Understanding Profitability in the Insurance Industry: New Concepts for Cost Management

By Phillips, John | CMA - the Management Accounting Magazine, November 1992 | Go to article overview

Understanding Profitability in the Insurance Industry: New Concepts for Cost Management


Phillips, John, CMA - the Management Accounting Magazine


New cost management systems must not only be able to report on traditional targets but also provide information on all the middle layers of costs and how these costs are consumed throughout the organization.

The insurance and banking industries are in turmoil. Customers are much more sensitive to interest rates in the products they buy. This has put more pressure on investment activities to provide a spread to support the increased cost of funds. The explosion in the cost of medical and health care has sent the cost of providing this benefit skyrocketing. In fact, providing medical benefits to their employees has become the one cost that many companies cannot afford to go alone. More and more companies are asking their employees to share in the cost of this benefit. Insurers are faced with more lawsuits in settling claims.

The result of these and other pressures has forced many insurance companies to take a hard look at the profitability of their companies. In many cases there has not been a balance between regulatory accounting and management accounting. This has resulted in numbers which were acceptable to regulators but which did not provide management with the information needed to manage in the volatile '90s.

The need for management accounting information comes from all levels of the organization in order to make decisions on a variety of issues such as pricing, cost awareness, performance improvement, regulatory reporting, internal management reporting, and the list goes on. So what is wrong with the information traditionally provided?

Traditional cost systems

Traditionally, cost management systems were set up to support the regulatory reporting requirements. As more information was required by senior management, these systems were expanded to look at profitability by function and product, but this perspective was deficient in providing management with the information needed. If one evaluates how these systems are structured, it is not hard to see their faults. In trying to derive profitability by product, the emphasis was on regulatory lines which are in some cases summarizations of product lines. Departments were asked how they spend their time in relation to these lines of business. The results were allocations which drive the cost to the statutory product level. In the case of functional allocations, these same departments were revisited and asked to provide information on how they spend their time by function and product and the numbers were rolled out again. By the time a department manager was asked to provide information on how that department spent time by function, by product, by geographical areas, etc., the departmental manager's enthusiasm for providing this information began to wane. The problem with this approach is that it focuses on an organizational structure and does not focus on the actual business processes that take place. Only by identifying the business processes and activities can one truly understand the profitability (or lack thereof) for the desired reporting target.

New approaches

Companies must take a new approach to cost management and cost management systems. New cost management systems must not only be able to report on the traditional targets, but must also be able to provide information on all of the middle layers of costs and how these costs are consumed throughout the organization down to the final target reporting level.

Fortunately, there is a new approach which can help. Activity-based costing (ABC) is a more accurate way of approaching the calculation of cost at the targeted reporting levels than any traditional method used in the past because it focuses on linking activities and resource consumption.

With ABC, a process is broken down into one or more activities. Costs are allocated or assigned to these activities through drivers which reflect the consumption of the resources from one or more cost centres to the associated activity. …

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