Applying Pareto’s Rule to Workers’ Compensation Claims Risk Management

Introduction

Italian sociologist Vilfredo Pareto (1848-1923) is best known for his namesake principle, the Pareto Rule, which states that for many distributions, approximately 80% of outputs are driven by just 20% of possible inputs, otherwise known as the “vital few.” The converse is that the other 80% of inputs, the “trivial many,” drive only 20% of outputs. Business leaders may recognize this as the more commonly recognized “80/20” rule, i.e., that 80% of business is driven by 20% of customers.

Pareto’s Rule: The Basics
One goal for business leaders is to identify the inputs most influential to desired business outcomes and then to prioritize them. If we manage inputs equally, we are not optimizing resources and risk being outpaced by better stewards of capital. Driving 80% of outputs, the vital few deserve 80% of resources, leaving 20% for the trivial. Therefore, an input among the few deserves 16x the resources (time, money, and manpower) as one of the many.

To be technical, 80 resource widgets directed to 20 vital gizmos is four widgets per gizmo, with 20 widgets remaining for 80 trivial gizmos. In other words, 0.25 widgets per gizmo.

4 = 16 x 0.25 (All gizmos are not created equal, as Pareto notes.)

Pareto’s Rule in Action

While theory is nice, how does Pareto’s Rule apply to workers’ compensation claims risk management? As it turns out, it is even more pronounced. In reviewing workers’ compensation claims data, we find just 15% of claims typically represent more than 80% of total costs (see Chart 1).

Chart 1. Workers’ Compensation Claims/Cost Ratio

Furthermore, those 15% of claims differ in severity and can be split into two buckets of nearly equal dollar amounts, but 2:1 in terms of volume. “Extreme Risk” claims account for 5% of the total (1/3 of the vital few), but 42% of the costs, while merely “High Risk” claims represent 10% of the total (2/3 the vital few) and another 39% of the costs. Moving back to our widget analogy, that’s roughly eight widgets per extreme gizmo (and four widgets per high gizmo, with less than 0.25 widgets remaining for each trivial – or lower risk – gizmo). (See Chart 2.)

Chart 2. Widget/Extreme Gizmo Ratio

Of course, if our resource “widgets” are people, i.e., claims/claims managers, they too are not fungible, with some better and more experienced than others. It’s not that we need more people on extreme gizmos, so much as needing the right people on them. Namely, those empowered with the bandwidth to focus and the right resources at the right time. The key is early identification, segmentation, and triage. If all claims are always managed equally, 85% of resources are absorbed by claims accounting for 20% of dollars. That’s a ticket to extinction.

Risk Monitoring of Claims
Risk monitoring of claims ensures that claims managers never miss a warning sign, putting the right resources on the right claims early, while not engaging complex and costly referrals unnecessarily. Supplementing experience with business intelligence is critical as millennials and Gen Z’ers take the reins from retiring baby boomers.

Historically, interventions like case management or independent medical examinations are only used after certain thresholds are hit, but the claim is already a mess and facilitating closure is more difficult, often resulting in permanent disability or lifetime reserves for claims that could be resolved sooner.

The Final Word

Vilfredo Pareto first observed his well-known principle when noting that 80% of the wealth in Italy belonged to 20% of the population. He could have been referring to 80% of revenue belonging to 20% of businesses (true in most industries, even today). What these businesses do well is prioritize efforts and resources, whether directing 80% of product efforts at 20% of customers – the best and biggest – or most cost-containment efforts at their biggest cost drivers. The key is to pick the right few, “the vital few,” and identify them early. Vilfredo Pareto would most certainly agree.

To learn more about Sapiens’ solutions for Workers’ Compensation, click here.

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