By PETER G. WICK, FCAS, MAAA, principal and consulting actuary, and TRAVIS J. GRULKOWSKI, FCAS, MAAA, consulting actuary, with Milliman Inc. in Milwaukee
For self-insured companies with divisions of one kind or another--stores, branches, regions, entities and so on--allocation of insurance costs can be challenging and fraught with internal politics. Every entity needs to balance the responsiveness of its allocation procedure to each division's actual claims experience with the desire to maintain some semblance of stability, which is critical to planning and budgeting activities.
For example, a company may choose to allocate workers' compensation funding proportionally based on payroll, disregarding claims experience. At some point, divisions with fewer claims begin to feel that they are not being rewarded for their risk management efforts. They may vigorously argue for a reduction in their allocation, making life difficult for those tasked with managing the insurance pool.
After a while, they may even put less resources and energy into risk management, ultimately increasing the costs for the entire company.
Divisions that are incurring a larger share of claims without seeing their premiums rise, on the other hand, may feel insulated from the consequences of their risk-related decisions. They may think: Why spend time and budget minimizing risk if claims don't really hurt my bottom line?
All of these effects could potentially undermine risk management efforts.
On the other hand, a company may choose to allocate funding based on the historical claims of each division. One critical consideration in employing this strategy is that some per-claim limit (cap) is usually established as to avoid bankrupting a division in a bad year.
But again, politics tends to be the deeper problem. Those shouldering a greater share of the burden may complain that they are being punished simply for having bad luck. They may even wait to report claims, trying to manage the impact on their allocation. Those whose allocations decrease based on a fortuitous random fluctuation in claims experience may think they are doing a good job managing risk, when perhaps they were just being lucky.
CONTROLLING ORGANIZATIONAL CONSEQUENCES
No matter which allocation strategy is used, there will be organizational consequences. It is possible to control those consequences, however, the best way to do so being:
1. Articulate clear reasoning behind the allocation strategy.
2. Get buy-in from managers concerning the allocation process.
3. Properly provide incentives for the type of behavior that management believes minimizes risk.
If a manager protests an allocation, one can return to the agreed-upon allocation strategy and show how it played out in her particular case. This is much easier than trying to explain the philosophy afterward, which may appear to the disgruntled manager as "justification after the fact."
Of course, it is almost impossible to prove what proportion of claims is preventable and what proportion is due to chance. It really comes down to a company's philosophy and strategy regarding risk. The important thing is to decide on an approach and stick to it.
There are many ways to put risk management philosophies into allocation practice. A company might believe that getting charged for losses (via higher allocations) will make managers take more ownership in risk management efforts. The company, therefore, may base 75 percent of the premium on loss experience.
This raises another concern: How much historical experience (number of years) should the company allocation rely on?
On the other hand, the company might decide that losses in excess of a certain amount per claim are purely random. They might choose to limit losses to a certain amount per claim and base allocations on the number of claims (frequency) for each entity.
The incidence of claims tends to vary directly with the exposure of the entity at risk. Some exposure examples include: payroll (workers' compensation), sales or number of employees (general liability), and number of autos (auto liability).
Consideration must be given to both the historical loss activity and the corresponding exposures when evaluating claims liabilities and expected future costs. It is important to select an exposure measure that is relevant to the unique situation of each self-insurance program.
In some cases, allocation strategies might be limited by available data. For hospital networks, it may be possible to allocate workers' compensation premiums individually (by type of employee), as the claims frequency is generally high enough to rely on. However, this may not be practical for medical-malpractice claims because there are too few to make statistically valid judgments.
As mentioned above, it is also important to consider how many years of experience to include in an experience-based allocation strategy. A shorter time horizon will tend to produce more "responsive" allocations and also may help limit how long entities are "punished" for having claims. A longer time horizon will be more "stable," reducing the effects of a single bad/good year. However, extremely bad years will haunt entities for a longer period of time.
The example in the charts here demonstrates an allocation problem a company may be faced with. The allocation specifics for our hypothetical company include both three years and five years of exposure information, claims frequency, and unlimited and limited loss experience for three company entities. Also displayed are each entity's calculated allocation percentage based on these measures.
As the tables display, if the company elected to allocate the funding strictly based on exposure, each entity would pay approximately an equal share. On the other hand, if the allocation was based on claims frequency, it is fairly clear that Entity 1 would pay a larger share. However, should they pay 51 percent (as the three-year history suggests) or 41 percent (as in the five-year history table), or something in between?
Another common allocation basis is claims severity, whether using total (unlimited) losses or losses limited to the self-insured retention. As the tables display, using this approach varies the allocation results by entity, as well.
ALL MEASURES AT ONCE
If the company wishes to balance stability and responsiveness, rather than using one basis (exposure, claims frequency or claims severity), it is perhaps best to use all these measures and give appropriate weight to each measure.
Other factors can be used as well, such as: using developed losses to an ultimate basis, analyzing how exposures change over time and reviewing capped losses at various size of loss retentions. It is also helpful to compare changes from year to year (perhaps capping increases and decreases) with any measure that is selected before releasing the allocation.
In making all of these decisions, it may be useful to leave the actual calculations to an outside firm, such as an actuarial firm. It will tend to have a broader range of experience in implementing allocation principles, such as types of exposure to use, years of experience to include, effect of limiting claim size in allocation process, capping allocation percentage swings and responsiveness versus stability issues.
Perhaps more importantly, the fact that the calculations are being performed by "outsiders" will help to naturally limit the degree to which managers can request changes to the model to produce more favorable results. Also, an outside firm can provide an independent, unbiased voice, one that can hopefully incent change (i.e., risk-control measures in the claims department).
After all, that is the most important measure of a risk manager's success: eliminating or mitigating losses for the company. At the end of the day, the managers not in favor of the end allocation result can always just "blame the actuary."
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July 23, 2009
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