With evolving regulatory requirements, ever growing product lines and no shortage of legal entities, allocations are critical for every insurance organization’s financial reporting process. An effective allocation process always starts with a good design, and in this blog post I will outline several best practices to consider.
What is an Allocation?
An allocation is essentially the concept of cost sharing between different parts of an organization. Revenue or Premiums can also be allocated too, but in this blog post I will focus on cost allocations. The idea is that if a part of the business benefits from goods or services that another group paid for, then the benefitting group should contribute to that cost. The allocation is the process of estimating each group’s contribution. It’s important to know that an allocation is a model and there is no objective way of validating if it is “right” or “wrong.”
Why Allocations?
Allocations are performed for financial reporting purposes to help paint a more accurate picture of a business units’ profitability. They also help demonstrate a department or business units’ true resource usage and foster a sense of accountability. Allocations can play a key role in future funding and stakeholder compensation, so having agreement from stakeholders on how the numbers are derived is critical.
Examples of Allocations
- An employee spends time working with the Claims, Underwriting and Finance groups, so this employee’s salary and benefits are allocated to the three departments.
- A dedicated space was leased for a call center, so the leasing cost of that property is allocated to all the business units it supports.
- A large claim requires an expensive investigation. These expenses are allocated to the business unit where the claim occurred.
Allocation Best Practices
Design the allocation with the end state in mind: The first question to ask is what level of detail is needed to break these costs down to, or in other words how many groups are going to share in the allocated cost. Once you know what the result needs to look like, then you can start coming up with a plan on how to get there.
Make transparency a priority: Stakeholders are naturally going to have questions on allocation results. A goal of the allocation should be to provide as much detail as possible so that involved parties can answer those questions themselves. A well-designed allocation should allow for users to clearly see where dollars are coming and going, what cost levels were pre-allocation and post-allocation and what factors were used to come up with the allocation amounts.
Use relevant factors to come up with allocation percentages: Doing an even spread of a cost to all receiving groups is usually insufficient as the recipients likely did not benefit from the cost equally. To come up with appropriate allocation percentages, various factors or can be used to help determine how much each group will receive. Examples of good drivers are Gross Written Premiums, Net Earned Premiums, Volume of Claims, Net Commissions Incurred, Direct Expenses, FTE, Square Footage and/or Time Entry information. Using drivers or factors will enable you to have the most accurate allocation percentages and should always be favored over “gut feel” proportions or “back-of-the-napkin” calculations.
Stay away from spreadsheets: Excel is always a fan-favorite but for allocation purposes, it’s best to steer clear. Spreadsheets make collaboration difficult and are inherently limited by the number of rows and columns in a workbook. Allocations are best performed in a centrally located, multi-dimensional database that allows for robust analysis on large data sets.
Keep your factors organized: Attempting to streamline data or factors from far away systems will greatly decrease the auditability of your allocation process and cause more trouble than its worth. Remember, we are building a model here that produces an estimate. If it takes an enormous effort to import factors that would slightly increase accuracy, is it worth it? Focus on factors that are readily available and can be systematically imported into your allocation tool.
Don’t forget about workflow: There are lots of interested parties in an allocation process so maintaining structure is key. If too many people are tweaking factors and constantly re-running the process, results will always be in flux. Try to limit the number of users who are involved in the administration of the process and be sure to have approvals at each step.
Conclusion
These principles are based off QueBIT’s 20+ years implementing allocation processes for both Insurance and Non-Insurance organizations. No allocation process is ever perfect, but hopefully this article provides a framework of best practices to consider. For more information on QueBIT’s experience in this space, please reach out to info@quebit.com or visit our Insurance industry webpage.
