Gibson Insurance Company Rebecca Hampton, the controller for Gibson Insurance Company, faced a challenging task at the end of the year. For the implementation of a new management planning and performance management system, Hampton had been asked to review the companys allocation of corporate support costs in order to better assign the costs attributed to product lines and business units. Better cost allocations would help management to obtain more accurate insight into product profitability, provide more in-depth information for product pricing decisions and sales agent compensation, and highlight areas for cost improvement. Insurance premiums and sales commissions were tracked at the legal business unit entity and product line level to properly compensate sales agents. Certain support functions, however, were only accounted for at the corporate level and were subsequently allocated to product lines and business units according to the number of policies outstanding. Historically, this simple approach had worked well. With the number of recent corporate acquisitions growing, however, Hampton felt that such an approach did not reflect the claim on resources that was made by various business units and product lines. Moreover, although sales volume had increased over the last few years, profitability declined, causing management to become concerned that either the prices were set incorrectly or costs were out of control. It was time to create a new method. Hampton was sure that a new cost allocation approach would help the company improve its pricing and resource allocation making decisions. Company Background Gibson Insurance sold two categories of financial products: annuities and life insurance. Annuities were tax-deferred investment vehicles that offered various lump sum or scheduled payout options to investors. Life insurance policies paid benefits to designated beneficiaries in the event of the policyholders death. At Gibson, both the annuity and life insurance policies were sold by in-house agents. Gibsons management planned to pursue a corporate acquisition strategy for the next several years, with intention of quickly growing both the companys customer base and its assets under management (AUM). This posed new cost allocation challenges as industry regulations required financial information from legal business unit entities. During the year, Gibson had made its first corporate acquisitions when it acquired Compton Insurance Services and Midwest Mutual Insurance Company. Compton, Midwest and Gibson each sold annuities and life insurance products, although the products sold by each entity varied in terms of price and features. (As for features, some products, for example, were whole life policies, while others were universal life policies, or term life policies. Each one provided different cash value alternatives and deferred tax-growth possibilities.) Gibson decided to maintain both Compton and Midwest as separate legal entities, and treated then as wholly owned subsidiaries for legal and financial reporting purposes. Although Gibson continued to sell various annuities and life insurance products under all three different legal entities, management closed the Compton and Midwest sales offices, as well as the other support departments, such as policy acquisitions, customer service, and accounting. Gibsons sales offices and the corporate headquarters in Kansas City, Missouri, provided those services for all three companies now. Cost Allocations Although premiums and sales commissions were tracked by both the legal business unit entity and product line in order to compensate sales agents, support function costs were mostly incurred at and accounted for at the corporate level. To date, Gibson used an objective measure the number of policies to allocate corporate support costs to the product lines. Such an approach was certainly better than the equal is equitable allocation philosophy that Hampton had observed at some other companies where she had worked. The product line and business unit support cost allocations, which have been based on the number of policies follow: Exhibit 1 Gibson Insurance Company Number of Policies by Type and Business Unit for this Year Midwest Gibson Compton Total Annuities: New Policies 10,000 8,625 1,215 19,840 In-force policies 45,000 36,200 4,700 85,900 Subtotal 55,000 44,825 5,915 105,740 Life Insurance: New Policies 1,250 3,450 8,100 12,800 In-force policies 5,600 13,500 31,600 50,700 Subtotal 6,850 16,950 39,700 63,500 Total Policies 61,850 61,775 45,615 169,240 Exhibit 2 Gibson Insurance Company Summary of Product Line and Business-Unit Support Cost Allocations Using the Number of Policies as the Allocation Basis ($13,920,000 169,240 policies = $82.25/policy) Midwest Gibson Compton Total Annuities: New Policies $ 822,500 $ 709,406 $ 99,934 $ 1,631,840 In-force policies 3,701,250 2,977,450 386,575 7,065,275 Subtotal $ 4,523,750 $ 3,686,856 $ 486,509 $ 8,697,115 Life Insurance: New Policies $ 102,813 $ 283,763 $ 666,225 $ 1,052,801 In-force policies 460,600 1,110,375 2,599,100 4,170,075 Subtotal $ 563,413 $ 1,394,138 $ 3,265,325 $ 5,222,876 Rounding 3 3 3 9 Total Policies $ 5,087,166 $ 5,080,997 $ 3,751,837 $ 13,920,000 Hampton admitted to herself as she perused the allocations and as she learned more about the nature of selling and supporting various products that she sensed those allocations did not reflect the relative claim that those products had on the shared corporate resources. The recent flurry of due diligence work on a variety of potential corporate acquisition candidates, along with the actual work involved in executing the acquisitions that had been undertaken, left her with no time to explore how to improve the cost allocations. Now that the recent acquisitions were finished, along with the unsettling increase that she had recently observed in corporate support costs to bolster the companys growth, and in concert with the simple need for better product line cost information for Gibson to be competitive in the marketplace, Hampton decided to focus on the cost allocation system to find a better method of allocation. Hampton began her task by reviewing the corporate general ledger wherein a myriad of cost line items were used for recording specific cost types. She knew that it was important to keep any revised cost allocation system intuitively understandable and manageable in implementation and operation. In other words, she knew that a cost allocation system with scores of different cost items each with a unique allocation means would not be a desirable outcome. After some though and effort, she was able to collapse nearly 50 different corporate cost accounts into these 4 categories: Aggregated Corporate Support Costs for this Year Policy acquisition $ 4,375,000 Customer service 2,426,000 Sales and marketing 4,552,000 Other corporate support 2,567,000 Total $ 13,920,000 Hampton knew that some of those aggregated costs were incurred to support new policies that had been issued during this year, while others supported in-force policies issued in previous years. As she dug further into the effort to issue and service policies, it was clear to her that there were distinct tasks repeated in, and different among, the various products. Those tasks for example, included items such as underwriting reviews, health screenings/evaluations, billings, collections, records creation/maintenance, and responding to customer queries. It seemed like the sale of a policy spawned a flurry of corporate activity. She wondered if Gibsons processes were as streamlined and efficient as they could be, but she filed that thought away for a later date the new cost allocation approach was her current imperative. It seemed to Hampton that there were a host of potential allocation bases that could be adopted in lieu of the currently used basis of the number of policies. She decided that there was merit in keeping the new approach simple (as best reflected in an underlying root cause for the cost), and acceptable to the departmental managers and product line managers who would be evaluated, in part, on their financial performance that involved the resulting allocations. Finally, Hampton decided to make her first attempt at using the new allocation bases as noted below. For each of the four new allocation bases, she presented herself with a test, which was to summarize her rationale for the allocation base in a brief, coherent, logical fashion. If she could not do that, then she must interpret that as a signal that she needed to investigate the proposed basis in more detail to settle on an intuitively defensible basis for that one. 1. Policy acquisition costs: New allocation basis: Number of steps involved in moving new policy applications to and in-force status. Rationale for new basis: The administrative staff at Gibsons headquarters processed new policy applications for all three legal entities and for both life insurance and annuity products. From an administrative staff resources perspective, annuities required two major steps to issue a policy: a review of the application data and the electronic imaging of the application. Life insurance policies required the same two steps as annuities, but they also required additional steps for the following administrative tasks pertaining to the underwriting work involved: generate files for reinsurance, review medical information and lab work to make sure it is complete and that all the required medical staffs evaluative comments are present, and lastly obtain the supervisors approval. 2. Customer service costs: New allocation basis: Number of incoming customer calls. Rationale for new basis: As the number of policies sold increased, so too did the number of calls that came in to the customer service center. Over the past year, the customer service staff had been increased to deal with customer calls in a quicker, more responsive manner. The customer service department fielded an average of 0.5 calls per year for each new annuity policy and 0.2 calls per year for each in-force annuity. Life insurance policyholders called Gibson an average of 0.6 times per year for new policies issued and 0.4 time per year for existing policies. 3. Sales and marketing costs: New allocation basis: Number of sales solicitations. Rationale for new basis: Sales and marketing expenses are costs incurred to run local sales offices and various marketing activities throughout the country. Those costs related solely to new business and could be traced directly to the sales efforts made by Gibsons agents. Historically, the companys agents averaged 10 customer contacts through calls, or visits, for each annuity sold and 20 customer contacts for each life insurance policy sold. 4. Other corporate overhead costs: New allocation basis: Dollar value of AUM. Rationale for new basis: Product management, accounting, actuarial, human resources, investments, and senior leadership costs comprised the remainder of Gibsons home office expenses. Home office personnel tended to spend more time on products that generated larger AUM for the company. On average, each new and in-force annuity product generated $50,000 in AUM for Gibson. Life insurance policies averaged $1,500 of AUM in the first year, while in-force life insurance policies averaged an AUM of $65,000. Hampton compiled a summary of the data related to the new allocation bases that she had identified for the past year. (See below) She felt confident that she could utilize that data to implement a better support cost allocation system for Gibson. Gibson Insurance Company Data Summary for New Allocation Base s Annuities Life Insurance Support Costs New Basis New In-Force New In-Force Policy Acquisition Steps 2.0 0 5.0 0 Customer Service Calls 0.5 0.2 0.6 0.4 Sales and Marketing Contacts 10.0 0 20.0 0 Corporate overhead AUM $ 50,000 $ 50,000 $ 1,500 $ 65,000 Questions: 1. Calculate the unit support cost per policy for new and in-force annuity and life insurance policies using the new allocation basis. In addition, calculate the total support costs to be reported by product for each legal business unit entity.