As Gov. Arnold Schwarzenegger and legislators negotiate over how to overhaul the system that compensates injured workers - with the governor seeking to dramatically lower costs borne by employers - a long-running squabble over the financial health of the quasi-public State Compensation Insurance Fund is looming ever larger.

The agency (known to insiders as "State Fund") was set up to be the insurer of last resort for employers who are unable to acquire insurance from private carriers, but with the virtual collapse of the private market, it is now writing well over half of the business in the state. And that is focusing attention on the status of its reserves and a feud over what authority, if any, the state insurance commissioner wields over its financial health.

State Fund leaders say their reserves are adequate, but Insurance Commissioner John Garamendi has questioned that assertion. Teams of rival auditors and actuaries have examined the agency's books and come to sharply different conclusions over the issue.

The relationship between Garamendi and State Fund officials has deteriorated so much that the latter have filed a lawsuit challenging his authority to oversee their operations and are accusing him of trying to drive the State Fund into a precarious financial situation to justify some form of takeover, citing documents they say proves he has a political motive.

"What's happened is that they (Garamendi's office) are trying to get the State Fund to adopt a rate structure that the commissioner can then go take credit for in a politically optimum way, knowing full well that by forcing the State Fund to adopt those frozen rates, he is driving the State Fund toward the levels (of reserves) that would result in it being conserved (taken over) in the years 2006 and 2007, and we've seen that in these documents," State Fund attorney Gregory Long declared in one recent courtroom clash over access to internal Department of Insurance documents.

Garamendi sharply denies trying to force State Fund to lower its rates dangerously or having any political motive, terming the State Fund assertions "totally out of context and flat-out incorrect." He is, however, asking Schwarzenegger and legislators to remove the ambiguity by declaring in law whether he does or does not have regulatory authority - a move that State Fund executives interpret to be a power grab.

Ironically, however, while Garamendi says he merely wants the State Fund to operate like a "well-run, efficient insurance company that prices its policies properly," legislative negotiators on workers' compensation reform are noodling around with exempting it from the reserve requirements that apply to private insurers and thus allowing it to make significant reductions in the premiums paid by employers.

Whether State Fund is underreserved, as Garamendi says, or more than adequately financed, as some in the Legislature maintain, is a critical point because it has become the trendsetter for workers' comp rates. If it's required to reduce its rates as part of a workers' comp compromise, private insurers will be bound to follow. But if it doesn't make big reductions because of countervailing pressure to increase its reserves, employers' costs may remain high and the avowed purpose of the current negotiations will be thwarted.

The interaction between the State Fund's rates and those of private insurers is so complex that some State Fund officials believe private insurance executives are influencing politicians to interfere in the State Fund's operations.

Garamendi says he is strongly opposing any effort to exempt State Fund from the reserve requirements. "While in the short run, an unregulated (State Fund) may be able to provide lower rates to employers, in the long run that deregulation will harm or destroy the financial viability of (State Fund) and cripple any attempt to bring healthy competition back to the California workers' compensation marketplace," Garamendi said in a letter to Schwarzenegger this week. He added that if Schwarzenegger and lawmakers exempt the State Fund from reserve requirements to lower its rates, they should also remove it from his purview "and make it an agency of the state, which should also entail the state guaranteeing (its) policyholder and claimant obligations. ..."