Our recent post, “How to Tackle Total Cost of Risk (TCOR)”, discussed the roadblocks and best practices to consider when calculating TCOR. It takes cost allocation, however, to realize the benefits of a TCOR program at the unit level. Through a cost allocation model, each unit sees the direct effects of their individual strategies on TCOR at the same time that the overall success of the risk management program is evaluated.
As Matt Payne and Melissa Huenefeldt of Lockton Companies describe in their white paper 1-2-3s of Allocating Cost of Risk, the “primary goal of an insurance cost allocation model is to distribute costs associated with insurance fairly.” Through this process, each unit becomes engaged with their contribution to TCOR. “When a business unit can relate safety and claims management to its profitability metrics, the cost of insurance becomes more relevant.”
The white paper also lists five objectives for any cost allocation model:
- Aligns with risk management goals while encouraging desired safety and claims management behaviors.
- Is fair and equitable: proportionate to the potential for loss without creating an undue burden to any individual unit.
- Is simple to understand and administer, to ensure ownership and avoid unintended behaviors.
- Is responsive to loss experience yet balanced for credibility.
- Represents the company’s total cost of risk.
A cost allocation approach that meets these objectives will translate the organization’s risk management goals into measurable, actionable feedback that units can use to make strategic decisions and measure progress.
While the benefits of an effective allocation model are universal, there is no single template that fits equally well across all types of organizations or industries. As the white paper notes, “Industry type, propensity for risk, insurance structure, ownership structure, operating metrics, geographic spread, and incentive compensation are just a sampling of the variables that can impact the selection of an allocation model.”
This underscores the need for a flexible, tailored solution– one able to easily accommodate all of the specific characteristics that drive your risk management organization. Without the ability to configure a solution to adapt to your organization’s structure and objectives, any cost allocation program is highly unlikely to be successful.
Potential allocation pitfalls
There are two areas that can impact the effectiveness of any allocation model.
An allocation model that is not easily understood at the unit level, or one too complex to be translated into unit-level decisions, breaks the feedback loop at the heart of the program. The International Risk Management Institute found this to be the case. “Cost allocation programs must be simple so operations managers can see the cost-benefit impact of the decisions they make.”
The Lockton Companies white paper echoes this idea. “Cost allocation can improve risk control outcomes only if the business units understand the connection between their actions and the impact to their company’s total cost of risk. Complex models also have a greater administrative burden to keep the model up-to-date.” The core purpose of the model is to allow operational units to make better decisions and monitor their own progress towards objectives. If the model is not easily understood, this objective cannot be achieved.
The model not only helps units plan actions and strategies to meet TCOR objectives, it also helps measure progress toward those goals. The white paper notes that this “requires data collection that captures these metrics and is updated frequently to reflect post-loss activities. This allows for the immediate impact of the claim to be felt by and visible to the location manager.” Managers must be able to tie changes in allocations to the decisions and strategies they have employed. Timely data is necessary to make that connection.
Removing the administrative burden associated with values collection can go a long way to creating a sustainable allocation model. Our posts on values collection go into some depth on the challenges and best practices of establishing an effective process.
As the white paper points out, the complexity and responsiveness each involve tradeoffs. “Companies should determine the appropriate balance between responsiveness and cost stability at the business unit level. Likewise, the balance between precision and simplicity will differ based on each business’s financial structure and the business unit’s capacity for volatility.”
Simple models will trade off precision, as responsive models will trade off stability. It is in the process of deciding where your organization fits along those spectrums that an allocation model becomes aligned with the operational realities that determine the long-term success of the program.
The article Best Practices for Cost Allocation Models recommends some ways to improve the chances for a successful program.
Use the right RMIS
The article notes, as we covered in our previous TCOR post, that the process of centralizing all of the data needed to generate these calculations is a task best suited for a RMIS. “RMIS software offers a more advanced mechanism for building an allocation because these platforms provide a systematic way of aggregating loss data and capturing exposure values required for the allocation. Using this type of technology to centrally house and organize this data provides the infrastructure required to creatively construct the necessary logic and algorithms.”
Include risk-specific elements
The article also highly recommends using behavioral and risk-specific elements in an allocation model. Doing so can help level the playing field across the organization. “Risk- specific elements ensure one entity isn’t unfairly subsidizing cost for another.” Just as unit managers must understand the model and how to deploy it in operational decisions, they should also feel that the model is equitable and fair in its administration of costs.
Ask the right questions
The white paper suggests that asking three questions continually during the process can help ensure a smoother and more effective process:
- Are we incentivizing the correct behavior?
- Is the appropriate field management team being rewarded or penalized for their unit’s loss experience?
- Can the field understand the model?
TCOR provides a valuable metric to measure risk management success and identify contributors to cost reduction. Allocation models convert that information into strategic direction for unit-level managers and provides feedback on the cost-reducing initiatives they undertake. By using a flexible RMIS like Origami Risk, with streamlined values collection and advanced TCOR and allocation capabilities, creating an effective allocation model is within reach.