Managing Your Risk
Create efficiency by allocating the cost of risk

By Michael Kelly
Property and Casualty Program Specialist

Risk cost allocation – first off, what is it? The definition of "allocating the cost of risk" is the process that identifies, then attributes the calculated insurance and other related risk costs among your various departments, accounting units or even capital improvement projects.

One of the primary objectives in developing a risk cost allocation system is to better understand the true total costs in your county's operations. Doing so will create accountability through budgeting according to each department's developed portion of the county's cost of risk.

As the county's risk manager, once you have calculated your actual cost of risk, it becomes possible to allocate or proportion these costs internally to help your county operate efficiently as possible by spending the least amount of taxpayer dollars toward risk management. Further, doing so will allow the capability to track, develop and provide more concise financial reporting of all types of organization costs to county management staff.

The two principal types of risk cost allocation systems are those derived from the exposure base (amount of payroll, number of employees, square footage, value of assets, etc.) versus an experience-based model that is linked entirely back to the costs created through your specific loss experience.

The advantage of an exposure-based cost allocation process is that it is easy to administer, simple to understand and painless to adjust in real time as necessary. The disadvantages are the insurance and related risk costs are not linked or impacted at all by loss experience and, as such, there is little incentive to reduce losses. This last issue of not providing an incentive for a department's employees to be interested in their own department's loss experience is often a real problem and the main reason for considering an experience-based model.

When insurance and risk costs are allocated by each department's loss experience, it becomes more difficult to administer but normally is more effective. The advantages are it encourages loss control, is explainable and, depending upon the exact method utilized, is easy to adjust. The disadvantages are again – depending on the method – it may actually be more complex to adjust, there are more details to keep track of, and it becomes more difficult to allow for strategic-based cost allocation.

Practically speaking, an ideal risk cost allocation system includes a balanced mix of both exposure and experienced-based processes. Typically utilizing a percentage-based allocation method tends to work by a portion of all insurance premiums being divided out on an exposure basis, depending on the type of insurance, by department. Any risk management departmental costs are allocated using an exposure base such as the number of employees. Any outside consultant costs are allocated back to those departments that use them. The balance of insurance premiums not already allocated on an exposure basis is allocated according to historical losses for that type of exposure. Finally, all retained losses, deductibles or otherwise, are charged back to the department that actually had the losses.

This process of segmented allocation allows a greater understanding of the cost of risk at the departmental level, especially if incentives for improvement are tied back to loss performance.

Spreading the cost of the risk to individual employees should serve as an incentive to amend day-to-day behavior in a manner most consistent with the goal of lowering your overall cost of risk. For example, when employees know that if they are in an automobile accident and that an investigation determines the accident was avoidable, they are going to be responsible for a portion of the collision deductible, this knowledge should begin to alter behavior in short order. Further, if the remaining balance from what the employee picks up of the deductible cost is also charged back against their respective department's budget, this will change managerial behavior as well.

Once you begin allocating risk costs back to the departments and areas driving your loss history, it will enhance the effectiveness of loss control. It should develop a motivation to reduce both frequency and severity of losses. It will provide managers with specific loss exposure information by their department and should help build an increased level of loss control into projects as well as day-to-day operational endeavors.

Finally, the backhanded benefit will be the identification of those locations, managers, departments and employees that likely need the greatest risk management attention. If done in a way to increase competition between departments, it is possible to make the investment in safety, loss prevention and risk control equipment more appealing, as well as effective. The managerial utilization of more "carrots" than "sticks" will go a long way toward improving morale as well as results through the cultivation of departmental team competition.

Through professional recognition, accolades and financial incentives, and given time and effort, utilizing a strong cost-of-risk allocation program will substantially impact, contain and eventually lower your risk management budget.

NCACC Property and Casualty Program Specialist Michael Kelly writes a regular column on risk management for CountyLines. With more than 32 years of risk management/insurance experience, he holds the Associate in Risk Management for Public Entities, Certified Risk Managers and Certified Insurance Counselors professional designations. He can be reached at michael.kelly@ncacc.org or (919) 719-1124. Archived versions of the column can be found online at www.ncacc.org/managingyourrisk.html.