l u t i o n of
the J o i n t L e g i s l a t i v e Oversight Committee. This performance a u d i t was
conducted as p a r t o f the Sunset review set f o r t h i n Arizona Revised
Statutes ( A. R. S. ) $ 5 41- 2351 through 41- 2379.
A l I employers w i t h one or more employees must provide workers'
compensation insurance f o r t h e i r employees. The State Compensation Fund
i s the major provider o f workers' compensation insurance i n Arizona.
Fund policyholders account f o r approximately 60 percent of a l l workers'
compensation p o l i c i e s i n the State. The Fund was established as p a r t o f
the I n d u s t r i a l Commission i n 1925 and became a separate agency i n 1969.
For calendar year 1988 the Fund has 689 author i zed pos i t ions and an
operating budget of approximately $ 34.3 m i l l i o n . The Fund's 1987
f i n a n c i a l statements reported assets of more than $ 659 mi l l ion.
The Fund Is A State Agency Subject
To Legislative Control
Arizona law c l e a r l y establ ishes the Compensation Fund as a State agency
and the State i s l i a b l e f o r losses sustained by the Fund. The Fund's
status as a State agency gives the L e g i s l a t u r e broad a u t h o r i t y over the
Fund, i n c l u d i n g t h e r i g h t of t e r m i n a t i o n under t h e Arizona Sunset Law.
Because the Fund i s a State agency, the L e g i s l a t u r e may arguably have
some c o n t r o l over the Fund's assets. For example, t e r m i n a t i n g the Fund
might allow the L e g i s l a t u r e t o d i s t r i b u t e the Fund's assets. Once a l l
outstanding claims against t h e Fund were resolved t h e L e g i s l a t u r e could
argue that any remaining funds belong to the State because the Fund i s a
State agency whose l i a b i l i t i e s are backed by the S t a t e . However, the
L e g i s l a t u r e ' s a u t h o r i t y beyond t h i s p o i n t i s u n c e r t a i n . No law
authorizes the sale of the Fund. However, recent court decisions i n New
York and Oregon might support a L e g i s l a t i v e attempt to appropriate some
of the Fund's s u r p l u s w i t h o u t t e r m i n a t i n g the agency, but Arizona case
law i s unclear on t h i s matter.
I f the L e g i s l a t u r e wishes to consider terminating the State Compensation
Fund and/ or t r a n s f e r r i n g some of the Fund's surplus t o the General Fund,
i t should obtain f u r t h e r legal research on the p o t e n t i a l consequences of
such a c t i o n .
The L e g i s l a t u r e Should Evaluate The S t a t e ' s Relationship
With The State Compensation Fund
The need for the Compensation Fund and i t s r o l e i n providing workers'
compensation insurance has changed since the Fund was established i n
1925. The Fund was i n i t i a l l y intended to insure a l l employers, and i n
p a r t i c u l a r those employers unable to obtain insurance elsewhere.
Hov~ ever, the Fund i s no longer required to insure employers, and i s now
one of more than 100 companies i n Arizona competing i n the workers'
compensation market.
Although the Fund no longer serves as an insurer o f l a s t r e s o r t , i t
continues to b e n e f i t from i t s past and present r e l a t i o n s h i p w i t h the
State. The Fund accumulated s u b s t a n t i a l reserves between 1926 and 1968
when the I n d u s t r i a l Commission allowed i t to charge rates 10 percent
below other insurers. These reserves provided s u f f i c i e n t investment
income to allow the Fund to s e l l p o l i c i e s at lower costs and o f f e r yearly
dividends a f t e r i t became a separate agency i n 196% As a r e s u l t , the
Fund has maintained a sizable market share and the reserves needed to
adequately fund t h i s share continue to enable the Fund t o o f f e r lower
prices and dividends. Thus, the Fund continues to enjoy a competitive
advantage over p r i v a t e insurers. In a d d i t i o n t o t h i s advantage, the Fund
saves approximate ly $ 2.4 m i l l ion annual l y because i t pays no Federal
income tax and i s not required to e s t a b l i s h the s e c u r i t y deposit required
of other insurers. The Fund saves another $ 1.4 m i l l i o n each year by
purchasing goods on S t a t e c o n t r a c t s and p a r t i c i p a t i n g i n the State
personnel system, r i s k management and cash management programs.
The L e g i s l a t u r e should consider reducing the Fund's competitive advantage
by r e q u i r i n g i t t o : 1) pay the equivalent of i t s Federal income tax
l i a b i l i t y to the General Fund, and 2) reimburse the State for the f u l l
cost of a l l services paid for by General Fund a p p r o p r i a t i o n s . The
L e g i s l a t u r e should also review the need for the Fund and determine
whether the State should compete w i t h p r i v a t e insurers.
Claims Management Could Be Improved
ThroughPrivate Sector Procedures
The Fund does not employ procedures commonly used by p r i v a t e insurers to
manage c l a i m s . U n l i k e most p r i v a t e companies contacted by Auditor
Genera! s t a f f , the Fund does not assign cases so that more experienced
s t a f f handle more d i f f i c u l t , complex cases. Procedures for managing
claims are also weak compared w i t h p r i v a t e i n s u r e r s . Supervisory review
of claims i s Iimi ted, i n v e s t i g a t i o n s are o f t e n not thorough o r t i m e l y ,
and the Fund does not use enough medical personnel to manage medical
aspects of claims.
F a i l u r e t o manage claims can r e s u l t i n unnecessary costs and,
consequently, higher premiums for p o l i c y h o l d e r s . For example, a claims
representative d i d not i n v e s t i g a t e discrepancies i n claims information or
follow up on medical reports that indicated a claim was not v a l i d . As a
r e s u l t , the Fund paid almost $ 90,000 for unnecessary treatment. In
another case, the Fund authorized questionable surgery t h a t r e s u l t e d i n
$ 99,000 o f unnecessary med i ca l and compensat ion costs.
Access Control And Disaster Recovery Procedur- es
For State Fund Data Processing Are Weak
Although the State Fund re1 ies heavi l y on i t s e l e c t r o n i c data processing
( EDP) system for many operations, c o n t r o l s are weak i n two c r i t i c a l
areas. The Fund has not established e f f e c t i v e c o n t r o l s such as
passwords, operations logs and physical r e s t r i c t i o n s t o protect EDP
operations and programs from unauthorized access. Lack of control
increases the r i s k of fraud and abuse. In a d d i t i o n , the Fund has not
developed adequate plans to ensure continued operations i n the event of a
d i s a s t e r . The Fund has an informal agreement w i t h another organization
to use i t s computer but has not determined how much time would be
a v a i l a b l e , frequency or duration of use.
Some Actions Have Not Been
F i s c a i l v Res~ onsible
The Fund has demonstrated questionable f i s c a l r e s p o n s i b i l i t y i n some
areas. Recent bui l a i n g a c q u i s i t i o n s d ~ d not comply w i t h s t a t u t o r y
requirements because the Fund did not submit c a p i t a l outlay plans to the
J o i n t L e g i s l a t i v e Budget Committee o r o b t a i n appropriate a u t h o r i z a t i o n
from i t s Investment Committee. In a d d i t i o n , some expenses from the Fund's
annual t r a i n i n g programs seem extravagant. The Fund spent more than
$ 113,000 i n 1987 and 1988 for two t r a i n i n g i n s t i t u t e s . Expenditures
included meals, lodging and a r r i v a l g i f t s for out- of- state guests;
lodging for employees not on t r a v e l s t a t u s ; and g i f t s of watches, luggage
and leather attache cases for some employees. Some of these expenses,
especially the g i f t s , may v i o l a t e c o n s t i t u t i o n a l and s t a t u t o r y
r e s t r i c t i o n s on use o f p u b l i c monies.
The Fund's education b e n e f i t s are much more l i b e r a l than those of most
other State agencies, allowing f u l l payment, i n advance, of a l l costs for
pursuing academic degrees. For example, the Fund paid nearly $ 11,000
between-~ anuar1~ 9 87 and February 1988 ' f o r one emp loyee1s educat con.
The Board May Not Adequately
Represent Pol i cyho l ders
The camposition of the State Fund Board of D i r e c t o r s l i m i t s i t s
effectiveness i n representing p o l i c y h o l d e r s . Although the law requires
that members be p o l i c y h o l d e r s when appointed, weaknesses i n the
appointment process have placed ficnpoiicyholders on the Board. O f the I ?
persons serving on the Board since i t was established i n 1969, three were
not policyholders when appointed and three others purchased l i m i t e d
p o l i c i e s just p r i o r to appointment. Thus, h a l f o f the Fund's d i r e c t o r s
did not have the p r i o r experience w i t h the Fund, as implied by law. I n
a d d i t i o n , the three- member Board may be too small to function
e f f e c t i v e l y . I t s s i z e makes compliance w i t h Arizona's Open Meeting Law
almost impossible, since any conversations or meetings between two
members c o n s t i t u t e a c t i o n s i n v o l v i n g a quorum of the Board.
DOUGLAS R. NORTON, CPA
AUDITOR GENERAL
STATE OFARIZONA
OFFICE OFTHE
AUDITOR GENERAL
LINDAJ BLESSING, CPA
uc PUTY AUDITOR GENERAL
December 8, 1988
Members of the Arizona L e g i s l a t u r e
The Honorable Rose Mofford, Governor
Mr. W i l l i a m L . F i n l e y , Chairman o f the Board
State Compensation Fund
Transmitted herewith i s a report of the Auditor General, a Performance
Audit of the State Compensation Fund. This report i s i n response to a
June 2, 1987, r e s o l u t i o n of the J o i n t L e g i s l a t i v e Oversight Committee.
We found that the State Compensation Fund i s a State agency subject to
control o f the L e g i s l a t u r e . Because the Fund i s a State agency, the
L e g i s l a t u r e may arguably have access to some or a l l of the Fund's
excess s u r p l u s . F u r t h e r , as a State agency, the Fund has b e n e f i t e d
from c e r t a i n advantages and subsidies not a v a i l a b l e to other workers'
compensation insurers. For example, the Fund was not required t o pay
$ 2 m i l l i o n i n 1987 Federal income taxes which i t would have incurred as
a p r i v a t e company. We also found that although the Fund operates much
like a p r i v a t e insurance company, i t has not adopted some important
techniques used w i t h i n the i n d u s t r y to e f f e c t i v e l y manage claims.
F i n a l l y , the Fund f a i l e d t o comply w i t h s t a t u t o r y requirements i n
purchasing approximately $ 33 mi l l ion worth of o f f ice b u i l d i n g s .
My s t a f f and I w i l l be pleased to discuss or c l a r i f y items i n the
r e p o r t .
S i n c e r e l y ,
~ W&? T&
O U ~ R N. or ton
~ u d h d rG eneral
STAFF: W i l l i a m Thomson
Mark Fleming
Cindy G. Whitaker
Dennis B. Murphy
Jayne E. Burgess
Eric l osu re
2700 NOR1 l i CENTRAL AVE @ SUITE 700 F'HOENIX, ARI70NA 85004 9 ( 602) 255- 4385
SUMMARY
The O f f i c e o f the Auditor General has conducted a performance a u d i t of
the State Compensation Fund i n response to a June 2, 1987, r e s o l u t i o n o f
the Joint L e g i s l a t i v e Oversight Committee. This performance audit was
conducted as part of the Sunset review set f o r t h i n Arizona Revised
Statutes ( A. R. S. ) 55 41- 2351 through 41- 2379.
A l l employers w i t h one or more employees must provide workers'
compensation insurance for t h e i r employees. The State Compensation Fund
i s the major provider o f workers' compensation insurance i n Arizona.
Fund policyholders account for approximately 60 percent of a1 l workers'
compensation p o l i c i e s i n the State. The Fund was established as p a r t of
the I n d u s t r i a l Commission i n 1925 and became a separate agency i n 1969.
For calendar year 1988 the Fund has 689 authorized p o s i t i o n s and an
operating budget of approximately $ 34.3 m i l l i o n . The Fund's 1987
f i n a n c i a l statements reported assets of more than $ 659 m i l I ion.
The Fund Is A State Agency Subject
To Legislative Control ( see pages 15- 23)
Arizona law c l e a r l y establishes the Compensation Fund as a State agency
and the State i s l i a b l e for losses sustained by the Fund. The Fund's
status as a State agency gives the L e g i s l a t u r e broad a u t h o r i t y over the
Fund, i n c l u d i n g the r i g h t ~ f termination under the Arizona Sunset Law.
Because the Fund i s a State agency, the L e g i s l a t u r e may arguably have
some control over the Fund's assets. For example, terminating the Fund
might allow the L e g i s l a t u r e t o d i s t r i b u t e the Fund's assets. Once a l l
outstanding claims against the Fund were resolved the L e g i s l a t u r e could
argue that any remaining funds belong to the State because the Fund i s a
State agency whose l i a b i l i t i e s are backed by the State. However, the
L e g i s l a t u r e ' s a u t h o r i t y beyond t h i s p o i n t i s uncertain. No law
authorizes the sale of the Fund. However, recent c o u r t d e c i s i o n s i n New
York and Oregon might support a L e g i s l a t i v e attempt to appropriate some
of the Fund's surplus w i t h o u t t e r m i n a t i n g the agency, but Arizona case
law i s unclear on t h i s matter.
I f the Legislature wishes t o consider terminating the State Compensation
Fund and/ or t r a n s f e r r i n g some of the Fund's surplus to the General Fund,
i t should obtain f u r t h e r legal research on the p o t e n t i a l consequences of
such action.
The Legislature Should Evaluate The State's Relationship
W i th The State Compensat ion Fund ( see pages 25- 37)
The need for the Compensation Fund and i t s r o l e i n providing workers'
compensation insurance has changed since the Fund was establ ished i n
1925. The Fund was i n i t i a l l y intended to insure a l l employers, and i n
p a r t i c u l a r those employers unable to obtain insurance elsewhere.
However, the Fund i s no longer required to insure employers, and i s now
one of more than 100 companies i n Arizona competing i n the workers'
compensa t i on market .
Although the Fund no longer serves as an i n s u r e r o f l a s t r e s o r t , i t
continues t o b e n e f i t from i t s past and present r e l a t i o n s h i p w i t h the
State. The Fund accumulated s u b s t a n t i a l reserves between 1926 and 1968
when the I n d u s t r i a l Commission allowed i t to charge rates 10 percent
below other insurers. These reserves provided s u f f i c i e n t investment
income to allow the Fund to s e l l p o l i c i e s at lower costs and o f f e r yearly
dividends a f t e r i t became a separate agency i n 1969. As a r e s u l t , the
Fund has maintained a sizable market share and the reserves needed to
adequately fund t h i s share continue to enable the Fund to o f f e r lower
prices and dividends. Thus, the Fund continues to enjoy a competitive
advantage over p r i v a t e insurers. In a d d i t i o n t o t h i s advantage, the Fund
saves approximately $ 2.4 mi l I ion annual l y because i t pays no Federal
income tax and i s not required to establ ish the s e c u r i t y deposit required
o f other insurers. The Fund saves another $ 1.4 m i l l i o n each year by
purchasing goods on State contracts and p a r t i c i p a t i n g i n the State
personnel system, r i s k management and cash management programs.
The Legislature should consider reducing the Fund's competitive advantage
by r e q u i r i n g i t t o : 1) pay the equivalent of i t s Federal income tax
l i a b i l i t y to the General Fund, and 2) reimburse the State for the f u l l
cost of a l l services p a i d f o r by General Fund appropriations. The
Legislature should also review the need for the Fund and determine
whether the State should compete w i t h p r i v a t e insurers.
Claims Management Could Be Improved
Through Pr i vate Sector Procedures ( see pages 39- 51 )
The Fund does not employ procedures commonly used by p r i v a t e insurers to
manage claims. Unlike most p r i v a t e companies contacted by Auditor
General s t a f f , the Fund does not assign cases so t h a t more experienced
s t a f f handle more d i f f i c u l t , complex cases. Procedures for managing
claims are also weak compared w i t h p r i v a t e i n s u r e r s . Supervisory review
of claims i s l i m i t e d , i n v e s t i g a t i o n s are o f t e n not thorough or t i m e l y ,
and the Fund does not use enough medical personnel t o manage medical
aspects of claims.
F a i l u r e to manage claims can r e s u l t i n unnecessary costs and,
consequently, higher premiums f o r p o l i c y h o l d e r s . For example, a claims
representative d i d not i n v e s t i g a t e discrepancies i n claims information or
follow up on medical reports t h a t indicated a claim was not v a l i d . As a
r e s u l t , the Fund paid almost $ 90,000 for unnecessary treatment. I n
another case, the Fund authorized questionable surgery t h a t resulted i n
$ 99,000 of unnecessary med i ca l and compensat i on costs .
Access Control And Disaster Recovery Procedures
For State Fund Data Processing Are Weak ( see pages 53- 58)
Although the State Fund re1 ies heavi l y on i t s e l e c t r o n i c data processing
( EDP) system for many operations, c o n t r o l s are weak i n two c r i t i c a l
areas. The Fund has not established e f f e c t i v e c o n t r o l s such as
passwords, operat ions logs and physical r e s t r i c t ions to p r o t e c t EDP
operations and programs from unauthorized access. Lack of c o n t r o l
increases the r i s k of fraud and abuse. I n a d d i t i o n , the Fund has not
developed adequate plans to ensure continued operations i n the event of a
d i s a s t e r . The Fund has an informal agreement w i t h another o r g a n i z a t i o n
to use i t s computer but has not determined how much time would be
a v a i l a b l e , frequency o r d u r a t i o n o f use.
Some Actions Have Not Been
F i scat ly Respons i b l e ( see pages 59- 66)
The Fund has demonstrated questionable f i s c a l r e s p o n s i b i l i t y i n some
areas. Recent b u i l d i n g a c q u i s i t i o n s d i d not comply w i t h s t a t u t o r y
requirements because the Fund d i d not submit c a p i t a l outlay p l a n s t o the
J o i n t L e g i s l a t i v e Budget Committee or obtain appropriate a u t h o r i z a t i o n
from i t s Investment Committee. In a d d i t i o n , some expenses from the Fund's
annual t r a i n i n g programs seem extravagant. The Fund spent more than
$ 113,000 i n 1987 and 1988 for two t r a i n i n g i n s t i t u t e s . Expenditures
included meals, lodging and a r r i v a l g i f t s f o r o u t - o f - s t a t e guests;
lodging for employees not on t r a v e l status; and g i f t s o f watches, luggage
and leather attache cases for some employees. Some of these expenses,
e s p e c i a l l y the g i f t s , may v i o l a t e c o n s t i t u t i o n a l and s t a t u t o r y
r e s t r i c t i o n s on use o f p u b l i c monies.
The Fund's education b e n e f i t s are much more l i b e r a l than those of most
other State agencies, a l l o w i n g f u l l payment, i n advance, of glJ costs for
pursuing academic degrees. For example, the Fund p a i d n e a r l y $ 11,000
between January 1987 and February 1988 for one employee's education.
The Board May Not Adequately
Represent Po l i cyho lders ( see pages 67- 71 )
The composition of the State Fund Board o f D i r e c t o r s l i m i t s i t s
effectiveness i n representing p o l i c y h o l d e r s . Although the law requires
that members be p o l i c y h o l d e r s when appointed, weaknesses i n the
appointment process have placed nonpo I icyho lders on the Board. Of the 12
persons serving on the Board since i t was established i n 1969, three were
not policyholders when appointed and three others purchased l i m i t e d
p o l i c i e s j u s t p r i o r to appointment. Thus, h a l f o f the Fund's d i r e c t o r s
d i d not have the p r i o r experience w i t h the Fund, as implied by law. In
a d d i t i o n , the three- member Board may be too small to function
e f f e c t i v e l y . I t s size makes compliance w i t h Arizona's Open Meeting Law
almost impossible, since any conversations or meetings between two
members c o n s t i t u t e a c t i o n s i n v o l v i n g a quorum of the Board.
TABLE OF CONTENTS
Page
INTRODUCTION AND BACKGROUND . . . . . . . . . . . . . . . . . . . . 1
SUNSETFACTORS. . . . . . . . . . . . . . . . . . . . . . . . . . . 9
FINDING I: THE STATE COMPENSATION FUND IS A STATE AGENCY
SUBJECT TO CONTROL BY THE LEGISLATURE . . . . . . . . . . . . . 15
Fund Operates Under Statutory Authority . . . . . . . . . . . . 15
Legislature Has Broad Authority Over The Fund . . . . . . . . . 18
Reconendation. . . . . . . . . . . . . . . . . . . . . . . . . 23
FINDING II: THE LEGISLATURE SHOULD EVALUATE
ARIZONA'S RELATIONSHIP WITH THE
STATE COMPENSATION FUND . . . . . . . . . . . . . . . . . . . . 25
Need For Fund And I t s Role In Providing Workers'
Compensation InsuranceHasChangedSignificantly. . . . . . . . 25
Fund Continues To Benefit From Relationship
With State. . . . . . . . . . . . . . . . . . . . . . . . . . . 28
Legislature Should Consider Altering The State's
Relationship With The Fund. . . . . . . . . . . . . . . . . . . 35
Recomnendations . . . . . . . . . . . . . . . . . . . . . . . . 36
FINDING Ill: THE STATE COMPENSATION FUND CAN SIGNIFICANTLY
l MPROVE I TS CLA l MS MANAGEMENT BY ADOPT l NG PROCEDURES
USED BY THE PRIVATE SECTOR. . . . . . . . . . . . . . . . . . . 39
Claims Are Not Assigned In An
EffectiveManner . . . . . . . . . . . . . . . . . . . . . . . . 39
More Supervisory Review, Better Investigations
And Stronger Medical Management Procedures
Are Needed. . . . . . . . . . . . . . . . . . . . . . . . . . . 41
Effective Claims Management Can
Reducecosts . . . . . . . . . . . . . . . . . . . . . . . . . . 48
Recomnendations . . . . . . . . . . . . . . . . . . . . . . . . 51
Page
FINDING I V : SIGNIFICANT WEAKNESSES EXIST IN ACCESS CONTROL
AND DISASTER RECOVERY PROCEDURES OF THE FUND'S
COMPUTER SYSTEMS, INCREASING THE RISK OF
FRAUDORABUSE . . . . . . . . . . . . . . . . . . . . . . . . . 53
Access Controls And Physical Security Are Weak. . . . . . . . . 54
Disaster Recovery Controls Are Inadequate . . . . . . . . . . . 56
Recomnendations . . . . . . . . . . . . . . . . . . . . . . . . 57
FINDING V: THE FUND HAS NOT BEEN FISCALLY RESPONSIBLE
IN SOME AREAS . . . . . . . . . . . . . . . . . . . . . . . . . 59
The Fund Has Not Complied With Statutory Requirements
During Building Purchases . . . . . . . . . . . . . . . . . . . 59
Employee Awards And Training And Education Benefits
Appear Excessive And May Be I l l e g a l . . . . . . . . . . . . . . 62
Recomnendations . . . . . . . . . . . . . . . . . . . . . . . . 66
FINDING V I : THE BOARD OF DIRECTORS MAY NOT
EFFECTIVELY REPRESENT POLICYHOLDERS . . . . . . . . . . . . . . 67
The Board Of Directors Has A Duty To Represent
Policyholders . . . . . . . . . . . . . . . . . . . . . . . . . 67
Appointment Process Has Been Weak . . . . . . . . . . . . . . . 68
The Board I s Too Small. . . . . . . . . . . . . . . . . . . . . 6 9
Recomnendations . . . . . . . . . . . . . . . . . . . . . . . . 71
AREAS FOR FURTHER AUDIT WORK . . . . . . . . . . . . . . . . . . . . 75
AGENCYRESPONSE. . . . . . . . . . . . . . . . . . . . . . . . . .
APPEND l X
I. LEGISLATIVE COUNCIL OPINION
LIST OF TABLES
Page
TABLE 1 - State Compensation Fund
Expenditures For
Calendar Years 1986 Through 1988
( Unaudited). . . . . . . . . . . . . . . . . . . . . . .
TABLE 2 - State Compensation Fund Statement
Of Operations And Changes In Policyholders'
Surplus, 1986And1987 . . . . . . . . . . . . . . . . . . 5
TABLE 3 - State Compensation Fund Balance
Sheet, 1986 And 1987 . . . . . . . . . . . . . . . . . . 6
TABLE 4 - Small Policyholder Representation In
State Compensation Fund,
Policy Years 1983 Through 1985 . . . . . . . . . . . . . 29
TABLE 5 - State Compensation Fund
Operational Analysis Of Net Increase in Surplus,
1987 And 1986. . . . . . . . . . . . . . . . . . . . . . 31
TABLE 6 - Estimated Savings To The Fund
Due To State Subsidies . . . . . . . . . . . . . . . . . 34
TABLE 7 - Supervisory Review Guidelines For
Selected Private Workersf Compensation
Insurance Carriers. . . . . . . . . . . . . . . . . . . 43
TABLE 8 - State Compensation Fund
i n s t i t u t e Expenses - 1987 And 1988. . . . . . . . . . . 63
TABLE 9 - Number Of Policyholders And Board Members
Of Competitive State Funds. . . . . . . . . . . . . . . 70
INTRODUCTION AND BACKGROUND
The O f f i c e of the Auditor General has conducted a performance audit of
the State Compensation Fund i n response to a June 2, 1987, r e s o l u t i o n o f
the J o i n t L e g i s l a t i v e Oversight Committee. This performance audit was
conducted as part of the Sunset Review set f o r t h i n Arizona Revised
Statutes ( A. R. S.) 9941- 2351 through 41- 2379.
Arizona law requires that a l l employers w i t h one or more employees
provide workers' compensation coverage. Employers may insure t h i s
l i a b i l i t y e i t h e r through the State Compensation Fund, through a p r i v a t e
insurance c a r r i e r , or through self- insurance. Workers' compensation
insurance pays a l l medical costs r e s u l t i n g from work r e l a t e d i n j u r i e s ,
and compensation for l o s t wages.
The State Compensation Fund was established i n 1925 as p a r t of the
I n d u s t r i a l Commission. The I n d u s t r i a l Commission administered the Fund
u n t i l 1969 when l e g i s l a t i o n established the Fund as an independent
agency. In 1983 a d d i t i o n a l l e g i s l a t i o n exempted the Fund from some
management and review requirements applicable to State agencies, such as
budgetary and f i s c a l reviews, surplus property and purchasing
requirements. In a d d i t i o n , the Fund became subject to State insurance
s t a t u t e s .
The Fund has grown s i g n i f i c a n t l y i n recent years, and i s c u r r e n t l y the
largest w r i t e r of workers' compensation insurance i n Arizona. According
to Fund budget information, the number of Fund p o l i c y h o l d e r s has
increased from 31,034 i n 1985 to an estimated 42,000 i n 1988. I n the
same period, premiums w i l l nearly double from $ 104.4 m i l l i o n to
approximately $ 190 mi l l ion. The number of claims processed by the Fund
i s expected to increase approximately 27 percent, from 54,524 i n 1985 to
an estimated 69,000 i n 1988.
Organization And S t a f f i n g
The Fund i s under the d i r e c t supervision of a three- member Board of
Directors appointed by the Governor for three- year terms. Members are
required to be Fund policyholders or employees of p o l i c y h o l d e r s . The
Board has a u t h o r i t y to make rules and regulations as i t deems proper, and
appoints the Fund Manager, responsible for the o r g a n i z a t i o n ' s d a i l y
operations. The Board may a l s o d e c l a r e dividends for i t s policyholders.
In 1987 i t declared dividends of approximately $ 30 m i l l i o n .
The Fund's Investment Committee i s s t a t u t o r i l y responsible for
establishing the investment p o l i c y and supervising the Fund's investment
a c t i v i t i e s . This five- member Committee c o n s i s t s o f the Chair of the
Board o f D i r e c t o r s , the Fund Manager, and three persons appointed by the
Governor who are knowledgeable i n investments and economics. In 1987 the
Fund invested more than $ 591 mi l I ion.
The Fund has 689 authorized f u l l - t i m e ( FTE) p o s i t i o n s f o r 1988. The Fund
operates from an o f f i c e located i n the Abacus b u i l d i n g i n central
Phoenix. The home o f f i c e has 534 FTEs. Fund s t a f f also work out of
d i s t r i c t o f f i c e s i n F l a g s t a f f , Tucson, Mesa, Glendale, Phoenix, Show Low,
Lake Havasu C i t y , Prescott and Yuma. D i s t r i c t operations account for 155
FTEs .
Budget And Financial P o s i t i o n
The . State Compensat ion Fund i s funded by premi um and investment income,
receiving no General Fund appropriations. I t operates on a calendar year
basis, and annually must submit an operating and c a p i t a l outlay budget to
the Joint L e g i s l a t i v e Budget Committee ( JLBC) for review and approval.
The JLBC approved $ 34 m i l l i o n for Fund operations i n 1988. Table 1 shows
Fund expenditures excluding compensation and medical b e n e f i t s for
calendar years 1986 and 1987 and the approved budget for 1988. No
c a p i t a l o u t l a y requests were made during t h i s period.
TABLE 1
FTE p o s i t i o n s
STATE COMPENSATION FUND
EXPENDITURES FOR
CALENDAR YEARS 1986 THROUGH 1988( a)
( unaudi ted)
Personal services
Employee r e l a t e d expenses
Professional & outside
se rv i ces
Travel - State
Travel - out- of- State
Other operating expenses
Equipment
Claims adjustment services
National Council fees
Premium tax to ICA
Uncol l e c t i b l e premiums
Rea l / pe r sona l
property tax
License and fees
B u i l d i n g occupancy costs
Computer software expenses
0 the r
TOTAL
1986
Actual
1987
Actual -.
( a) Expenditure amounts are rounded.
Source: J o i n t L e g i s l a t i v e Budget Committee s t a f f .
1988
Approved
In a d d i t i o n , the Fund i s required by s t a t u t e to have an audit of i t s
accounts, funds and s e c u r i t i e s by an independent f i r m o f c e r t i f i e d public
accountants. Financial statements for the years ended December 31, 1986
and 1987 were audited by pub1 i c accounting f i rms whose reports expressed
u n q u a l i f i e d opinions on the statements. Table 2 ( page 5) presents the
1986 and 1987 statement of operations and statements of changes i n
p o l i c y h o l d e r s ' s u r p l u s . In 1987, the Fund's revenues increased 10
percent while i t s expenses increased 22 percent over p r i o r years. Table
3 ( page 6) presents the Fund's balance sheets for 1986 and 1987.
Audit Scope and Purpose
This performance a u d i t was conducted to evaluate the State Compensation
Fund's operations, focusing on these s p e c i f i c o b j e c t i v e s .
0 To determine the extent of L e g i s l a t i v e a u t h o r i t y over the Fund.
e To evaluate the r o l e of the State Fund i n providing workers'
compensation insurance i n Arizona and to determine the extent of
State support for Fund operations.
e To determine the e f f i c i e n c y and effectiveness o f the Fund's claims
management and operations.
e To evaluate the adequacy of access controls and disaster recovery
procedures of the Fund's computer system. \
0 To determine i f the Fund has acted i n a f i s c a l l y responsible manner.
0 To determine i f the State Fund Board o f D i r e c t o r s adequately
represents p o l i c y h o l d e r s .
This report a l s o c o n t a i n s Other Pertinent Information regarding the
Investment Committee, i t s operations and i t s r e l a t i o n s h i p t o the Board of
D i r e c t o r s ( see page 73).
TABLE 2
STATE COMPENSATION FUND
STATEMENTS OF OPERATIONS AND
STATEMENTS OF CHANGES IN POLICYHOLDERS' SURPLUS,
1986 AND 1 9 8 7 ( a )
Statement of Operations
Revenues
Premiums earned
Investment income:
I n t e r e s t
A l l o c a t i o n to s e l f - r a t e r s
Net gain on sale of investments
0 the r i ncome
Benefits and other expenses
Compensation and medical b e n e f i t s
Premium taxes
Administrative expenses
Year ended December 31,
9 1987
( i n thousands ( i n thousands
Net gain $ 29.212
Statement of changes in policyholders' surplus
Balance, beginning of year $ 63,838 $ 73,050
Net gain 29,212 35,742
Provision for p o l i c y h o l d e r s ' dividends ( 20,000 ) ( 30,000
Balance, end of year
( a) Financial statement notes accompany t h e i n f o r m a t i o n presented i n t h i s t a b l e . See
State Compensation Fund 1987 Annual Report, Financial Statements, f o r these notes.
Source: Arizona State Compensation Fund 1987 Annual Report.
TABLE 3
STATE COMPENSATION FUND
BALANCE SHEET
1986 AND 1 9 8 7 ( a )
December 31 ,
1986 1987
( i n thousands) ( i n thousands)
Assets
Investment s e c u r i t i e s :
Bonds and c e r t i f i c a t e s
Mortgages
Short- term investments
Cash 292- 103
Premiums receivable, net of allowance for
u n c o l l e c t i b l e premiums of $ 600,000 i n
1986 and $ 700,000 i n 1987 28,375 27,918
Accrued i n t e r e s t receivable 8,921 10,914
Land, b u i l d i n g s and equipment, net 35,301 - 39-, 78 0
L i a b i l i t i e s and p o l i c y h o l d e r s ' surplus
L i a b i l i t v for incurred but unpaid losses
Pol icyhoiderst dividends
Policyholders' advance premiums
Accounts payable and other accrued
l i a b i l i t i e s
P o l i c y h o l d e r s ' s u r p l u s 73,050 78,792
( a) Financial statement notes accompany t h e i n f o r m a t i o n presented i n t h i s tab1 e.
See State Compensation Fund 1987 Annual Report, Financial Statements, f o r these
notes.
Source: Arizona State Compensation Fund 1987 Annual Report.
The section Areas For Further Audit Work ( page 75) addresses issues we
i d e n t i f i e d during the course of our a u d i t but were unable to research due
to time c o n s t r a i n t s .
This audit was conducted i n accordance w i t h generally accepted government
a u d i t i n g standards.
The Auditor General and s t a f f express a p p r e c i a t i o n to the Board of
D i r e c t o r s , Investment Committee, Fund Manager and s t a f f of the State
Compensation Fund for t h e i r cooperation and assistance during the course
of our a u d i t .
SUNSET FACTORS
I n accordance w i t h Arizona Revised Statutes 541- 2354, the L e g i s l a t u r e
should consider the f o l l o w i n g 12 f a c t o r s i n determining whether the State
Compensation Fund ( the Fund), the Board o f D i r e c t o r s , the Investment
Committee and the Fund Manager should be continued o r terminated.
1 . Objective and purpose in establishing the Fund
I n 1925 the L e g i s l a t u r e established the State Compensation Fund
w i t h i n the I n d u s t r i a l Commission t o provide workers' compensation
insurance. I n a d d i t i o n , the Fund was required to insure Arizona
employers who c o u l d n o t o b t a i n workers' compensation insurance
coverage from p r i v a t e c a r r i e r s or generate the f i n a n c i a l a b i l i t y t o
sel f- insure.
The r o l e of the Fund changed i n 1968 when the L e g i s l a t u r e removed the
Fund from the I n d u s t r i a l Commission and set i t up as a separate State
agency. L e g i s l a t i o n passed at t h i s time also e l i m i n a t e d the
requirement t h a t the Fund serve as the insurer o f l a s t r e s o r t and
created an assigned r i s k plan ( see F i n d i n g 1 1 , p- age 25). Although
the Fund remains a State agency, i t competes w i t h p r i v a t e c a r r i e r s i n
the workers' compensation insurance market and i s the major provider
of worker's compensation insurance i n Arizona.
2. The effectiveness with which the Fund has met i t s objective and
purpose and the efficiency with which the Fund has operated
The Fund has been generally e f f e c t i v e i n p r o v i d i n g s i g n i f i c a n t
b e n e f i t s t o Arizona employers through lower premiums and dividends
than might be o f f e r e d by p r i v a t e c a r r i e r s . I n a d d i t i o n , the Fund
appears to insure the m a j o r i t y of Arizona employers engaged i n
hazardous i n d u s t r i e s such as underground and surface mining, logging
and a i r c r a f t o p e r a t i o n s .
Although the Fund appears to have been e f f e c t i v e i n meeting i t s
objective, we i d e n t i f i e d ways i n which the Fund could improve the
e f f i c i e n c y and e f f e c t i v e n e s s of i t s operations.
o The Fund could s i g n i f i c a n t l y improve i t s claims a d m i n i s t r a t i o n
and p o t e n t i a l l y reduce claims costs through more appropriate
case assignments, improved supervisory review of claims,
ensuring a minimum level of i n v e s t i g a t i o n f o r claims, and
strengthening medical management of claims ( see Finding I l l ,
page 39).
The Fund could e l i m i n a t e s i g n i f i c a n t weaknesses i n i t s
e l e c t r o n i c data processing system, i n c l u d i n g computer access
controls and physical s e c u r i t y which expose the Fund to
p o t e n t i a l fraud and abuse. A d d i t i o n a l l y , the Fund could improve
i t s EDP disaster recovery control procedures ( see Finding I V ,
page 53).
The Board of Di rectors could more e f f e c t i v e l y represent pol icyholders
i f members were required t o be Fund policyholders for at least one
year p r i o r to t h e i r appointment, and i f the size and makeup af the
Board were enhanced ( see Finding V I , page 67).
3. The extent to which the Fund has operated w i t h i n the p u b l i c i n t e r s
The Fund i s g e n e r a l l y o p e r a t i n g i n the p u b l i c i n t e r e s t by meeting i t s
o b j e c t i v e and purpose. I t provides d i r e c t b e n e f i t s to those
employers who choose to insure w i t h the Fund. However, the Fund did
not act i n the p u b l i c i n t e r e s t when i t v i o l a t e d statutes regarding
a c q u i s i t i o n o f real p r o p e r t y , used t r a i n i n g funds to purchase g i f t s
and awards for employees and others, and established education
benefits well beyond those of most State agencies ( see Finding V ,
page 59).
4. The extent t o which r u l e s and regulations promulgated by the Fund
are consistent w i t h the L e g i s l a t i v e mandate
Although the Board o f D i r e c t o r s and the Fund Manager have s t a t u t o r y
a u t h o r i t y to promulgate rules and regulations, n e i t h e r has chosen to
do so.
5. The extent to which the Fund has encouraged input from the public
before promulgating rules and regulations and the extent to which i t
has informed the public as to i t s actions and their expected impact
on the pub1 ic
Since neither the Board of D i r e c t o r s nor the Fund Manager have chosen
to promulgate r u l e s and regulations, input from the p u b l i c has not
been necessary. The Board of D i r e c t o r s and the Investment Committee
post public n o t i f i c a t i o n s of t h e i r meetings i n accordance w i t h the
Open Meeting Law to inform the p u b l i c o f t h e i r meetings. However,
due to the smal I size of the Board of D i r e c t o r s , two Board members
c o n s t i t u t e a quorum and, therefore, even conversations between
members could v i o l a t e the Open Meeting Law i f adequate n o t i f i c a t i o n
i s not made ( see Finding V l , page 67).
6. The extent to which the Fund has been able to investigate and
resolve complaints that are within i t s j u r i s d i c t i o n
This factor does not apply since the Fund i s not a r e g u l a t o r y agency.
7. The extent to which the Attorney General or any other applicable
agency of State government has the authority to prosecute actions
under enabling l e g i s l a t i o n
This factor does not apply since the Fund i s n o t a r e g u l a t o r y or
enforcement agency.
8. The extent to which the Fund has addressed deficiencies i n i t s
enabling statutes which prevent it from ful f i I l ing i t s statutory
mandates
According to Fund o f f i c i a l s , i n 1986 the Fund d r a f t e d and supported
l e g i s l a t i o n which extended the b e n e f i t s of the Workers' Compensation
Law t o i n d i v i d u a l owners of business ( sole p r o p r i e t o r s ) i f these
i n d i v i d u a l s d e s i r e d such coverage. P r i o r to t h i s , the Fund proposed
l e g i s l a t i o n , enacted i n 1983, which eliminated General Fund support
f o r some Fund s e r v i c e s , i n c l u d i n g teIecommunications, motor pool,
finance, and l i brary and archives.
9. The extent to which changes are necessary in the laws of the Fund to
adequately comply with the factors l i s t e d in the Sunset Law
Based on our a u d i t work we recommend that the L e g i s l a t u r e consider
the following changes to the s t a t u t e s of the Fund and i t s Board of
Di rectors.
11
a Amend A. R. S. $ 23- 987 to require the Fund to pay an amount to the
State General Fund equivalent to the Federal income tax i t would
owe as a private company ( see Finding I I , page 25).
a Amend A. R. S. $ 23- 981.01 to require that persons appointed to the
Board o f D i r e c t o r s be insured by the Fund for a minimum of one
year p r i o r to t h e i r appointment ( see Finding VI, page 67).
a Amend A. R. S. $ 23- 981.01 to increase the s i z e o f the Board of
Directors to at least f i v e members and provide for expanded
pol i cyho lder representat ion of speci f ied occupat ions and
interests on the Board ( see Finding VI, page 67).
10. The extent to which the termination of the Fund would s i g n i f i c a n t l y
harm the public health, safety or welfare
Termination of the Fund would not s i g n i f i c a n t l y harm public welfare.
More than 100 private insurance carriers are c e r t i f i e d to provide
workers' compensation insurance to Arizona employers. In addition,
there i s an assigned r i s k plan f o r those employers who are unable to
obtain insurance from p r i v a t e c a r r i e r s . However, terminating the
Fund could cause disruptions in the supply of workers' compensation
insurance, and may be p a r t i c u l a r l y d i f f i c u l t for the employers
engaged in hazardous industries who tend to insure with the Fund ( see
Finding l I , page 25).
11. The extent to which the level of regulation exercised by the Fund i s
appropriate and whether less or more s t r i n g e n t l e v e l s of regulation
would be appropriate
This factor does not apply since the Fund i s not a regulatory agency.
12. The extent to which the Fund has used private contractors in the
performance of i t s duties and how e f f e c t i v e use of p r i v a t e
contractors could be accomplished
The Fund u t i l i z e s the services of a v a r i e t y o f p r i v a t e contractors in
performing i t s duties. Major services used by the Fund include
computer assistance, outside temporary help, legal assistance,
r e h a b i l i t a t i o n counseling, and hospital cost reviews. During 1987,
the Fund spent over $ 2 mi I I ion for these services.
I n a d d i t i o n , the Board of D i r e c t o r s contracts w i t h an outside
a u d i t i n g f i r m t o conduct an annual a u d i t of the Fund, at a cost of
$ 37,000 for 1987. The Board also u t i l i z e s t h e s e r v i c e s of an outside
a c t u a r i a l f i r m t o e s t a b l i s h the reserves needed by the Fund to cover
losses which have already occurred but have not yet been p a i d . The
Board paid $ 67,500 f o r a c t u a r i a l services i n 1987.
The Investment Committee, as mandated by s t a t u t e , uses the services
of an investment counsel to advise i n i n v e s t i n g Fund monies, at a
cost of approximately $ 112,000 i n 1987.
FINDING I
THE STATE COMPENSATION FUND IS A STATE AGENCY,
SUBJECT TO CONTROL BY THE LEGISLATURE
The Arizona L e g i s l a t u r e can exercise s i g n i f i c a n t c o n t r o l over the State
Compensation Fund. The Fund i s a State agency, e s t a b l i shed and operating
under s t a t u t o r y a u t h o r i t y granted by the L e g i s l a t u r e . As such, the
L e g i s l a t u r e has broad c o n t r o l over the Fund.
Fund Operates
Under Statutory Authority
The Fund was established and i s authorized t o operate by s t a t u t e . An
analysis of Arizona s t a t u t e s shows that the Fund i s a S t a t e
agency. ( I ' This a n a l y s i s does not support contentions that the Fund
i s a mutual insurance company c o n t r o l l e d by the p o l i c y h o l d e r s .
Fund i s a State agency - The s t a t u t o r y a u t h o r i z a t i o n of the Fund
i d e n t i f i e s i t as a State agency established t o insure employers against
l i a b i l i t y f o r workers' compensation and medical b e n e f i t s . As a S t a t e
agency, the assets of the Fund are p u b l i c funds. In a d d i t i o n , Arizona
law makes the State l i a b l e f o r the losses sustained by the Fund.
Arizona laws i n d i c a t e that the Fund i s a State agency. Numerous
s t a t u t o r y p r o v i s i o n s support t h i s p o s i t i o n .
a A. R. S. 923- 981. A. The Fund i s established by the L e g i s l a t u r e f o r
the purpose of i n s u r i n g employers against
l i a b i l i t y f o r workers' compensation and medical
benef i t s .
( ' 1 This f i n d i n g i s generally based on a l e g a l analysis from t h e Attorney General's
O f f i c e . We requested advice on the L e g i s l a t u r e ' s a u t h o r i t y t o terminate the Fund
under the Arizona Sunset Law, and on the s t a t u t o r y and case law a p p l i c a b l e t o the
exercise o f l e g i s l a t i v e a u t h o r i t y . Informal advice was requested because a formal
opinion could not be obtained w i t h i n a u d i t time c o n s t r a i n t s .
A . R. S. $ 23- 981 . E The annual operating and c a p i t a l o u t l a y budget
of the Fund i s approved by the J o i n t L e g i s l a t i v e
Budget Comm i t tee .
a A. R. S. 923- 981.01 . A The Fund i s under the supervision o f a Board of
D i r e c t o r s appointed by the Governor.
a A. R. S. 923- 982. A& BThe State Treasurer i s the custodian of the
Fund. A l l monies c o l l e c t e d by the Fund and a l l
disbursements made by the Fund, except for
authorized investments, must go through the
State Treasurer.
a A. R. S. 923- 982. C An annual f i n a n c i a l a u d i t of the Fund i s f i l e d
w i t h the Secretary o f State and the lnsurance
Department , and i s open to pub I i c inspect i an.
a A. R. S. 923- 983. A The Fund sha l I be ne i ther more nor less than
s e l f - s u p p o r t i n g .
A. R. S. 923- 985 M a j o r i t y o f members of an Investment Committee,
established to set investment p o l i c y and
supervise the investment a c t i v i t i e s of the Fund,
are appointed by the Governor.
0 A. R. S. $ 23- 986. A & D The insurance r e g u l a t o r y p r o v i s i o n s of T i t l e 20
apply to the Fund to the same extent as any
mutual c a s u a l t y i n s u r e r a u t h o r i z e d to w r i t e
workers' compensation insurance. However, i n
the event recommendations made by t h e D i r e c t o r
of lnsurance as a r e s u l t o f an examination of
the Fund are n o t complied w i t h , the D i r e c t o r of
Insurance s h a l l n o t i f y the Governor, President
of the Senate and Speaker of the House.
Because the Fund i s a State agency, the assets of the Fund are p u b l i c
funds i n the hands of p u b l i c o f f i c i a l s . This p o s i t i o n i s supported by
the f a c t t h a t a l l monies c o l l e c t e d and disbursed by the Fund, except
those for authorized investments under A. R. S. $ 24- 945, must go through
the State Treasurer. Fund o f f i c i a l s are p u b l i c o f f i c i a l s because the
Board of D i r e c t o r s i s appointed by the Governor. The Board i n turn
appoints the Fund Manager who i s empowered to oversee the d a i l y
operations of the Fund.
The Fund's status as a State agency i s f u r t h e r supported by the S t a t e ' s
l i a b i l i t y for the losses sustained by the Fund. A. R. S. $ 23- 981. C reads,
in part
" A Manager s h a l l administer the s t a t e compensation fund, subject
to the a u t h o r i t y o f the Board of d i r e c t o r s , without l i a b i l i t y of
the s t a t e beyond payment of losses sustained on account of the
fund . " ( emphas i s added)
This s t a t u t o r y provision makes the State l i a b l e for losses sustained by
the Fund beyond the amount o f reserves") and held by
the Fund. In a d d i t i o n , p r o v i s i o n s e s t a b l i s h i n g procedures to be followed
i f the Fund becomes unable to meet i t s l i a b i l i t i e s also support the
p o s i t i o n that the State i s l i a b l e for claims against the Fund. When
p r i v a t e companies face insolvency, the D i r e c t o r o f the Department of
Insurance can order the company ta cease operations. However, i f the
Fund i s i n danger of becoming i n s o l v e n t , A. R. S. $ 23- 986. D requires the
Insurance Department Di rector to make recommendat ions to the Fund and
n o t i f y the Governor, Speaker of the House and President of the Senate i f
the Fund f a i l s to comply w i t h the recommendations.
Fund i s not a mutual insurance company - Although Fund o f f i c i a l s
describe i t as a mutual insurance company, i t i s a State agency and not a
mutual insurance organization. Therefore, the p o l i c y h o l d e r s a r e not
l i a b l e for losses sustained by the Fund, nor are they e n t i t l e d to
dividends.
Although the provisions of T i t l e 20 which regulate companies o f f e r i n g
insurance in Arizona apply to the Fund, the Fund's a u t h o r i z i n g s t a t u t e s
( ' 1 Reserves are those assets set aside t o make f u t u r e payments on losses t h a t have
a1 ready occurred.
(' 1 When discussing a State agency operating as an e n t e r p r i s e fund, such as t h e S t a t e
Compensation Fund, balance i s t h e a p p r o p r i a t e term f o r those assets which
exceed l i a b i l i t i e s . However, the Fund i s governed by Arizona insurance laws and
regulations which general1 y use the term surolus t o r e f e r t o assets i n excess of
l i a b i l i t i e s . This usage i s common w i t h i n the insurance i n d u s t r y . Therefore, t o
ensure consistency w i t h Arizona law and i n d u s t r y p r a c t i c e , we have used the term
surplus to describe those assets which exceed 1 i abi 1 i ti es.
do not e s t a b l i s h the Fund as a mutual insurance company. A mutual
insurance company i s generally defined as an e n t i t y which i s organized
and operated for the b e n e f i t of i t s p o l i c y h o l d e r s , who are by v i r t u e of
t h e i r p o l i c i e s members o f the company. Members usually e l e c t the Board
of Directors and are l i a b l e for losses should the company become
insolvent. The payment of dividends may be mandated by s t a t u t e or be
d i s c r e t i o n a r y w i t h the Board. I f the Board has d i s c r e t i o n , the r i g h t to
receive a dividend creates no t r u s t or property i n t e r e s t o f the
pol icyholder i n the surplus!')
Based on t h i s d e f i n i t i o n , the Fund does not appear to be a mutual
insurance company because: 1) the Fund was created by the L e g i s l a t u r e and
e x i s t s as a S t a t e agency, 2) the State, not the policyholders, i s l i a b l e
for the payment of losses sustained by the Fund, 3) the Board members are
appointed by the Governor rather then elected by the p o l i c y h o l d e r s and 4)
Fund policyholders are not e n t i t l e d to dividend^.'^'
L e g i s l a t u r e Has Broad A u t h o r i t y
Over The Fund
Since the Fund i s a S t a t e agency, the L e g i s l a t u r e has broad a u t h o r i t y
over the Fund. The L e g i s l a t u r e has the a u t h o r i t y to terminate the Fund
under the Arizona Sunset Law, but there i s no s t a t u t o r y a u t h o r i t y for
s e l l i n g the Fund. However, courts i n two states have upheld l e g i s l a t i v e
use of a state compensation fund's surplus monies for other pub1 i c
purposes.
A u t h o r i t y t o terminate Fund - The L e g i s l a t u r e may terminate the Fund.
The Legislature has s t a t u t o r y a u t h o r i t y to control the d i s t r i b u t i o n of
assets upon d i s s o l u t i o n of the Fund, and may be able to obtain any
remaining assets.
( 1 ) See Methodist H o s o i t a l o f Brooklyn v . State Insurance Fund. 64 N. Y. 2d 365. 486
N. Y. S. 2d 905.909- 910.476 N. E. 2d 304 ( C t . ADD. 1985).
( 2) A. R. S. 523- 981.01. A. g r a n t s t h e Board d i s c r e t i o n i n d e c l a r i n g d i v i d e n d s t o
p o l i c y h o l d e r s b u t does not r e q u i r e the Board t o pay dividends.
The L e g i s l a t u r e ' s a u t h o r i t y over the Fund includes the r i g h t to terminate
the Fund under the sunset provisions and repeal the s t a t u t o r y provisions
establishing the Fund. Under A. R. S. 941- 2366. A. 9, the State Compensation
Fund Board of D i r e c t o r s , the Fund Manager and the Investment Committee
are scheduled to be terminated on July 1, 1990. Furthermore, A. R. S.
941- 2377. F provides that the Sunset provisions do not p r o h i b i t the
Legislature from terminating an agency at an e a r l i e r date, or from
considering any other l e g i s l a t i o n r e l a t i v e to the agency. Thus, the
Legislature has the a u t h o r i t y to Sunset the Fund's a d m i n i s t r a t i v e
functions or repeal the s t a t u t o r y provisions r e l a t i n g to the Fund.
The Legislature arguably may c o n t r o l the d i s t r i b u t i o n of assets i f i t
terminates the Fund. A. R. S. 923- 1029.8 s t i p u l a t e s t h a t a l l money i n the
Fund i s subject to the d i s p o s i t i o n of the L e g i s l a t u r e i f the Fund's
enabling l e g i s l a t i o n i s repealed. This s t a t u t e provides one basis for
the argument that repeal of the Fund's enabling s t a t u t e s would subject
i t s assets to d i s p o s i t i o n by the L e g i s l a t u r e . I f the Fund were dissolved
and a l l outstanding claims against the Fund were properly resolved, the
remaining surplus may arguably belong to the State because the Fund i s a
State agency whose l i a b i l i t i e s are backed by the State.
Arizona statutes and case law provide l i t t l e support for the argument
that the assets would belong to the policyholders upon termination of the
Fund because: 1) the Fund i s a State agency, not a mutual insurance
company, and 2) the insurance contracts w i t h the Fund do not give
policyholders any property i n t e r e s t i n the Fund.
It would be d i f f i c u l t to estimate what assets would remain a f t e r a l l
outstanding claims against the Fund were properly resolved. However, the
loss reserves established by the Fund, and required by s t a t u t e , for
incurred but unpaid losses are a c t u a r i a l l y determined to be s u f f i c i e n t t o
cover such claims. Therefore, at least a p o r t i o n , i f not a l l , of the
approximately $ 78 mi l l i o n i n surplus c u r r e n t l y maintained by the Fund may
remain a f t e r d i s s o l u t i o n o f the Fund and proper r e s o l u t i o n of a l l claims
and l i a b i l i t i e s .
Sale of Fund - The L e g i s l a t u r e ' s a u t h o r i t y over the Fund would probably
not include the sale of the Fund t o a t h i r d p a r t y . ~ l t h o u g h l e g i s l a t i o n
has been introduced during recent l e g i s l a t i v e sessions to s e l l the Fund,
such l e g i s l a t i o n may not provide adequate a u t h o r i t y for the sale of the
Fund as an ongoing e n t i t y . A preliminary review found no precedent i n
case law i n w h i c h a s t a t e attempted to s e l l a s t a t e insurance fund as an
ongoing s t a t e agency. Furthermore, Arizona case law c h a r a c t e r i z i n g the
Fund as a p r i v a t e t r u s t fund could m i t i g a t e arguments that the
Legislature has a u t h o r i t y to s e l l the Fund.
Use of surplus funds - The L e g i s l a t u r e may have access to the surplus
maintained by the Fund w i t h o u t t e r m i n a t i n g i t . The S t a t e ' s l i a b i l i t y for
losses sustained by the Fund provides support f o r the argument that the
Legislature may obtain a l l or a p o r t i o n of the Fund's surplus. I n other
states, the l e g i s l a t i v e t r a n s f e r of insurance fund surplus also presents
an argument that Fund surplus monies may be avai lable to Arizona. The
New York and Oregon l e g i s l a t u r e s have t r a n s f e r r e d surplus monies from
t h e i r s t a t e insurance funds i n t o t h e i r respective general funds.
I n 1987, the State Compensation Fund had approximately $ 21 .5 mi l l i o n of
excess surplus. According to the D i r e c t o r o f the Department of
Insurance, A. R. S. 920- 210 requires the Fund to maintain a $ 750,000
surplus. A d d i t i o n a l l y , a departmental g u i d e l i n e used to measure
f i n a n c i a l solvency suggests that a c a r r i e r maintain a minimum of $ 1 of
surplus monies for each $ 3 of premium earned, or a r a t i o of 1 to
3."' Auditor General analysis of the Fund's 1987 balance sheet found
that the Fund retained approximately $ 78.8 mi l l ion i n surplus whi le
reporting earned premiums o f $ 171 .8 m i l l ion, a r a t i o of 1 to 2.18. As
such, for the year ending December 31, 1987, the Fund's reported
( ' 1 According t o DO1 o f f i c i a l s , the surplus t o premium r a t i o of I t o 3 i s a standard
used by regulators t o evaluate t h e solvency of a l l c a r r i e r s . When a c a r r i e r
exceeds t h i s r a t i o , i t sends a signal to r e g u l a t o r s t h a t an evaluation o f the
c a r r i e r ' s p r a c t i c e s be i n order. A d d i t i o n a l l y , as a p a r t o f the Fund's anrlual
request t o DO1 f o r approval of a s u b s t a n t i a l d e v i a t i o n ( discount) from f i l e d r a t e s ,
DO1 o f f i c i a l s have r a i s e d questions about the Fund's surplus t o premium r a t i o .
However, DO1 o f f i c i a l s stressed t h a t t h e i r concern i s whether the Fund can support
such a l a r g e d e v i a t i o n from e s t a b l i s h e d r a t e s and not whether the Fund maintains
s u f f i c i e n t surplus to remain solvent.
surplus exceeded Department of lnsurance guidelines by approximately
$ 21.5 m i l l i o n . ( 1 )
The New York l e g i s l a t u r e t r a n s f e r r e d $ 190 m i l l i o n from surpluses of i t s
State lnsurance Fund ( the equivalent of the Arizona State Compensation
Fund) to i t s general fund. In exchange, the L e g i s l a t u r e provided an
annual $ 190 m i l l i o n " d r y a p p r o p r i a t i o n " to be included as an asset of the
Fund, which would not a c t u a l l y be paid unless the Fund's reserves become
depleted. Legal challenges to the t r a n s f e r i n New York were defeated
based on a decision by the court t h a t : 1 ) the insurance fund was a s t a t e
agency and not a mutual insurance company c o n t r o l led by the
policyholders, 2) the insurance fund's proceeds were held as s t a t e monies
against which the p o l i c y h o l d e r s had no property r i g h t s , and 3) the
insurance fund's l i a b i l i t i e s were those of the s t a t e and not those of the
policyholders. S i m i l a r arguments could be made i n r e l a t i o n to the
Arizona Fund.
The Oregon L e g i s l a t u r e t r a n s f e r r e d $ 81 m i l l i o n o f surplus proceeds from
i t s Compensation fund, the State Accident lnsurance Fund ( SAIF), to i t s
general fund. The l e g i s l a t u r e also imposed a 44.5 percent franchise tax
on the fund's surplus proceeds, to be e f f e c t i v e only i f the statutes
t r a n s f e r r i n g surplus proceeds are declared i n v a l i d by the
The $ 21.5 m i l l i o n represents a conservative estimate of the excess surplus
maintained by the Fund. By s t a t u t e , the Fund need only maintain $ 750,000 i n
surplus. Furthermore, the State i s l i a b l e f o r losses sustained by the Fund, and
the Department o f Insurance i s required t o n o t i f y the Governor, the President of
the Senate and the Speaker of the House i n the event the Fund i s i n danger of
becoming i n s o l v e n t . As such, any a c t i o n taken against the Fund i n the event i t d i d
not meet the Department o f Insurance g u i d e l i n e f o r premium t o surplus r a t i o would
be l e f t t o the Governor and the L e g i s l a t u r e . I n a d d i t i o n , due t o the low discount
rates used by the Fund i n c a l c u l a t i n g i t s l o s s reserves ( see Areas For Further
Audit Work, page 75), i t may be possible t o t r a n s f e r a d d i t i o n a l l o s s reserves t o
surplus.
courts. A lawsuit challenging the t r a n s f e r o f surplus i n Oregon i s
presently pending before i t s State Supreme Court. The Oregon Attorney
General i s arguing against the appeal on the basis that the Oregon SAlF
i s an i n s t r u m e n t a l i t y of the State which by law can not be owned by the
insured employers. Rather, the insured employers have a contract w i t h
the SAlF which provides workers' compensation insurance coverage for a
s p e c i f i e d time period. The Oregon Attorney General concludes that since
the employer/ policyholder i s not c o n t r a c t u a l l y or s t a t u t o r i l y e n t i t l e d to
a dividend, the t r a n s f e r o f surplus d i d not v i o l a t e any property
r i g h t s . ( 1 )
Arizona case law i s not clear on the t r a n s f e r o f Compensation Fund
monies. The Arizona Supreme Court i n Sims v. Moeur ( 1933) and I n d u s t r i a l
Commission v. School D i s t r i c t No. 48 ( 1941) held that the Fund i s a t r u s t
fund undertaken by the State to be administered f o r the use and b e n e f i t
of employees and employers/ policyholders. ( 2 ) However, the Court has
also recognized t h a t : 1) the L e g i s l a t u r e established the Fund and can
also terminate i t , 2) the Fund i s p u b l i c monies i n the hands o f p u b l i c
o f f i c i a l s who administer i t , 3) the Fund should be self- supporting and no
more, and 4) the Fund does not belong to those who administer i t , the
insured employees or the employer/ policyholders. These cases are nearly
50 years o l d , and were decided while the Fund was administered by the
I n d u s t r i a l Commission before i t became a separate State agency. However,
courts have not considered the proper d i s p o s i t i o n o f State Fund monies
upon i t s termination or the use ~ f surplus monies for non- Fund purposes:
( 1) L e g i s l a t i v e attempts t o t r a n s f e r surplus monies from t h e s t a t e insurance fund i n
two o t h e r s t a t e s , Oklahoma and Utah, were unsuccessful. Unlike New York and
Oregon, the states of Oklahoma and Utah have no l i a b i l i t y f o r losses sustained by
t h e i r r e s ~ e c t i v e s t a t e funds, an important f a c t o r raised i n court decisions.
( 2) A 1979 Attorney General Opinion ( Arizona Attorney General Opinion No. 179- 091
( R78- 340)) also held t h a t premiums paid to the Fund are not State t a x revenue under
the d e f i n i t i o n set f o r t h i n the former subsection E, deleted i n 1980, of A. R. S.
541- 562. However, t h i s opinion addressed a much narrower question - whether
premiums were tax revenues. The opinion d i d not address the l a r g e r l e g a l issues
addressed i n our i n f o r m a l o p i n i o n , namely the L e g i s l a t u r e ' s a u t h o r i t y over the Fund
and i t s monies.
RECOWENDAT I ON
The Legislature should consider obtaining f u r t h e r legal research on the
p o t e n t i a l issues involved i n terminating the State Fund. Further
research should address questions regarding the d i s p o s i t i o n of Fund
assets upon termination, the L e g i s l a t u r e ' s a u t h o r i t y t o t r a n s f e r Fund
assets to the General Fund and l e g i s l a t i v e a u t h o r i t y to s e l l the State
Fund.
FINDING I1
THE LEGISLATURE SHOULD EVALUATE
ARIZONA'S RELATIONSHIP WITH
THE STATE COMPENSATION FUND
The L e g i s l a t u r e should evaluate the State of Arizona's r e l a t i o n s h i p w i t h
the State Compensation Fund ( the Fund). The need for the Fund and i t s
role i n providing workers' compensation insurance to Arizona employers
has changed s i g n i f i c a n t l y since the inception o f the Fund. Although the
nature of the Fund has changed, i t continues t o b e n e f i t from i t s
r e l a t i o n s h i p with the S t a t e . Based on the e f f e c t o f these changes, the
Legislature should consider a l t e r i n g the S t a t e ' s r e l a t i o n s h i p w i t h the
Fund.
Need For Fund And I t s Role I n Providing
Workers' Compensation Insurance
Has Changed S i g n i f i c a n t l y
The need for the Fund and i t s r o l e i n p r o v i d i n g workers' compensation
insurance has changed s i g n i f i c a n t l y since the inception of the Fund. The
Fund was i n i t i a l l y established to act as a source of l a s t r e s o r t f o r
workers' compensation insurance. However, due to changes over time, the
Fund i s now Arizona's major workers' compensation c a r r i e r . This
evolution of the Fund i n d i c a t e s that the need for the Fund has changed.
Source of last resort - The Fund was i n i t i a l l y established to serve as
a source of l a s t r e s o r t f o r employers unable to obtain workers'
compensation insurance. However, while under the a d m i n i s t r a t i o n of the
I n d u s t r i a l Commission o f Arizona ( I C A ) , the Fund held a v i r t u a l monopoly
on workers' compensation insurance. This monopoly ended when the
Legislature established the Fund as a separate State agency.
The Fund was i n i t i a l l y e s t a b l i s h e d t o insure Arizona employers who could
not obtain workers' compensation insurance elsewhere. In 1925 the
Legislature adopted l e g i s l a t i o n t h a t r e q u i r e d employers to obtain
insurance coverage for i n j u r i e s sustained by t h e i r employees. The
Legislature gave employers three a l t e r n a t i v e s to secure such coverage: 1)
the State compensation ~ u n d , " ' 2) p r i v a t e insurance c a r r i e r s , and 3)
self- insurance, provided the employer could furnish proof of financial
a b i l i t y to pay for losses.
According to the 1925 l e g i s l a t i o n , the Fund was established ". . . for
the purpose of insuring employers against l i a b i l i t y for compensation
under t h i s act . . I ' Furthermore, a review of the 1925 l e g i s l a t i o n
indicates that p r i v a t e c a r r i e r s were not required to provide coverage to
employers. Therefore, i f an employer could not obtain coverage from a
private c a r r i e r and did not have the f i n a n c i a l a b i l i t y to self- insure,
the Fund was the only remaining a l t e r n a t i v e .
The 1925 l e g i s l a t i o n establishing the Fund placed i t under the
administrative a u t h o r i t y of the ICA. The l e g i s l a t i o n gave the ICA
authority to set premium rates for both the Fund and p r i v a t e c a r r i e r s . A
review of the early ICA annual reports reveals that the Fund's share of
the workers' compensation insurance market grew from approximately 40
percent in 1927 to more than 97 percent i n 1934. Accor- ding to ICA annual
reports and the Fund's former chief counsel, the ICA was able to capture
the vast m a j o r i t y of the market by a1 lowing the Fund to offer
approximately a 10 percent discount on i t s premium rates from the rates
which the ICA set f o r p r i v a t e c a r r i e r s .
The Fund's 40- year monopoly domination of the Arizona workers'
compensation insurance market ended when the Fund was established as a
separate State agency. In 1968, the Legislature adopted l e g i s l a t i o n that
removed the Fund from the administrative a u t h o r i t y o f the I C A , thereby
creating the Fund as a separate State agency. The l e g i s l a t i o n
( ' 1 The 1925 l e g i s l a t i o n r e q u i r e d t h e S t a t e of Arizona and a l l p o l i t i c a l subdivisions
to obtain t h e i r workers' compensation coverage from the Fund.
also removed the ICAts a u t h o r i t y to set insurance r a t e s " ) , thereby
ending the Fund's monopoly over the Arizona workers' compensation
insurance market.
Although the Fund no longer maintains a monopoly over the workers'
compensation insurance market, i t remains the major workers' compensation
insurance c a r r i e r i n Arizona. I n 1986 the Fund had approximately 36,000
policyholders. During the same period, the Fund reported $ 145.3 m i l l i o n
i n earned premiums to the r a t i n g s organization, approximately 40 percent
of a l l earned premiums for workers' compensation insurance i n Arizona.
The Fund has averaged approximately 40 percent of the earned premium
market since i t s separation from the ICA i n 1969.
. Need for Fund has changed - The Fund's e v o l u t i o n over time suggests
that the need for the Fund has changed. The Fund no longer acts as the
source of l a s t r e s o r t to provide workerst compensation insurance. In
a d d i t i o n , the Fund does not appear to represent small policyholders
beyond what i t s t o t a l market share would d i c t a t e .
The Fund no longer acts as the source of l a s t resort for workers'
compensation insurance. The 1968 l e g i s l a t i o n that made the Fund a
separate State agency also established an assigned r i s k plan. Under t h i s
plan, any employer who i s refused coverage by the Fund and two or more
c a r r i e r s i s placed i n the assigned r i s k plan. Assigned r i s k employers
are apportioned among c a r r i e r s authorized to w r i t e workers' compensation
insurance w i t h i n Arizona based on each c a r r i e r s share of the t o t a l
premi urns wr i t t e n . ( * ' Because of the assigned r i s k plan, the Fund i s
no longer required to extend coverage to a1 I Arizona employers.
Contrary to claims made by the Fund, the Fund does not appear to
represent small policyholders beyond what i t s t o t a l market share would
d i c t a t e . According to data obtained from the r a t i n g organization, the
( 1 Workers' compensation insurance r a t e s are now submitted by a r a t i n g s o r g a n i z a t i o n ,
t o which workers' compensation c a r r i e r s must subscribe, t o the Department o f
Insurance f o r review and approval.
( 2 ) The r a t i n g organization used by t h e S t a t e ' s workers' compensation insurance
c a r r i e r s to submit r a t e changes t o the Department o f Insurance a d m i n i s t e r s t h e
assigned r i s k plan.
National Council on Compensation Insurance ( NCCI), for p o l i c y years 1983
through 1 9 8 5 , " ) the Fund's share of small p o l i c y h o l d e r s ( those w i t h
annual earned premium of $ 5 , 0 0 0 ' ~ ) or less) c l o s e l y matched i t s t o t a l
market share of p o l i c y h o l d e r s ( Table 4, page 29). For example, i n 1985
the Fund insured 64 percent of small p o l i c y h o l d e r s , a p o r t i o n equal to
i t s t o t a l market share. However, small p o l i c y h o l d e r s accounted f o r 80
percent of the market. I f the Fund d i d i n f a c t concentrate on i n s u r i n g
small policyholders, i t s share of small p o l i c y h o l d e r s would exceed 65
percent. The Fund's share of small p o l i c y h o l d e r s a l s o equaled i t s t o t a l
market share i n 1983 and 1984.
Fund Continues To Benefit
From Relationship With State
Although the Fund has become Arizona's major workers' compensation
c a r r i e r , i t continues t o b e n e f i t from i t s past and present r e l a t i o n s h i p
w i t h the State. These b e n e f i t s have r e s u l t e d i n c e r t a i n advantages which
have helped the Fund s u s t a i n a dominant market share. These advantages
include: 1) a large investment p o r t f o l i o , derived i n p a r t from the Fund's
p r i o r monopoly, 2) exemption from Federal income taxes and a s i g n i f i c a n t
s e c u r i t y deposit required o f p r i v a t e workers' compensation insurance
c a r r i e r s , and 3) r e c e i p t of goods and services subsidized by the State of
Arizona.
( 1 ) NCCI c o l l e c t s pol i cyhol der data from a1 1 workers' compensation i n s u r e r s i n Arizona
f o r r a t e making purposes, and provides s p e c i f i c guidelines on the submission of
t h i s data. As such, NCCI represents the only source f o r comparative data on
workers' compensation p o l i c y h o l d e r s . The years analyzed represent the l a t e s t
periods f o r which NCCI had complete data.
( 2) We used the $ 5,000 earned premium l e v e l since the vast m a j o r i t y of p o l i c y h o l d e r s i n
t h e S t a t e had earned premiums o f l e s s than $ 5,000 ( earned premiums ranged from less
than $ 250 t o more than $ 500,000). I n a d d i t i o n , premium discounts, o f f e r e d to
" l a r g e r " pol i c y h o l d e r s , begin a t the $ 5,000 earned premi um l e v e l . However, we a1 so
analyzed the Fund's market shares a t 1 ower earned premi um 1 eve1 s ($ 250, $ 1,000, and
$ 3,500) and found t h a t the Fund's share d i d not change appreciably.
TABLE 4
SMALL POL l CYHOLDER REPRESENTAT l ON I N STATE COMPENSAT l ON FUND
POLICY YEARS 1983 THROUGH 1985
Policy Year
Total Arizona
policyholders
Total SCF
p o l icyholders
SCF Percentage
o f t o t a l Arizona
pol i cyho lders( a)
Total Arizona
policyholders w i t h
earned premium less
than $ 5,000
Total SCF
policyholders w i t h
earned premium less
than $ 5,000
SCF pe r cen t age
of t o t a l Arizona
policyholders w i t h
earned premium less
than $ 5,00O( a)
( a) A1 1 percentage f i g u r e s have been rounded.
Source: Auditor General analysis of data obtained from NCCl for p o l i c y
years ( March through February) 1983, 1984 and 1985.
Investment income - Income from investments has a1 lowed the Fund to
remain extremely competitive by o f f e r i n g s i g n i f i c a n t premium reductions
and dividends to p o l i c y h o l d e r s . The large market share maintained by the
Fund, both before and a f t e r the 1968 l e g i s l a t i o n , has required the Fund
t o e s t a b l i s h s i g n i f i c a n t reserves for , the f u t u r e payment of losses which
have already occurred. I n a d d i t i o n , the Fund maintains a large amount of
surplus monies ( see Finding I , page 15). These reserves and surplus
monies comprise a large investment p o r t f o l i o from which the Fund earns
s i g n i f i c a n t i n t e r e s t income. For example, f o r calendar year 1987 the
Fund reported i n t e r e s t income of $ 58.4 mi l l ion"' on investments that
t o t a l led more than $ 580 mi l l i o n .
In e f f e c t , t h i s investment income allows the Fund to o f f e r premium
reductions and dividends t o policyholders. Since 1982 the Fund has given
a l l of i t s policyholders a sizeable deviation ( discount) from the premium
rates that are f i l e d by the ratings organization. This r a t e d e v i a t i o n
has ranged from 17.5 percent i n 1982 to 32.5 percent i n 1984. The
current rate deviation i s 25 percent, and represents one of the highest
deviations offered by a workers' compensation insurance c a r r i e r i n
Arizona. In a d d i t i o n , the Fund has c o n s i s t e n t l y paid dividends to
policyholders each year since 1969.
Offering such discounts has two e f f e c t s . F i r s t , i t allows the Fund to be
one of the most c o m p e t i t i v e l y p r i c e d workers' compensation c a r r i e r s i n
Arizona. Second, i t s i g n i f i c a n t l y reduces the amount of premiums earned
per p o l i c y by the Fund while leaving losses incurred by policyholders
unaffected by the discounts. As such, the Fund operates at a level where
incurred losses exceed premiums earned. However, as i l l u s t r a t e d i n Table
5, ( page 31) the Fund has r e l i e d upon investment income to compensate for
these losses, and i n e f f e c t , finance premium deviations and dividends.
( ' I Approximately $ 2.1 m i l l i o n o f t h i s investment income was allocated to a group of
employers termed sel f - r a t e r s who establ i sh t h e i r own l o s s reserves which are
maintained and invested by the Fund.
TABLE 5
STATE COMPENSATION FUND
OPERATIONAL ANALYSIS OF NET INCREASE IN SURPLUS
1987 AND 1986
Premium revenues
Less compensation and medical
b e n e f i t s paid
1987 1986
( i n thousands) ( i n thousands)
Excess of premiums over ( under)
i ncur red losses 9,640 ( 3,534)
Ope r a t i ng expenses :
Administrative
Premium taxes
Net loss before investment and
other inc~ me ( 25,499) ( 33,672
lnvestment and other income:
lnvestment
0 the r
Net gain 35,742 29,212
Less dividends declared 30,000 20,000
Net increase i n surplus $ 5.742 $ 9,212
Source: Auditor General analysis of the Arizona State Compensation Fund
1987 Annual Report.
The Fund's use of investment income t o o f f s e t i t s operating d e f i c i t and
finance annual dividends raises questions about compliance w i t h s t a t u t o r y
requirements. A. R. S. 923- 983. A requires that the Fund ". . be neither
more nor less than s e l f - s u p p o r t i n g . " The large reserves maintained to
cover f u t u r e costs of claims provides s u b s t a n t i a l investment income.
However, the Fund may have overstated i t s needed reserve amounts ( see
Areas For Further Audit Work, page 75) and may be accumulating
unnecessary surplus amounts ( see Finding I , page 15). As a resu I t , the
Fund i s able to finance both operating losses and annual dividends,
actions which f u r t h e r improve i t s competitive advantage over p r i v a t e
i nsurance compan i es .
Exemptions - As a State agency, the Fund has remained exempt from
paying Federal income taxes and from e s t a b l i s h i n g a s t a t u t o r i l y required
s e c u r i t y deposit. However, A. R. S. 923- 987 requires the Fund to determine
the amount of Federal taxes i t would owe as a p r i v a t e insurance c a r r i e r .
According to the Fund's outside a u d i t o r s , for the year ended December 31,
1987, the Fund would have owed more than $ 2 m i l l i o n i n Federal
taxes. "' In a d d i t i o n , due to changes i n the tax laws and a projected
increase i n premiums c o l l e c t e d , the equivalent Federal tax owed by the
Fund for 1988 could be even higher.
In a d d i t i o n to not paying Federal taxes, i t appears the Fund i s not
requi red to establ i sh a s e c u r i t y deposit that i s s t a t u t o r i ly requi red of
p r i v a t e workers' compensation insurance c a r r i e r s . A. R. S. 923- 961. C
requi res insurance c a r r i e r s to place secur i t i e s approved by the
Department of Insurance w i t h the State Treasurer or f i l e an equivalent
surety bond. The amount of the s e c u r i t y deposit i s based on the amount
of premiums w r i t t e n by the c a r r i e r . However, because the Fund i s not
expressly mentioned i n A. R. S. 923- 961. C and there i s no clear a p p l i c a t i o n
of the s t a t u t e to the Fund, i t would appear that the s e c u r i t y deposit
requirement does not apply to the ~ u n d . ' ~ ' Auditor General analysis
determined that i f the provisions of A. R. S. 623- 961 applied to the Fund
( 1) 1987 was the f i r s t year since 1983, when the s t a t u t e r e q u i r i n g the c a l c u l a t i o n of
Federal taxes became e f f e c t i v e , t h a t the Fund would have actual 1 y owed Federal
taxes. For the years 1983 through 1986, the Fund reported losses s u f f i c i e n t to
o f f s e t taxable income.
(' 1 An Attorney General representative suggested t h a t c l a r i f i c a t i o n i s needed of A. R. S.
523- 961 as it a p p l i e s t o the Fund.
3 2
as with a l l other c a r r i e r s o f f e r i n g workers' compensation insurance i n
Arizona, for 1988, the Fund would have to place ap'proximate~ y $ 84.1
m i I l i o n o f s e c u r i t i e s w i t h the State Treasurer. The purchase of an
equivalent surety bond would cost the Fund more than $ 420,000. ( 1 )
Such a bond would, however, reduce the amount by which the State i s
responsible for Fund l i a b i l i t i e s .
State subsidies - Advantages to the Fund also include r e c e i p t of goods
and services t h a t are subsidized by the State o f Arizona. C u r r e n t l y , the
Fund receives property and casualty insurance coverage through
p a r t i c i p a t i o n in the S t a t e ' s self- insurance program, a t a p r i c e
s i g n i f i c a n t l y less than the Fund could probably obtain i n the p r i v a t e
market. Because Fund employees are p a r t of the S t a t e ' s m e r i t system, the
Fund receives c e r t a i n services from the Department of A d m i n i s t r a t i o n -
Personnel D i v i s i o n , and p a r t i c i p a t e s i n the S t a t e ' s r e t i r e m e n t , h e a l t h
and l i f e b e n e f i t s programs. Although exempt from the S t a t e ' s procurement
code, the Fund b e n e f i t s from the S t a t e ' s volume purchasing power by
p e r i o d i c a l l y making purchases from vendors who are on State c o n t r a c t .
F i n a l l y , Arizona law requires the Fund to deposit a l l funds received and
make a l l payments through the State Treasurer. Therefore, t h e Fund
receives these services at no charge and occasionally uses other monies
maintained by the Treasurer to cover payments made by the Fund. The
subsidies and the estimated d o l l a r b e n e f i t s to the Fund are i l l u s t r a t e d
i n Table 6 ( page 34).
( 1 ) I n 1988, the L e g i s l a t u r e amended A. R. S. $ 23- 961, e f f e c t i v e f o r 1989, changing the
method f o r c a l c u l a t i n g the s e c u r i t y deposit t o i n c l u d e l o s s reserves establ i shed by
the c a r r i e r as well as premiums w r i t t e n . According t o c a l c u l a t i o n s by Fund
o f f i c i a l s , based on 1987 data, i f the s e c u r i t y deposit requirement had applied to
the Fund it would have t o place approximately $ 326.8 m i l l i o n of s e c u r i t i e s w i t h the
State Treasurer. A u d i t o r General analysis c a l c u l a t e s t h a t an e q u i v a l e n t s u r e t y
bond would cost the Fund more than $ 1.6 m i l l i o n .
TABLE 6
ESTIMATED SAVINGS TO THE FUND
DUE TO STATE SUBSIDIES
Agency
Pe rsonne l
Type of Subs i dy Annual Est imated Sav i ngs to Fund ( a)
P a r t i c i p a t i o n i n
health, l i f e and
d i s a b i l i t y b e n e f i t s
programs
Job recruitment
R i sk Management Property and
casualty insurance
State Treasurer Cash management
State Purchasing Use of State
purchasing contracts
and a d m i n i s t r a t i v e
pe rsonne 1
TOTAL
( a) While each estimate represents the savings to the Fund over a 12- month p e r i o d , t h e
data used t o e s t a b l i s h the various estimates was c o l l e c t e d from time periods t h a t
ranged from f i s c a l years 1987 through 1989.
( b) This f i g u r e represents State Personnel ' s estimated cost o f $ 209 per p o s i t i o n f i l l e d
f o r f i s c a l year 1986- 87 mu1 t i p 1 ied by 148 ( t h e number of employees h i r e d by the
Fund during t h a t period. )
( c ) This f i g u r e represents the d i f f e r e n c e between the charges to the Fund from Risk
Management f o r the insurance coverage and t h e lowest o f three estimates f o r s i m i l a r
coverage from insurance companies obtained through an insurance broker. The
differences between the Risk Management charges and the two higher estimates were
$ 1 72,000 and $ 225,000.
Source: Auditor General analysis of data obtained from State
Compensation Fund, DOA - Risk Management D i v i s i o n , Personnel
D i v i s i o n and State Purchasing O f f i c e , State Treasurer, and a
p r i v a t e insurance broker.
Legislature Should Consider Altering
The State's Relationship With The Fund
The changes i n the nature and r o l e of the Fund and the environment i n
which i t operates may require changes i n the r e l a t i o n s h i p between the
Fund and the State of Arizona. The L e g i s l a t u r e should consider steps to
c u r t a i l benefits the Fund receives from i t s r e l a t i o n s h i p w i t h the State
i n order to reduce the Fund's competitive advantage over p r i v a t e
insurers. The L e g i s l a t u r e may also wish to review the need for the Fund
given the a v a i l a b i l i t y of workers' compensation insurance through the
p r i v a t e market.
Curtail benefits - The Legislature should consider c u r t a i l i n g the
Fund's exemptions from requirements met by other insurers, and reducing
State support of Fund operations that give i t a competitive advantage.
Exemptions from Federal income tax saved the Fund more than $ 2 m i l l i o n i n
1987. Requiring the Fund to pay the equivalent Federal income tax to the
State General Fund would eliminate a s u b s t a n t i a l competitive advantage.
The Legislature should also c u r t a i l State support of Fund operations that
give the Fund a competitive advantage. Annually, the Fund b e n e f i t s from
at least $ 1.4 m i l l i o n i n State support for such functions as employee
b e n e f i t s , purchasing, property and casualty insurance, and cash
management. Most of these b e n e f i t s are not d i r e c t l y paid f ~ bry taxpayer
do1 l a r s , but rather are in- kind b e n e f i t s or savings received by the Fund
through i t s p a r t i c i p a t i o n i n these a c t i v i t i e s . However, c e r t a i n services
provided to the Fund by State Personnel, State Purchasing and t h e S t a t e
Treasurer are subsidized by taxpayer d o l l a r s . The L e g i s l a t u r e should
requi re the Fund t o reimburse those agencies for those services.
Need for Fund - The continued need for the State Compensation Fund i s a
l e g i s l a t i v e p o l i c y question. As a p o l i c y question, arguments can be made
for and against continuing the Fund. One argument against continuing the
Fund i s that the need for which i t was created no longer e x i s t s . The
Fund was established to ensure that workers' compensation insurance would
be a v a i l a b l e to a l l Arizona employers. However, at least 100 companies
now o f f e r workers' compensation insurance, and an assigned r i s k plan
ensures that a l l employers w i l l be able to obtain the required
i nsurance . ( 1 )
A second argument i s that the Fund's existence i s contrary to more recent
l e g i s l a t i v e pol i c y . The L e g i s l a t u r e has established a clear pol icy that
l i m i t s State agencies from o f f e r i n g services that are a v a i l a b l e from the
private sector. A. R. S. 541- 2752 p r o h i b i t s State agencies from competing
with p r i v a t e e n t e r p r i s e unless authorized by law. Although the Fund i s
s p e c i f i c a l l y authorized to o f f e r such services, the need for the Fund to
do so has been lessened by the changes i n the workers' compensat ion
market since 1969.
Arguments for continuing the Fund include the f a c t that i t provides
s i g n i f i c a n t b e n e f i t s to some Arizona employers. Because of i t s large
market share and investment p o r t f o l i o , many employers pay lower premiums
and receive dividends through the Fund. These b e n e f i t s may not be widely
available from the p r i v a t e sector. The Fund also appears to insure the
majority of Arizona employers engaged i n hazardous i n d u s t r i e s such as
underground and surface mining, logging, and a i r c r a f t operations. The
Fund's w i l l i n g n e s s to insure these employers enables _ them to avoid the
higher costs ~ f assigned r i s k insurance. F i n a l l y , because of i t s large
market share, discontinuing the Fund could disrupt the supply of workers'
compensation insurance i n Arizona.
RECOWENDATIONS
1. The L e g i s l a t u r e should consider amending A. R. S. $ 23- 987 to require
the Fund to annually pay to the State General Fund an amount
equivalent to the Federal income tax i t would owe as a p r i v a t e
company.
( ' ) Twenty states have compensation funds. The 30 other s t a t e s r e l y s o l e l y on the
p r i v a t e insurance market t o provide workers' compensation insurance. I n the l a s t
45 years, two s t a t e s have established compensation funds, Minnesota i n 1983 and
Hawaii i n 1985. However, the Minnesota Fund i s incorporated as a mutual insurance
company, subject t o the same r e g u l a t o r y c o n t r o l s as p r i v a t e i n s u r e r s , i n c l u d i n g the
payment of Federal income taxes. The Hawaii Fund has yet t o begin operations due
to a l a c k o f l e g i s l a t i v e funding.
2. The L e g i s l a t u r e should consider r e q u i r i n g the Fund to annually
i d e n t i f y and reimburse v a r i o u s S t a t e agencies for the f u l l cost of
services received by the Fund which are p a i d f o r w i t h taxpayer
do1 l a r s .
3. The L e g i s l a t u r e should consider:
0 The need for the Fund given t h e a v a i l a b i l i t y of workers'
compensation insurance through the p r i v a t e market.
0 Whether the State should compete w i t h p r i v a t e insurers to
provide workers' compensation insurance.
FINDING Ill
THE STATE COMPENSATION FUND CAN SIGNIFICANTLY IMPROVE
ITS CLAIMS MANAGEMENT BY ADOPTING PROCEDURES
USED BY THE PRIVATE SECTOR
The State Compensation Fund ( the Fund) does not employ procedures
commonly used by p r i v a t e companies to manage claims. Claims a r e n o t
assigned to s t a f f i n a way t h a t ensures a p p r o p r i a t e e x p e r t i s e o r equal
workloads. Moreover, the Fund's supervisory reviews, i n v e s t i g a t i o n s and
medical management procedures are weak. More a c t i v e claims management
may reduce claims costs and u l t i m a t e l y reduce the costs of insurance to
policyholders.
The Fund paid over $ 162 m i l l i o n f o r claims during 1987. The Fund's
claims department evaluates claims and determines the amount of medical
b e n e f i t s and compensation t o be paid to p o l i c y h o l d e r s ' employees w i t h
work- related i n j u r i e s . There are two major categories of claims: ( 1)
claims f o r the costs of medical treatment of employment r e l a t e d i n j u r i e s
or diseases and ( 2) claims f o r time l o s t from work ( indemnity claims)
which may also include payment of medical costs. Claims i n v o l v i n g l o s t
time are more d i f f i c u l t and time- consuming to handle than claims f o r
medical costs only.
State Fund claims r e p r e s e n t a t i v e s e v a l u a t e c l a i m s to determine i f
coverage applies and to determine appropriate amounts. As of June 1988,
the Fund had 93 s t a f f i n i t s compensation u n i t , which processes claims.
Representatives need to have t e c h n i c a l e x p e r t i s e t o adequately evaluate
claims i n order to process them i n a timely manner and take other a c t i o n s
to contain medical and compensation costs.
Claims Are Not Assigned
I n An E f f e c t i v e Manner
The Fund's method of a s s i g n i n g c l a i m s to i t s r e p r e s e n t a t i v e s may not be
e f f e c t i v e . The current assignment method does not match the complexity
of cases w i t h the r e p r e s e n t a t i v e s ' experience as i s done by companies
reported to have some of the best claims management p r a c t i c e s . In
a d d i t i o n , the Fund does not t r a n s f e r cases i f the complexity o f the cases
changes.
The Fund assigns claims based on the policyholder/ employer's l o c a t i o n and
name. For example, a claim made by an employee of " Acme Company" i n
Glendale would be assigned to the desk handing policyholders whose names
begin with the l e t t e r A i n the Glendale U n i t . This method does not
d i s t i n g u i s h among representatives' a b i l i t y and experience. Instead,
representatives handle a1 l claims for the l o c a t i o n and alphabet they are
assigned. Thus, a new representative w i t h l i t t l e experience may handle
extremely complex and d i f f i c u l t claims, such as head, back, and
paralyzing i n j u r i e s that can r e s u l t i n permanent d i s a b i l i t y w i t h
p o t e n t i a l f o r h i g h compensation, medical and other costs.
In contrast, p r i v a t e workersf compensation insurers we contacted and the
Workers' Compensation Fund of Utah assign more complex and d i f f i c u l t
claims to t h e i r more experienced representatives. We asked an
independent consultant s p e c i a l i z i n g i n workers' compensation claims to
i d e n t i f y companies which managed claims p a r t i c u l a r l y w e l l . She
recommended f i v e companies and we contacted each of the f i v e . Claims
o f f i c i a l s at each of these f i v e p r i v a t e workers' compensation insurance
companies indicated that they made assignments based on s e v e r i t y of the
claims and representatives' experience. According to these o f f i c i a l s ,
assigning cases i n t h i s manner ensures that representatives w i t h greater
expertise handle the claims that have the higher p o t e n t i a l costs.
The Fund also does not t r a n s f e r cases i f they become more complex.
Private c a r r i e r s reassign cases to more experienced representatives i f
payment or reserve amounts escalate, i n d i c a t i n g that a case i s becoming
more complex. In a d d i t i o n , at least one company we talked to t r a n s f e r s
cases to less experienced representatives once an award i s made and the
case requires l i t t l e monitoring, thus allowing experienced claims
representatives t o concentrate on cases that most require t h e i r s k i l l s .
Fund o f f i c i a l s c i t e one major reason for not reassigning cases. They
state that claims representatives e s t a b l i s h rapport w i t h policyholders
which maintains good policyholder r e l a t i o n s . However, while the Fund
rarely reassigns claims based on changes i n t h e i r status or to
r e d i s t r i b u t e the workload, our review of Fund reports shows that i t
frequently reassigns f i l e s because the employer changes l o c a t i o n o r
name. Between A p r i l 1 and June 30, 1988 the Fund t r a n s f e r r e d 563 claims
among representatives.
More Supervisory Review, B e t t e r I n v e s t i g a t i o n s And
Stronger Medical Management Procedures Are Needed
The Fund's procedures for managing claims o f t e n do not follow standards
generally used throughout the insurance i n d u s t r y . Supervisory review
appears to be l i m i t e d . Many claims are not i n v e s t i g a t e d thoroughly or i n
a timely manner. Moreover, the Fund makes l i t t l e e f f o r t to manage the
medical aspects o f i t s claims.
Limited supervisory review - The Fund does not e f f e c t i v e l y review
claims processed by i t s s t a f f . Although some review guidelines have been
recently developed, they are more l i m i t e d than review requirements used
by p r i v a t e insurance companies.
P r i o r t o 1988, supervisors did not r e g u l a r l y review a l l claims f i l e s .
F i l e s were generally reviewed by supervisors only when representatives
s o l i c i t e d t h e i r advice."' Beginning i n January 1988, supervisors
( 1) I n a memorandum reportedly c i r c u l a t e d t o claims representatives during i n i t i a l
t r a i n i n g , the Fund has established 12 c r i t e r i a f o r o b t a i n i n g supervisory review. A
review of these c r i t e r i a i n d i c a t e s t h a t i n a l l cases the supervisor must r e l y on
the claims representatives t o i d e n t i f y those instances i n which supervisory review
i s c a l l e d f o r . I n a d d i t i o n , the m a j o r i t y of these 12 c r i t e r i a i n v o l v e
a d m i n i s t r a t i v e processing of the claim and do n o t r e q u i r e the supervisor t o
a c t u a l l y review the claim f i l e . As such, the 12 c r i t e r i a do not represent regular
supervisory review which can i d e n t i f y p o t e n t i a l problems and allow the Fund to take
appropriate steps to prevent unnecessary claims costs.
were d i r e c t e d t o randomly " a u d i t " 9 or 10 f i l e s from each desk every
month. I n January of 1989, the Fund plans t o begin r e q u i r i n g supervisors
to review a l l cases o l d e r than 120 days. "' According t o Fund
o f f i c i a l s , programming i s c u r r e n t l y being developed f o r the Fund's
computerized claims processing system which w i l l allow i t t o a l e r t claims
supervisors of a l l claims which are 120 days o l d or have reached t o t a l
payments of $ 1 0,000, $ 25,000 and $ 1 00,000.
Regular supervisory review can i d e n t i f y p o t e n t i a l problems and allow the
insurer to take appropriate steps to prevent costs from e s c a l a t i n g
unnecessarily. The p r i v a t e c a r r i e r s surveyed have methods to assure a l l
or most cases are seen by supervisors a t regular i n t e r v a l s ( Table 7 , page
43). These companies generally use two c r i t e r i a f o r review. One
c r i t e r i o n i s based on the length of time cases remain open or p e r i o d i c
review of a l l open cases. The second c r i t e r i o n i s the reserve amount, or
what the company expects a claim to c o s t . Generally older cases or cases
where expected costs exceed c e r t a i n l e v e l s a r e targeted f o r review.
( 1 ) According to the Fund's Claims Manager and former Claims T r a i n i n g Supervisor, the
Fund current1 y requi res supervi sory review of c e r t a i n claims once they reach 120
days. However, t h i s review i s l i m i t e d t o those claims which the claims
representative i d e n t i f i es and be1 ieves could r e s u l t i n a permanent impai rment
award.
TABLE 7
Company
A
SUPERVISORY REVIEW GUIDELINES FOR SELECTED
PRIVATE WORKERS' COMPENSATION INSURANCE CARRIERS
Age of Claim Amount o f Reserves
A1 I f i l e s open more than A t $ 20,000 local o f f i c e
180 days manager reviews
A t $ 100,000 home o f f i c e
management reviews
A l l f i les w i t h i n f i r s t Supervisor and manager review
30 days; t h e r e a f t e r as reserves monthly
necessary
A l l f i l e s every 90 days Supervisor reviews when reserve
amount reaches s p e c i f i e d l i m i t
f o r r e p r e s e n t a t i v e
A t I f i l e s every 120 days Supervisor reviews monthly
report of reserves; manager
rev i ews a t $ 75,000
A l l f i l e s every 30 days A t $ 25,000 supervi SOP reviews
except permanent payment
cases( a) , wh i ch are
reviewed every 90 days
( a) Permanent payment cases are those where awards have been issued and payments are
made on a r e g u l a r basis.
Source: Compiled by Auditor General s t a f f from i n f o r m a t i o n obtained from
the companies i n June, 1988.
Poor claims i n v e s t i g a t i o n s - The Fund does not adequately i n v e s t i g a t e
claims for compensation payments. Several a u d i t s of the Fund's claims
management have noted that i n v e s t i g a t i o n s are o f t e n not done or are
inadequate. The Fund's lack of a t t e n t i o n t o t h i s important aspect of
claims management contrasts w i t h common practices w i t h i n the insurance
industry and can r e s u l t i n accepting inappropriate cases.
Audits of the Fund's claims processing have c o n s i s t e n t l y i d e n t i f i e d
inadequate i n v e s t i g a t i o n s as a problem, p a r t i c u l a r l y for the more complex
claims involving time l o s t from employment. The Arizona Department of
Admi ni s t r a t ion Ri sk Management D i v i s i on ( DOA- Ri sk Management) r e v i ew of
claims against the S t a t e ' s self- insurance program(" i n 1985 found
that the Fund's claims representatives r a r e l y made needed i n i t i a l
telephone i n q u i r i e s t o employers, claimants, and witnesses. In a d d i t i o n ,
DOA concluded that when claims representatives requested special
investigations from Fund i n v e s t i g a t o r s , the r e s u l t s were usually l a t e and
poorly d~ curnented.'~' Two years l a t e r DOA found that i n v e s t i g a t i o n s
were s t i l l infrequent, t y p i c a l l y made at the request o f employers or i n
unusual cases. ( 3
The National Council on Compensation Insurance ( NCCI) found s i m i l a r
deficiencies in 1987 when i t audited the Fund's assigned r i s k claim
f i l e s . NCCI found the Fund's i n v e s t i g a t i o n s were o f t e n untimely and
poorly documented. According to the r e p o r t , the Fund f a i led to document
t h a t basic i n v e s t i g a t i v e steps were taken w i t h i n standard time frames.
The report also noted that contact w i t h employers " . . . consisted mainly
of wage v e r i f i c a t i o n and time loss determination w i t h only cursory
discussion of i n j u r y . ." and that i n v e s t i g a t o r s ' contacts w i t h
physicians often d i d not document what caused the i n j u r i e s . Further,
( 1 ) The State Fund processes workers' compensation claims f o r DOA- Risk Management.
To ensure t h a t claims are processed i n a t i m e l y , e f f i c i e n t manner, DOA contracts
w i t h a special i s t i n workers' compensation claims management to review selected
claims and evaluate Fund's performance.
( 2) According t o Fund management, the Fund's i n v e s t i g a t i o n s section s o l i c i t s feedback
on the q u a l i t y and t i m e l i n e s s of i n v e s t i g a t i o n s from claims and l e g a l s t a f f
requesting i n v e s t i g a t i o n s . The r e s u l t s o f t h i s survey i n d i c a t e t h a t those
requesting i n v e s t i g a t i o n s are s a t i s f i e d w i t h the qua1 i t y and time1 iness of the
i n v e s t i g a t i o n s . However, t h i s survey does not define what c o n s t i t u t e s timeliness
of each i n v e s t i g a t i o n , nor does i t consider the complexity o f each i n v e s t i g a t i o n .
( 3) Our review of the 1987 OOA a u d i t disclosed t h a t of the claims cases DOA reviewed
and f e l t warranted an i n v e s t i g a t i o n , 80 percent had untimely i n v e s t i g a t i o n s , 83
percent had inadequate i n v e s t i g a t i o n s , and 76 percent contained no i n v e s t i g a t i o n
r e p o r t i n t h e c l a i m f i l e .
representatives had not documented p r i o r i n j u r y i n v e s t i g a t i o n s where
necessary.
Thorough, timely i n v e s t i g a t i o n s are an important component of claims
management. One insurer emphasized that an i n i t i a l i n v e s t i g a t i o n must be
done " quickly and completely" before making a d e c i s i o n t o accept or deny
a c l a i m . Generally, i n i t i a l i n v e s t i g a t i o n s at the p r i v a t e companies
surveyed by Auditor General s t a f f include contacting the claimant,
employer, witnesses, and the t r e a t i n g physician w i t h i n a few days of
receiving a c l a i m . F a i l u r e to adequately i n v e s t i g a t e a claim completely
can lead to unnecessary costs as shown i n the f o l lowing example.(')
An e l e c t r i c i a n f o r a State i n s t i t u t i o n f i l e d a claim for a hernia
reportedly sustained on July 14, 1987. The employee reported the
i n j u r y to h i s employer and obtained i n i t i a l medical treatment for the
i n j u r y on August 28, 1987, 45 days a f t e r the reported date of
i n j u r y . The claimant underwent surgery for the hernia on September
8, 1987. The only i n v e s t i g a t i o n of the claim was a phone c a l l to the
claimant who s t a t e d t h a t he d i d not immediately r e a l i z e he had hurt
himself and discovered the hernia lump sometime l a t e r . The claimant
a l s o s a i d t h a t he reported t h e i n j u r y a f t e r seeing h i s doctor on
August 28, 1987 and then had to t a l k w i t h h i s superv'Lsor to determine
the date of the i n j u r y . The claim f i l e contains no documentation of
further attempts to i n v e s t i g a t e the circumstances surrounding the
i n j u r y and why the claimant waited 45 days to o b t a i n medical
a t t e n t i o n and report the i n j u r y to h i s employer. On October 5, 1987,
the Fund accepted the c l a i m f o r b e n e f i t s .
Comnent: The i n i t i a l i n v e s t i g a t i o n was inadequate because the
claims representative d i d not o b t a i n s u f f i c i e n t information to
evaluate the claim. The representative only contacted the claimant,
not the employer or t r e a t i n g p h y s i c i a n . I n a d d i t i o n , the
representative apparently d i d not review State law governing the
compensabi l i t y o f hernias which requi res that the i n j u r y r e s u l t from
a s p e c i f i c event and t h a t the onset of symptoms occur immediately
a f t e r the event. According to Risk Management o f f i c i a l s , t h i s
condition d i d not meet the requirements of A. R. S. 523- 1043 that
define compensability. F a i l u r e to conduct an adequate i n v e s t i g a t i o n
resulted i n the acceptance of a non- compensable claim, which cost the
State of Arizona more than $ 2,700 i n b e n e f i t s .
( 1 ) I n t h e i r response t o the i n i t i a l d r a f t of the a u d i t r e p o r t , Fund o f f i c i a l s
contended t h a t a l a t e i n v e s t i g a t i o n r e p o r t does n o t n e c e s s a r i l y r e s u l t i n the
acceptance of an i n v a l i d claim since the claim can be denied and l a t e r accepted i f
the i n v e s t i g a t i o n r e p o r t resolves t h e b a s i s f o r the i n i t i a l denial . However,
according t o an I n d u s t r i a l Commission o f f i c i a l , denying a claim under these
circumstances would probably c o n s t i t u t e an unfai r claim processing p r a c t i c e
v i o l a t i o n as defined by A. R. S. 523- 930 since the denial would knowingly be based
on incomplete i n f o r m a t i o n .
45
Inadequate medical management - The Fund does not adequately manage the
medical aspects of i t s compensation claims. Claims representatives and
investigators r a r e l y sol i c i t informat ion about claimants' p r i o r medical
conditions. Moreover, the Fund lacks medical s t a f f for evaluating cases
and makes l i m i t e d use of second opinions.
a Claims representatives and i n v e s t i g a t o r s r a r e l y s o l i c i t p e r t i n e n t
medical records. For example, the 1985 and 1987 DOA audits found
that several claimants had undergone surgery p r i o r to the i n j u r y for
which they sought compensation, yet no medical reports or records
were sol i c i ted to determine i f the previous medical problem a f f e c t e d
the new claim. No medical h i s t o r i e s were sought i n 82 percent of the
f i l e s sampled i n 1987 i n which DOA f e l t p r i o r medical information
should have been s o l i c i t e d . DOA's c r i t e r i a s t a t e s t h a t a claimant
should be queried about medical h i s t o r y , p a r t i c u l a r l y i f the
a t t e n d i n g p h y s i c i a n s t a t e s t h a t the c l a i m a n t ' s h i s t o r y may be a
s i g n i f i c a n t factor a f f e c t i n g recovery.
The f i v e p r i v a t e c a r r i e r s we spoke to use c r i t e r i a simi l a r to DOA's.
They obtain medical records i n instances, such as when there i s 1) an
i n d i c a t i o n o f a p r i o r i n j u r y o r c o n d i t i o n that could impact the
indemnity claim, 2 ) a possibi I i t y of permanent impairment, or 3) the
i n j u r y i s severe. One company s o l i c i t s records for a l l claims of any
s i g n i f i c a n c e , such as cases where the time l o s t from work i s more
than 14 days. Another company obtains records for a l l time l o s t
claims.
0 The Fund also lacks medical expertise needed for e f f e c t i v e claims
management. Unlike many workers' compensation i n s u r e r s , the Fund
does not employ nurses o r other medical professionals t o a s s i s t i n
making judgments about claims. Nor does the Fund make adequate use
of independent medical examinations to ~ b t a i nse cond opinions.
Private insurers use nurses to v i s i t claimants, t a l k to physicians,
and review medical records i n order to evaluate claims and d i r e c t
treatment. Nurses are used because they have the expertise to watch
for and i d e n t i f y improper or non- related treatment, assess a
claimant's progress, and coordinate any r e h a b i l i t a t i o n that may be
required. In p a r t i c u l a r , other insurers r e f e r c e r t a i n types o f cases
to nurses o r other medical professionals. These cases include:
i n j u r i e s i n v o l v i n g loss of earning capacity, cases without f i r m
diagnoses a f t e r 60 to 90 days, and cases i n v o l v i n g catastrophic
i n j u ry , t rauma, and/ or ex tended med i ca I t reatmen t . DOA- R i sk
Management recommended i n i t s 1985 and 1987 aud i t s that the Fund use
nurses to manage medical claims.
Several state workers' compensation agencies also make extensive use
of medical personnel. The Oregon State Accident Insurance Fund ( SAIF
Corporation) has one t o four nurses i n each of i t s s i x o f f i c e s , an
orthopedic surgeon on s t a f f , and contracts w i t h several other
physicians. The Minnesota State lnsurance Fund uses a subsidiary
organization, which has a physician, c h i r o p r a c t o r , and s i x nurses to
manage medical claims.
The Fund maintains i t uses the services of a u t i l i z a t i o n review
organization to a s s i s t i n medical management of claims. However,
t h i s service i s l i m i t e d to determining whether h o s p i t a l i z a t i o n i s
required for a s p e c i f i c procedure o r c o n d i t i o n . I t does not
c o n s t i t u t e the on- going medical management used by p r i v a t e insurers
and other sates.
a Past audits and reviews have also recommended that the Fund make more
use of independent medical examinations ( IMEs). DOA- Risk Management
recommended t h i s approach i n 1985 and 1987. The Fund's i n t e r n a l
auditors found i n 1987 that medical care was " fragmented or
non- directed" and recommended lMEs as a means for improving medical
management. In May 1988, the Fund established an IME u n i t
responsible for a s s i s t i n g claims representatives i n scheduling lMEs
and o b t a i n i n g r e p o r t s of the examinations. However, t h i s u n i t has no
r e s p o n s i b i l i t y for determining when lMEs are needed.
Independent medical examinations strengthen an i n s u r e r ' s a b i l i t y to
manage medical aspects of workers1 compensation claims. According
to o f f i c i a l s interviewed at the f i v e p r i v a t e companies and s t a t e
funds i n Utah, Oregon, Minnesota, and C a l i f o r n i a , lMEs should be
ordered i n a v a r i e t y of circumstances where there are questions about
the nature of the medical problem or effectiveness of the treatment.
E f f e c t i v e Claims Management Can Reduce Costs
More active claims management i s necessary to e f f e c t i v e l y reduce the
costs of workers' compensation insurance to p o l i c y h o l d e r s . Actions taken
by the Department o f Administration to ensure that the Fund adequately
manages State workers' compensation claims appear to have reduced costs
to the State's self- insurance program.
F a i l u r e to manage claims increases costs - F a i l u r e to use good claims
management practices can r e s u l t i n unnecessary costs, as i l l u s t r a t e d i n
the following examples:
On May 29, 1982 a worker at a State medical f a c i l i t y reportedly was
injured while attempting to r e s t r a i n a p a t i e n t . The Fund accepted
the claim 10 days l a t e r . S h o r t l y a f t e r accepting the claim, the Fund
received reports submitted by the c l a i m a n t ' s physician, a consulting
physician, and a p s y c h i a t r i s t that described d i f f e r e n t i n j u r i e s and
circumstances than c i t e d by the claimant.
The claims representative requested an orthopedic medical evaluation
i n A p r i l 1983. On May 23, 1983, the claims representative received
the r e s u l t s o f the orthopedic evaluation i n which the doctor
concluded that the claimant had a back s t r a i n but no apparent
0
evidence of disc disease. The doctor expected the claimant to become
stable w i t h i n the f o l l o w i n g 30 days w i t h no permanent physical
impairment.
On June 14, 1983, the claimant was again h o s p i t a l i z e d for back pain.
An orthopedic examination found that the claimant continued t o s u f f e r
from a back s t r a i n but concluded the c l a i m a n t ' s major problem was
p s y c h i a t r i c i n nature.
In July 1984, more than two years a f t e r the claim had been accepted
f o r b e n e f i t s , the claims representative learned that the claimant had
been treated for a nearly i d e n t i c a l i n j u r y i n another s t a t e and had
rece i ved a $ 20,000 set t l emen t .
DOA- Risk Management r e f e r r e d the claim to a p r i v a t e r e h a b i l i t a t i o n
f i r m for medical management i n August 1986. The claim was closed on
February 17, 1987 a f t e r the claimant had been discharged by h i s
physician with no permanent d i s a b i l i t y . The claimant appealed t h i s
action to the I n d u s t r i a l Commission which sustained DOA's d e c i s i o n .
Comment: Inadequate claims management was evident at l e a s t three
times during the d u r a t i o n o f t h i s claim. F i r s t , the discrepancies i n
i n j u r i e s and circumstances reported when the claim was f i l e d should
have led the r e p r e s e n t a t i v e t o i n v e s t i g a t e the f a c t s . Second, the
representative should have taken action to close the case upon
r e c e i p t o f the May 1983 orthopedic r e p o r t , i n d i c a t i n g t h a t the
claimant's back problems were l i m i t e d . T h i r d , the evidence of a
nearly i d e n t i c a l c l a i m i n another state was another reason for
a c t i o n . Instead, the claimant was allowed to continue treatment for
three more years at a cost of almost $ 90,000, b r i n g i n g the t o t a l
costs of the claim to $ 147,700.
CASE 3
A State employee f i l e d a c l a i m f o r a work- related back i n j u r y i n
December 1983. The employer informed the Fund claims representative
that the claimant ( a) had had four previous back surgeries, and ( b)
had previously made statements that she might seek d i s a b i l i t y based
on these p r i o r surgeries. Neither the claimant nor employer was able
to e s t a b l i s h a s p e c i f i c date of i n j u r y . The Fund claims
representative also received a report from the c l a i m a n t ' s physician
describing four previous back surgeries and a non- industrial back
i n j u r y . The claim was accepted by the Fund on February 1, 1984. No
i n v e s t i g a t i o n was conducted nor were p r i ~ mr edical records obtained.
For the next 15 months the claimant was seen by f i v e doctors and
continued to complain o f chronic back pain although most of the
doctors could f i n d l i t t l e or no physical explanation for the pain.
One doctor indicated that the claimant could r e t u r n to work.
In A p r i l 1985 an independent medical examination by four physicians
concluded that 1) the c l a i m a n t ' s c o n d i t i o n was s t a b l e , 2) there was
no evidence of permanent i mpai rmen t , and 3 the c l aiman t was capab l e
of returning to the type o f work done p r i o r to the reported i n j u r y .
However, in June 1985 the c l a i m a n t ' s physician informed the Fund that
the claimant needed back surgery but refused to say whether the
surgery was related t o the c l a i m a n t ' s p r i o r back surgeries or to the
reported i n j u r y . Although other medical and psychological reports
questioned the need for the surgery, surgery was performed i n October
1985. The claimant developed serious post- operative complications
and continued to complain o f back pain.
In March 1986 DOA- Risk Management intervened and d i r e c t e d the Fund to
refer the claim t o a p r i v a t e r e h a b i l i t a t i o n f i r m and closed the case
i n A p r i l 1987. The claimant appealed the decision to the I n d u s t r i a l
Commission ( I C A ) which ruled t h a t :
m The c l a i m a n t ' s c o n d i t i o n as a t t r i b u t e d to the reported
i n d u s t r i a l i n j u r y required no f u r t h e r treatment a f t e r A p r i l 1985.
a The claimant had not sustained any permanent impairment as a
r e s u l t of the reported i n d u s t r i a l i n j u r y .
a The October, 1985 surgery was not r e l a t e d t o or required by the
reported i n d u s t r i a l i n j u r y , although the surgery and a l l
r e s u l t i n g problems were treated and p a i d f o r as an i n d u s t r i a l
r e s p o n s i b i l i t y by the Fund.
Comnent: I n t e r v e n t i o n by DOA- Risk Management appears to have
resolved t h i s poorly managed claim. According to Risk Management
o f f i c i a l s , the claim representative f a i l e d to close the case when the
independent medical evaluation team found the claimant capable of
r e t u r n i n g t o work i n A p r i l 1985. The subsequent a u t h o r i z a t i o n of
surgery resulted i n thousands of d o l l a r s o f unnecessary medical and
compensation expenses which, according to the ICA award, were
u n j u s t i f i e d by the circumstances. The State paid $ 99,200 as a r e s u l t
of the October 1985 surgery.
DOA experience - The Department of Administration has a c t i v e l y reviewed
the Fund's management o f workers' compensation claims against the S t a t e ' s
self- insurance program. Since 1985, DOA has audited claims against the
State's self- insurance program and has also requested the Fund assign
experienced claim representatives and legal s t a f f to manage State
claims. DOA's review r e s u l t s i n more a c t i v e claims management for State
claims than other Fund p o l i c y h o l d e r s r e c e i v e .
Results from DOA's e f f o r t s suggest other Fund policyholders would b e n e f i t
i f the Fund provided more claims management. According to Risk
Management o f f i c i a l s , actual b e n e f i t s paid by Risk Management have been
s i g n i f i c a n t l y less than the payments forecast by i t s outside a c t u a r i e s .
The actuaries forecasted payments of $ 8.6 m i l l i o n by June 1988. However,
actual b e n e f i t payments at that time were only $ 6.8 m i l l ion, 21 percent
less than expected
The reduction occurred during a period when Risk Management o f f i c i a l s
indicated events should have increased Arizona's compensation payments:
( 1) the l i m i t s on h o s p i t a l and physician charges were increased; ( 2) the
maximum wage b e n e f i t s that could be paid were increased; and, ( 3) the
number of employees covered by Risk Management increased. A l l of these
should have increased the b e n e f i t s paid by the State for workers'
compensation b e n e f i t s .
RECOWENDATIONS
1. The Fund should assign claims to employees based on the complexity of
the claim and the employee's experience and e x p e r t i s e .
2. The Fund should develop a clear p o l i c y for supervisory review of
claims, including
a Review c r i t e r i a based on age of cases and projected costs.
a I d e n t i f i c a t i o n o f s p e c i f i c a r e a s for review
a Continue the development of information systems to i d e n t i f y
claims that meet the review c r i t e r i a .
3. The Fund should establ i s h s p e c i f i c guide1 ines to ensure that each
claim receives at least a minimum level o f i n v e s t i g a t i o n , Guidelines
should also provide d i r e c t i o n f o r a d d i t i o n a l i n v e s t i g a t i o n f o r more
complex or p o t e n t i a l l y c o s t l y claims.
4. The State Fund should strengthen medical management of claims cases by
a Ensuring that claims representatives obtain complete medical
h i s t o r i e s for a l l claims where p r i o r conditions may c o n t r i b u t e
to the current d i s a b i l i t y or l i k e l i h o o d of recovery.
a H i r i n g nurses or other medical professionals to assist claims
representatives i n evaluating medical treatment.
a Developing guidelines i d e n t i f y i n g s i t u a t i o n s where use of
medical s t a f f i s warranted.
FINDING IV
SIGNIFICANT WEAKNESSES EXIST IN ACCESS CONTROL
AND DISASTER RECOVERY PROCEDURES OF THE FUND'S
COMPUTER SYSTEMS, INCREASING THE RISK OF
FRAUD OR ABUSE
S i g n i f i c a n t weaknesses e x i s t i n two c r i t i c a l c o n t r o l s o f the State
Compensation Fund's ( the Fund) e l e c t r o n i c data processing system.
Computer access c o n t r o l s and physical s e c u r i t y are weak, exposing the
Fund t o p o t e n t i a l fraud and abuse. In a d d i t i o n , disaster recovery
control procedures are inadequate.
The State Compensation Fund r e l i e s heavily on i t s e l e c t r o n i c data
processing ( EDP) system for many operations, such as processing claims
and payments and maintaining pol icyholder records. Computerization
allows quicker and more e f f i c i e n t data storage, manipulation, and
r e t r i e v a l . I n 1987, the Fund processed approximately 57,000 compensation
claims. The Fund alsa processed approximately 335,500 checks
( representing compensation and medical payments, general disbursements,
p a y r o l l , and dividends), amounting to nearly $ 704 m i l l i o n . ( 1 )
Furthermore, the computer system maintains c o n f i d e n t i a l information on
current and p r i o r p o l i c y h o l d e r s and claimants.
Auditor General EDP s t a f f reviewed the Fund's computer system because the
Fund r e l i e s extensively on EDP and i t s data was used i n the a u d i t . The
auditors concentrated on the adequacy of general c o n t r o l s used to provide
r e l i a b i l i t y o f , and s e c u r i t y over, the data being processed.
( 1 ) This amount i n c l u d e s b e n e f i t payments f o r sel f - i n s u r e d accounts, assigned r i s k
claims, and claims from p r i o r years.
Access Controls And Physical Security Are Weak
The Fund does not adequately p r o t e c t computer operations from
unauthorized access. Lack o f adequate c o n t r o l creates a high exposure to
p o t e n t i a l fraud and abuse.
Access controls - P r o t e c t i o n against unauthorized access t o computer
data should be standard p r a c t i c e to guard a g a i n s t p o s s i b l e fraud and
abuse. The Fund, however, does not use adequate s e c u r i t y measures to
control computer access even though these measures a r e a l r e a d y
a v a i l a b l e . Normally, users should be able t o gain access to computerized
i n f o r m a t i o n o n l y through established passwords and a u t h o r i z a t i o n
procedures. However, claims processing s t a f f a r e n o t r e q u i r e d t o log on
or enter passwords. The Fund's management i n f o r m a t i o n system ( MIS) s t a f f
are required to log on and enter passwords. However, they circumvent
t h i s c o n t r o l by using predefined keys (" hot keys") which automat i c a l ly
supply t h i s information t o the t e r m i n a l .
An adequate c o n t r o l system should also be capable of i d e n t i f y i n g and
logging attempts a t unauthorized use. For example, attempts t o gain
access by entering i n v a l i d passwords should be logged and the terminal
disconnected or the keyboard locked a f t e r several unsuccessful attempts
to gain e n t r y . Jobs submitted f o r execution should be monitored so that
any unauthorized attempts would be detected and the r e l a t e d job
cancelled. No such c o n t r o l s are i n place at the Fund.
F u r t h e r , according to the Fund's MIS s t a f f , reports of terminal a c t i v i t y
( r e p o r t s i d e n t i f y i n g those accessing computer data and what they do w i t h
i t ) are seldom produced. EDP management should r e g u l a r l y prepare and
review these types of r e p o r t s to detect unauthorized computer o p e r a t i o n s ,
thus p r o v i d i n g a c o n t r o l over computer use.
Easy access to computer data and i n s u f f i c i e n t m o n i t o r i n g o f terminal use
increase the r i s k of fraud. Although Fund management maintains the r i s k
of fraud i s low because they can track changes to claims i n f o r m a t i o n , we
found some changes t o c l a i m s i n f o r m a t i o n are recorded and maintained for
only a s h o r t p e r i o d of time, while other changes t o data are simply not
tracked. For example, changes made to addresses and benef i t t e r m i n a t i