Porter Insurance Company has three lines of insurance: automobile, property, and life. The life insurance segment has been losing money for the past five quarters, and Leah Harper, Porter’s controller, has done an analysis of that segment. She has discovered that the commission paid to the agent for the first year the policy is in place is 55 percent of the first-year premium. The second-year commission is 20 percent, and all succeeding years a commission equal to 5 percent of premiums is paid. No salaries are paid to agents; however, Porter does advertise on television and in magazines. Last year, the advertising expense was $500,000. The loss rate (payout on claims) averages 50 percent. Administrative expenses equal $450,000 per year. Revenue last year was $10,000,000 (premiums). The percentage of policies of various lengths is as follows:
First year in force ....... 65%
Second year ........... 25
More than two years in force ..... 10
Experience has shown that if a policy remains in effect for more than two years, it is rarely cancelled.
Leah is considering two alternative plans to turn this segment around. Plan 1 requires spending $250,000 on improved customer claim service in hopes that the percentage of policies in effect will take on the following distribution:
First year in force .......... 50%
Second year ......... 15
More than two years in force .... 35
Total premiums would remain constant at $10,000,000, and there are no other changes in fixed or variable cost behavior.
Plan 2 involves dropping the independent agent and commission system and having potential policyholders phone in requests for coverage. Leah estimates that revenue would drop to $7,000,000. Commissions would be zero, but administrative expenses would rise by $1,200,000, and advertising (including direct mail solicitation) would increase by $1,000,000.
Required:
1. Prepare a variable-costing income statement for last year for the life insurance segment of
Porter Insurance Company.
2. What impact would Plan 1 have on income?
3. What impact would Plan 2 have on income?