Allocating insurance cost to business segments
Insurance costs are typically determined on a company-wide level. However, those costs often need to be allocated to business segments, which can differ in size, risk exposure, and performance. Whether you are allocating to business units, locations, franchises, contractors, or another segment, an actuary can help design an allocation model that aligns with your organization’s unique structure and goals.
Designing the Right Allocation Model
The optimal model depends on your organization’s objectives, available data, and risk culture. A well-designed model can promote accountability, encourage safety and loss control, and align costs with actual risk. When determining the best model for your organization, consider the following trade-offs:
- Straightforward vs. Complex: Simple models are easier to explain and implement but may not accurately reflect each segment’s risk profile or loss experience.
- Consistency vs. Responsiveness: While it’s important for the model to reflect changes in loss experience, excessive year-over-year fluctuations can be disruptive. How much change is too much?
- Ease of administration: How difficult is it going to be to administer? Consider the resources required to maintain and communicate the model effectively.
To manage these challenges, organizations can implement features such as caps on year-over-year changes for each business unit to help limit volatility. Additionally, standardized templates can be developed to explain shifts in allocated costs by highlighting key drivers such as growth in exposures and changes in loss experience at the business unit level as well as changes in the overall loss rate trend for the organization and increases in the total cost to be allocated. These tools not only enhance transparency but also support more informed and constructive conversations with stakeholders.
Methods for Allocating Insurance Cost
There are several methods for allocating insurance costs, each offering distinct advantages and limitations. The following overview highlights key approaches, though in practice, a blended strategy often yields the most effective results.
The simplest method is an exposure-based allocation. For example, auto liability costs might be allocated based on the number of vehicles for each business unit. If a business unit’s number of vehicles is 20% of the company’s total vehicles, then 20% of the cost is allocated to this unit. While the method is easy to understand and administer, the allocated cost may not reflect the actual risk and loss experience of each business unit.
To reflect the actual risk and loss experience, a model can incorporate historical data such as the number of claims and the total losses for a business unit. When using loss experience, the actuary should consider the credibility of each unit’s experience as well as how much impact the organization wants any individual large claim to have on the allocation. In addition, thought should be given to how many years of experience to include and whether losses should be developed and trended to an equivalent level. The benefit of this approach is it reflects the business unit’s actual loss experience. However, it can be volatile. For example, if a business unit had two large claims in the experience period included in last year’s model that are outside of the experience period in review this year, the allocation could drop significantly.
Another method, which considers the loss experience and exposures for each business unit, is to calculate an experience modification factor for each business unit. This approach compares the expected losses for a business unit to the actual losses for the business unit. The expected losses are based on the organization’s overall loss rate. If the actual losses are 90% of the expected losses, then the experience modification factor is 0.9. This factor is multiplied by the organization’s overall loss rate to calculate a modified rate for each unit. When this modified loss rate is multiplied by the business unit’s exposures for the period being allocated, the share of the organization’s overall cost can be obtained. In the calculation of the experience modification factor, the credibility of each business unit losses should be considered. This model is more complex. However, the calculation of an experience modification factor using the expected losses for the business unit prevents the need for adjustments which could be needed if business units have grown at different rates over the time period being used. For example, if one unit used to be 10% of the total exposures three years ago and it is now 25% of the total exposures, then this approach would prevent this growth from distorting the allocation when reviewing losses or exposures over the time period.
If promoting safety and compliance is a goal, metrics such as timely claim reporting or adherence to safety protocols can be incorporated. Units that meet standards may receive lower allocations, while non-compliant units may pay more. This approach encourages desired behaviors, but requires a system for tracking and verifying compliance, increasing the administrative burden.
Allocation Model Basic Example
Here’s a basic example of an allocation model using a combination of exposures, reported claims, and reported losses to allocate the costs for the upcoming year. In this model, weights of 30%, 35%, and 35% are assigned to revenue, reported claims, and reported losses (limited to $100,000 per occurrence), respectively.
| Entity | Estimated Revenue For upcoming year | Percent of Revenue | Number of Reported Claims for 3 Years | Percent of Reported Claims | Losses Limited to $100,000 per Occurrence for 3 Years | Percent of Losses Limited to $100,000 | Allocation Percent | Allocated Costs |
| (1) | (2) | (3) | (4) | (5) | (6) | (7) | (8) | |
| A | $50,000,000 | 13.7% | 189 | 17.7% | $2,500,000 | 8.8% | 13.4% | $1,355,723 |
| B | 86,000,000 | 23.5% | 245 | 23.0% | 7,600,000 | 26.9% | 24.5% | 2,479,109 |
| C | 120,000,000 | 32.8% | 402 | 37.7% | 13,200,000 | 46.6% | 39.3% | 3,983,950 |
| D | 67,000,000 | 18.3% | 163 | 15.3% | 2,700,000 | 9.5% | 14.2% | 1,435,501 |
| E | 43,000,000 | 11.7% | 68 | 6.4% | 2,300,000 | 8.1% | 8.6% | 870,716 |
| Total | $366,000,000 | 100.0% | 1,067 | 100.0% | $28,300,000 | 100.0% | 100.0% | $10,125,000 |
|
(7) = 30% × (% of Revenue) + 35% × (% of Claims) + 35% × (% of Losses) |
| (8) = Allocation % x Total Cost to be Allocated |
While this example is easy to explain and calculate, it doesn’t incorporate the credibility of the business units or any changes in the size of the individual units over the time period.
Cost to be Allocated
In addition to determining the best allocation model, it’s important to define which costs should be included in the allocation. This can vary by company. Examples of costs that an organization might want to allocate include, but are not limited to, expected retained losses, insurance premiums, safety program expenses, and advisor fees. Any cost deemed appropriate for allocation can be included.
If desired, the method used to allocate different types of costs can vary within the model. For instance, some costs may be allocated using a simple exposure-based method, while others may rely on a loss experience-based approach. Additionally, the model can be designed to allocate costs for a single property and casualty coverage or across multiple coverages, depending on the organization’s needs.
Conclusion
In the end, the best model is different for each organization. Choosing and building the right model depends on the goals of the organization. An actuary can help you determine what model might be best and help to build the model that meets your goals. The options are endless.
If you would like to continue the conversation, get in touch with Principal, Audit Solutions, Amanda Marsh, at amanda.marsh@us.davies-group.com
