realistic under every future scenario. It’s
important to re-evaluate the allocation
process periodically, as a sanity check
of the model against the real world, in
order to avoid proceeding blindly into
the future.
sharing lessons learned
As with the development of all allocation
models, it’s important to stress-test the
results under numerous scenarios. This
is especially important for allocation
models that are dealing with non-work-ing-layer losses in which loss activity
can be sparse. The following examples
of lessons learned may save an organization time and money when building an
allocation model.
Exposure Explosion—Light
Be wary of allocation models with little
or no weight to exposures. If an operating
unit significantly increases its exposure
(and hence risk), the operating unit will
benefit from being undercharged until
losses emerge in the future.
Exposure Explosion—Heavy
Be wary of allocation models with a
heavier weight toward exposures. If an
operating unit significantly increases its
exposure but the increase is driven by the
addition of lower-risk exposures (e.g., an
operating unit introduces a new product
that doubles sales but is one-tenth as risky
as its current products), the operating
unit will be overcharged until favorable
loss emergence affects the model.
Free Pass
Be wary of allocation models that don’t
adjust for mergers and acquisitions. This
isn’t a question of whether the acquiring
company has agreed to cover the target’s
outstanding liabilities, but one of properly allocating costs. To the extent the
allocation model doesn’t include historical experience from the newly acquired
operations, the model may give an operating unit a free pass until losses emerge.
When the allocation
affects an operating
unit’s bottom line,
there’s nothing better
than having an
educated customer base
with a strong sense of
ownership in the success
of the process.
Free Lunch
Be wary of allocation models for longer-tail lines of business that don’t include
an adjustment for significant reserve increases on old claims. The organization
may want to consider including an adjustment for significant reserve changes
outside the loss period used in the model. To the extent older claims develop
adversely, the allocation model should
add in a load for a predefined number of
years in order to eliminate the free lunch
earned by operating units when claims
are adjusted late in the game.
Musical Chairs
Be wary of high excess-layer allocation
models with a heavy loss-weighting and
low frequency. To the extent that operating units experience losses on an
infrequent basis, the allocation model
may cause wild swings between operating units as large losses work their way
in and out of the history.
Excessive Force
Be wary of high excess-layer allocation
models with a heavy loss-weighting, low
frequency, and light penetration into the
excess layer. To the extent that operating unit losses have trouble extending
far into the excess layer, operating units
could receive excessive allocations driven
by small-dollar penetration. For example, an operating unit may have a claim
for $1,005,000. If the attachment point is
$1,000,000, and no other operating units
have losses, the $5,000 of excess losses
would result in 100 percent of losses being allocated to the one operating unit.
Developing an effective cost allocation model requires a commitment of
resources across the organization. From
risk managers, claims handlers, and lawyers to the individual operating unit staff
and the accountants booking the allocated
costs, a no-surprises process is absolutely
critical. In the end, if each operating unit
manager responsible for the delivery of
results feels a sense of ownership in the
process, understands the key drivers, and
can communicate the results to senior
management with confidence, the entire
organization wins. When the allocation
affects an operating unit’s bottom line,
there’s nothing better than having an educated customer base with a strong sense of
ownership in the success of the process.
KEVIN BINGHAM is a principal with
Deloitte Consulting llP in Hartford, Conn.
and chairperson of the academy’s medical
Professional liability subcommittee.
KIM MITCHELL is a director with
Deloitte Consulting llP in Hartford.
LEON PALMER is director of risk
management at United technologies Corp.
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