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Share and share alike: corporations can create savings incentives by the way they allocate the cost of risk internally. (Property/Casualty: Risk Management).

The cost of property and casualty risk for American businesses, nonprofits and governments is roughly $200 billion, taking insurance and self-insured losses into the equation. How organizations account for these costs can range from a model of lucidity to a perverse maze. There are some examples of best practices, however.

Many organizations charge operating units their fair share of risk and insurance costs. Most controllers and risk managers like to do so. About half seem to believe that getting operating units to budget for the cost of risk will lower the cost of risk. Even executives who don't know whether the practice results in a cost savings still feel it is a good one.

In a recent survey of risk managers and risk consultants, about half confidently predicted that a well-run allocation system will generate savings in cost of risk of about 5% to 10%. Thus a company with $1 million in annual property/casualty losses could save from $50,000 to $100,000, simply by making managers more financially accountable for the losses in their departments The most popular candidates for allocation were workers' compensation and liability exposures.

But it's not easy to get the allocation system right. As one risk manager noted, the system must be perceived as fair and impartial or it will cause those affected to thwart the system or leave. It must also have a strong enough impact on the bottom line to be worthwhile to those in the best position to reduce loss costs.

Allocation of Risk

Examples of flawed, even perverse allocation practices are easy to find. Some years ago, a division of a major paper products company assiduously reduced its workers' comp claims costs by 90% only to find that home office increased its assessment for the next year. Its allocation policy simply did not take recent experience into account. In another example, a major nonprofit organization repeatedly assessed its local chapters for insurance at rates far in excess of the prevailing market quotes. Without telling the chapters, home office was building up a large surplus in its captive insurance company.

Risk managers appear to divide into two camps about how to allocate the Cost of risk. The primary concern of one camp is year-to-year stability in assessments to operating units. They aim to make these allocations as predictable as possible. The other camp is concerned mainly about the accountability of division managers. This group of risk managers tends to favor allocations which reward or punish behavior, fast.

Every method starts with an aggregation of costs called "cost of risk." Since the mid-1990s, prevailing cost of risk for corporations has been tracked by the Risk and Insurance Management Society and Ernst & Young, the accounting firm, using an annual survey. They count insurance premiums, retained losses, internal risk management, outside services, financial guarantees, fees and taxes. For organizations with $100 million or less in annual revenues, the cost of risk has been about 3% of revenues. For those with revenues of more than $1 billion, the cost of risk has been under 1% of revenues. The vast majority of costs relate to workers' comp and liability.

Actuaries such as Kevin Bingham, in the Hartford, Conn., office of Deloitte & Touche, can come up with estimates of costs if contingencies are large and can only be guessed at by nonactuaries. "We can use methods with great names like the Bornhuetter Ferguson method to weight actual experience with expected experience, if need be," Bingham said.

Once the base costs are tallied, the next step is to allocate, or charge back, the costs to divisions. A simple way to allocate costs is to spread the total cost of risk, by line, according to the appropriate common denominator for the line. Thus, workers' comp costs could be allocated by full-time equivalent employee count or payroll. Liability risk costs can be assigned by sales dollars or units of service. This approach emphasizes stability.

While this method is simple, it fails to create any serious incentive to reduce the cost of risk. Say the chief executives of divisions might have average tenures of three years. Cost control investments, however fast-acting in cutting claims, are slow to trigger a reduction in allocation. From the perspective of the division chief with the next promotion in sight, spending scarce dollars on reducing the cost of risk might even appear a waste of resources.

Bingham believes that charging back the cost of risk to operating units "can really help an organization drive down its costs by motivating line managers to focus on the importance of return-to-work initiatives. As I have observed with clients, nothing motivates managers more than a comp system that weighs in the cost of risk when determining their final salary," he said.

Best Practice

A search resulted in several finds of what one might call "best practice." Aimed at self-insured organizations, with some modifications they can work well for insured entities.

United Technologies Corp., which makes building systems and aerospace products, deserves a gold medal with actuarial clusters for an ingenious approach. David Bowen, a former executive with the company, originally authored it, and George Levine, a consultant, later refined it. What follows is a somewhat simplified version.

United Technologies values its claims shortly after the close of a period, such as a fiscal quarter. The total value of new claims for an operating unit is computed as a percentage of the new claims value of all operating units. The company then applies this percentage to an actuarially set total "premium" cost for the company, and allocates each operating unit its proportional share.

This approach allocates 100% of "premium" to operating units. This is an important goal as United Technologies maximizes indirect cost reimbursement from governmental customers, which have strict guidelines on indirect cost accounting.

The focus on new claims cost promotes cost reduction. Even stronger incentives to reduce the cost of risk can be bolted on. For instance, to encourage reducing claims frequency, a corporation using this approach could base the premium allocation on a blending of an operating unit's share of total new claims valuation and share of new claim volume. What about large single losses? United Technologies has a provision to cap large losses so that rare events do not wreak havoc on departmental budgets.

The United Technologies approach has ingredients which risk managers say they want in their allocation method.

* The allocations link to new claim trends. Division executives have a clear incentive to prevent and manage new claims.

* The methodology is acceptable under federal standards for charging risk costs to contracts and grants.

* Allocations can be computed frequently based on recent experience.

* 100% of the cost of risk can be allocated to operating units.

This approach has yet another virtue: it is easy for divisional executives to understand.

Lost-Time Method

Many organizations tend to think of workers' comp differently than they do other risks. A special method for this line of risk may be a good idea. For example, focus attention on reducing lost time. A lost-time calculator can allocate not just workers' comp but also short- and long-term disability costs. Total cost of unsheduled absences has been estimated by the Integrated Benefits Institute of San Francisco at 10% of personnel costs.

In one scenario, a company computes the accumulated lost time of every new lost-time claim through the end of the period. It assigns a standard cost per lost day, derived from analysis of prior claims, reflecting indemnity, medical and other costs. For claims that remain out of work at the end of the period, it can add an additional standard cost per claim. (A claim with five lost days at the end of the period could be assigned an additional cost much lower than a claim with 60 lost days to date). The corporation can allocate the total cost of workers' comp risk proportionately.

An alternative method recognizes lost-time claims from prior periods as well as new claims. All lost days incurred within a period are given a per day cost value. The corporation allocates total workers' comp costs in proportion to the division's share of total lost days for the entire corporation.

Accelerated Experience Method

Some companies may want to inject the right incentives, but they are required to use an allocation system that does not quickly reflect recent loss experience. Then consider the following method that the Commonwealth of Massachusetts used successfully in the 1990s to sharply reduce claims costs in the workers' comp assigned risk pool. An Australian insurer is now using it. If it can work for an insurer vis-a-vis hundreds of insureds, it can work for a corporation with multiple operating units.

To begin, invite operating units to demonstrate competence in a portfolio of safety and claims-management practices known to have very fast implementation times. Certify them through an audit process. Then, award them a "credit" to regular allocations. A typical formula for workers' comp is a credit for three years for 15%, 10% and 5%. By the third year, the normal, slow-moving allocation system will have essentially recognized the improved loss experience.

The key to this method is that divisions often can produce fast, big improvements. In 1)0th the Massachusetts and Australian cases, the plan is designed to save twice the amount of the credit and thus create a big financial cushion. The risk management department acts as if it were an insurer. It makes an "underwriting" bet that the improved results match or exceed the discount.

Allocating cost of risk is built into the current corporate culture. A huge share of managing risk is borne by corporate departments, not by home office executives. Is there any better way to spell accountability?

RELATED ARTICLE: Sources for Allocation Accounting Standards

Generally Accepted Accounting Principles: GAAP standards are formulated by the Financial Accounting Standard Board Statements (FASB, and its affiliate, the Governmental Accounting Standard Board (GASB, Specifically pertinent statements include FASB 117, "Financial Statements for Not-for-Profit Organizations," and GASB 29, "The Use of Not-for-Profit Accounting and Financial Reporting Principles by Governmental Entities."

Statutory Accounting Principles: Insurance entities are, in addition to GAAP, also subject to Statutory Accounting Principles (SAP). A source is the National Association of Insurance Commissioners (NAIC) Web site, Pertinent statements include SSAP No.70, "Allocation of Expenses," and SSAP No. 25, "Accounting for and Disclosures About Transactions with Affiliates and Other Related Parties" and Appendix A-440.

Federal Standards: Federal accounting standards govern how costs should be allocated by recipients of federal grants and contracts.

Major sources of standards include:

* National Institutes of Health (NIH) Web site, Grants Policy Statement, for recipients of NIH grants.

* Office of Management and Budget (OMB) Web site, OMB Circular A-122 (nonprofits), Circular A-21 (educational institutions) and Circular A-87 (local governments).

* Federal Acquisition Regulation (FAR) and Cost Accounting Standards (GAS) Web site,, in particular Part 28. for firms contracting to provide goods and services to the federal government.

Source: Deloitte & Touche LLP

IRS Definition: For tax purposes, the IRS allows for costs to be expensed "to the extent that types of coverage, extent of coverage, rates, and premiums would have been allowed had insurance been purchased to cover the risks. However, provision for known or reasonably estimated self-insured liabilities, which do not become payable for more than one year after the provision is made, shall not exceed the present value of the liability."

Peter Rousmaniere is president of Pain Disability Management, a Manchester, N.H.-based firm that specializes in assessment and treatment of chronic pain.
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Author:Rousmaniere, Peter
Publication:Best's Review
Geographic Code:1USA
Date:Nov 1, 2002
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