Casualty insurance costs, including premium and retained losses, can represent a large percentage of a company’s overall insurance expenses. Risk management professionals may choose to allocate these costs down to the division, entity, or location level; however, finding the ideal allocation can be tricky. No two companies are the same, and differences in insurance program structure, industry type, geography, risk control, and operations can impact which allocation methodology would be most effective.

There are a lot of considerations when allocating insurance costs.

• What is the optimal balance of stability with responsiveness?
• What is the optimal balance between simplicity and complexity?
• How can year-over-year volatility be tempered for an individual business unit?

This article will discuss specific insurance costs that may be allocated, outline five objectives of an effective insurance cost allocation, and provide multiple methods of allocating insurance costs.

What costs should be allocated?

Before an allocation method can be decided, it is important to determine which costs should be allocated. The most common insurance cost allocated is insurance premium. For companies with loss-sensitive programs, retained losses may be a significant portion of the total cost of risk (TCoR). Selecting the proper allocation methodology can also help in containing losses.

Other components of TCoR that may be allocated are:

• Cost of collateral
• Third-party administrator costs
• Risk management information system (RMIS) expenses
• Broker fees
• Risk control and safety
• Internal claims handling

Five objectives of allocation methods

The first objective is that the allocation methodology is fair and equitable. When allocating a fixed cost, such as premium, it may make sense to allocate based on a percentage of total exposures, a measure that corresponds to propensity to loss, such as payroll for workers’ compensation. However, when allocating a variable cost, such as losses, an exposure-based method may not be appropriate. One location may contribute a large percentage of payroll; however, if that payroll is all clerical and/or salespersons, there may not be a large propensity for loss. In that case, a loss-sensitive method may be more equitable. Alternately, an adjustment to the exposures, to account for geography and job type, can be made and used as an option to allocate expected losses.

An allocation methodology should also be easy to administer and explain. While a method that involves frequent updates of charging actual loss dollars to the corresponding business units may be the most accurate approach, it’s administratively taxing. Using a proxy of historical loss experience will be less burdensome.

Additionally, the risk management professional needs to be able to explain to the business units why they are being charged as they are. If an allocation methodology is too intricate, there may be pushback on the charges. A more straightforward approach will be easier to communicate.

For companies retaining losses, a loss-sensitive allocation is beneficial. There are several considerations here, such as:

• How much weight should be given to a loss-sensitive approach compared to the stability of an exposure-based approach?
• How many years of losses should be reviewed for use in the allocation? Considering the most recent two to three complete years will provide enough experience to be meaningful without over-penalizing for past mistakes.
• Should the losses considered be limited or unlimited? If a business unit has a large loss, will the use of unlimited losses allocate too much based on that single event?
• Will the allocation methodology include a chargeback mechanism, reflecting actual loss experience of the business units?

The fourth objective is that the methodology is incentivizing. An effective allocation can shape the behavior of the business units by encouraging safety, loss control, and claims management using a performance-based method. A focus on controllable metrics, such as report lag, claims closure, and return-to-work practices, can decrease expected losses, resulting in less to allocate in the future.

Finally, an allocation method should be sufficient. One hundred percent of the total cost of risk should be allocated.

Pros and cons of various allocation methodologies

An effective allocation methodology should be tailored to the needs of the business. This may include allocating all costs using a single methodology, or allocating costs based on separate or a blend of methodologies. No two allocations are the same, nor should they be. Identifying a company’s risk management goals can help determine which allocation methodology would align the best.

Exposure-based allocation

In this allocation methodology, costs are allocated based on percentage of total exposure (e.g., payroll, revenue, auto units, or mileage).

Figure 1: Sample exposure-based allocation

Figure 1 shows Business Unit A receiving 25% of the insurance cost allocation as it has 25% of the payroll. The simplicity and stability of an exposure-based allocation methodology is attractive, but there are pitfalls. For one, it doesn’t promote loss control. Additionally, without any adjustment for job type or geography, it may penalize locations with heavy payroll in low-risk class codes.

Loss-based allocation

As the name implies, this method uses percentage of loss to allocate insurance costs.

Figure 2: Sample loss-based allocation

In Figure 2, three complete years of historical losses have been totaled, and the percentage of total has been used to allocate the insurance costs. Business Unit A makes up 18% of the losses, and it is receiving 18% of the insurance cost allocation. Counter to the exposure-based methodology, the loss-based methodology is responsive to actual loss experience; however, there is additional volatility associated with relying completely on this method. As mentioned above, there are additional considerations regarding the number of years used and limitation of losses, if this method is applied.

Performance-based allocation

A performance-based methodology is more subjective than the loss- and exposure-based methods, but it may be effective in shaping the behavior of the business units. If a company is trying to focus on and control particular metrics, such as report lag, claims closures, or lost time days, it can implement a scoring system to use as a part of the allocation.

For example, if report lag is the metric that is being considered, a possible scoring system may be:

• 0 points for 0-3 days
• 1 point for 4-10 days
• 2 points for 11+ days

All claims for the past two to three years can be reviewed, a score can be assigned, and these scores can be averaged and totaled, allocating based on the percentage of total performance score. Alternately, the business units can be rank-ordered based on their scores, and that can be used to allocate costs.

Figure 3: Sample performance-based allocation

Figure 3 demonstrates how three separate scores can be added and the percentage of total can be used to allocate the costs. While this does achieve the objective of incentivizing good behavior, as well as aligning with risk management goals, there are a few potential weaknesses. There is a need for the business units to directly relate the performance score to the metric being measured. Additionally, the behavior needs to be controllable. It may be difficult for a business unit to have control over litigation, depending on the jurisdiction. Finally, the score should incentivize the right behaviors. Some allocation methodologies may inadvertently promote a suppression of claims reporting to improve the appearance of a business unit, which may lead to behavior counter to what is trying to be controlled.

Hybrid methodology

While there are advantages and disadvantages to the three methods described above, each one individually may not align with the objectives of an effective allocation methodology. Because of this, a hybrid approach can incorporate the stability of an exposure-based methodology, the loss sensitivity of a loss-based methodology, and the incentivizing behavior of a performance-based methodology.

Figure 4: Sample hybrid allocation

This hybrid approach shown in Figure 4 accomplishes the five objectives, but the selection of the weights to each of the components may be difficult to determine or explain.

Additional features and methods

The exposure-, loss-, and performance-based allocation methodologies are not exhaustive. These methods are typically used prospectively, allocating costs before actual insurance costs are known. Other methods are concurrent with actual experience. For example, an inter-deductible may be applied as losses develop. If a company has a $250,000 workers’ compensation deductible, it may not want to burden the business units by having them absorb that full amount. Instead, it may apply an inter-deductible of $5,000 or $10,000 for each claim that develops for each business unit. Alternatively, a per-claim charge can be assessed for each claim reported, possibly a separate charge for medical-only claims and indemnity claims. As mentioned, this methodology runs the risk of becoming complex if reviewed too frequently or if the charges become too complicated.

An alternative to a performance-based allocation is to credit or charge based on a particular metric. If report lag is of interest, a credit could be awarded for each claim reported within three days to incentivize that behavior. Conversely, a charge could be applied for each claim reported after three days.

Finally, to avoid volatility in the allocation, year-over-year changes for each business unit can be capped. If Business Unit A had an allocation of $1.4 million last year and the calculation indicates an allocation of $2.1 million this year, that 50% increase can be tempered by capping to a specified amount. The risk with this mechanism is that the amount excess of the cap will have to be redistributed to maintain sufficiency, either to the other business units or to corporate. This may result in a difficult conversation with the business units absorbing the overage.

In summary

Selecting an effective allocation methodology can involve several decisions but finding a method that accomplishes all five objectives doesn’t have to be difficult. Your actuary can help walk through various methodologies, pointing out the benefits and the pitfalls of each, helping you create a tailored approach that will best align with your company’s risk management goals. Additionally, as these goals change and shift, your actuary can help review and adjust your allocation methodology for continued success.