Insurance Budgeting: STOP Wasting & START Dreaming
“... the budgeting process at most companies has to be the most inefficient practice in management. It sucks the energy, time, fun, and big dreams out of any organization.” Jack Welch, Winning
I couldn’t agree more with the above quote. I think that budgeting (or planning) the traditional way is painfully long, lacking in transparency, and often ends with mediocre results. It usually follows two routes: The bazaar and the hammer:
> In the former, you end up with a mediocre negotiated settlement where everybody walks away feeling happy that there has been some give-and-take.
> The hammer approach, on the other hand, is when the head- or regional-office hammers the front lines troops down with a number, regardless of whether it is realistically achievable. Sounds familiar? Read on . . .
The Purpose of Budgeting
Paradigm shift: The purpose of budgeting should be for you to live up to your greatest potential, win, dazzle, shine, and dominate your chosen competitive spaces. Your ambition should be to outperform previous periods in terms of profits, equity, growth, employee retention, brand recognition, customer satisfaction, and whatever other success metrics you track.
The purpose of a plan is NOT to:
> Rig the system, lowball or sandbag your figures, and put up a number that you are guaranteed to hit. That’s dishonest at worst and could result in you being recognized as a “fake star” at best; or
> Deceive your head office by promising to deliver high numbers, knowing that they aren’t achievable, to attract investment dollars into your business. This is socially irresponsible as it amounts to a waste of shareholders’ funds as well as inevitably making people redundant.
I strongly believe in committing to stretch budgets so long as they carry a reasonable probability of being realistically achievable.
NOTE: The budget is NOT a guide or wish list. Once the numbers are agreed to, everybody must be laser-focused on achieving them. A big part of performance reviews should be based on whether or not the budget figures were achieved. Attitude, contribution, innovation, leadership, and other factors must also be taken into account, but numbers’ delivery must come first.
I am not making the argument that the budgeting process is totally useless. It is the conventional way companies go about it that is frustrating. Budgeting allows you to:
> Infuse more discipline in your organization.
> Track your figures with more precision.
> Control your business better.
> Measure your team’s performance fairly.
> Communicate clearly with the financial markets and shareholders, and
> Keep a scorecard.
I address the variations in insurance companies’ budgeting philosophies in The Insurance Management Playbook to give you a flavor of what’s out there. I won’t go through them here but will, instead, suggest a pretty basic model to follow when putting together your plan.
Your budgeting process should have four key drivers: High-level financial objectives, investment returns, top line (premiums), and cash outflows (claims, expenses, and commissions).
A. High-Level Financial Alignment
Your board of directors sets your ROE, IRR, ROIC, desired share price, book value, solvency, and dividend policy objectives as a starting point. You should figure out what level of premium you need to achieve at what expense, commission, and loss ratios to deliver the net profit number you require to hit the above-stated financial metrics. The share price is a tricky one, but the rest can be fairly accurately planned with the help of your CFO and extended team.
Pretty straight-forward, right? Yes, IF you have a strong CFO. You don’t? Check out last week’s blog, Insurance Finance & Investments: Cash is still King, for guidance on great CFOs’ top attributes.
B. Investment Strategy
As advised in last week’s blog as well, your overarching investment philosophy should be capital preservation. Plan to invest conservatively, hire experienced investment managers, and give them a rate-of-return target to work towards so their mandate is aligned with your budget figures.
Make sure it is a realistic rate of return to avoid unnecessary risk-taking.
C. Top Line
The top-line budgeting process is a lot more straightforward than most people think. You basically need to make educated predictions as to:
> How much of the business you wrote in the previous period you will non-renew.
> How much more or less premium you will gain or lose from your existing renewal base due to rate and deal structure changes, economic downturn (payroll reduction), and asset value or revenue additions or deletions.
> What is the size of your “recurring non-recurring” base (project business) and how you will fill that premium hole.
> How much new business you will write by line, class, and customer segment to hit your desired growth figure.
D. Cash Outflows: Claims, Expenses, and Commissions
The claims part of the budgeting process requires extreme discipline and precision. Your claims planning is two-pronged: Claims frequency (otherwise referred to as attritional losses) and claims severity (otherwise referred to as large, shock, or freak losses).
You need lots of data especially in high-frequency lines of business such as motor/auto, medical, and homeowners to be able to accurately project your frequency loss ratios. But then again, claims reserving sometimes makes astrology look respectable and we still witness claims reserves movements in the billions of dollars.
As for claims severity planning, well, understand historical patterns, systemic risks, natural catastrophes trends, and hope for the best really! It’s not like we can accurately predict when a Black Swan is going to appear. The best we could do is build enough cushion in our claims severity loss ratio loadings to avoid wiping out our company’s balance sheet when the next “Katrina” or “Sandy” hits.
It is prudent never to budget for an expense ratio (ER) growth rate that is higher than 50 percent of your net earned premium (NEP) growth rate. I suggest that you stick to NEP as your denominator when budgeting your ER, and not use gross written premium (GWP), to you give yourself a cushion. This is because NEP normally lags behind (is smaller than) GWP due to the premium-earning nature of our business. Again, when in doubt, go conservative.
The above guidance on ER growth assumes a business-as-usual modus operandi of course. This means no acquisitions, accelerated growth plans, or massive fraud or breakdown in controls which are situations that could require additional spending to prevent the business from derailing. We will discuss start-ups, M&As, and integration in future blogs.
The cost of your most valuable asset class, PEOPLE, is your 2nd or 3rd largest cash outflow bucket after claims and commissions. Plan it very carefully as it amounts for nearly 60% of your ER.
I have already highlighted the impact that standard and contingent commissions, profit sharing arrangements, and other intermediary compensation methods can have on your margins in the Distribution: A Rapidly Changing Landscape blog.
Remunerate your intermediaries well but remain focused on this significant cash outflow area. Budget your commission assumptions with laser-precision and don’t forget to factor-in the reinsurance commissions you receive on business ceded to reinsurers as they offset some of the commission payments to your intermediaries.
> Planning should to be an exercise in ambition-setting and dreaming that is injected with a dose of sanity.
> Build your plan from the ground up and avoid the temptation to back your way into a given figure. You are an insurance executive whose mandate is to produce high quality earnings, reduce costs, become more efficient, build and lead a great team, service customers better, and grow, grow, and grow.
> The budget is NOT a guide. You should live and die by the numbers.
> Executives should be involved in at least some of the functional deep-dive planning sessions such as claims, HR, finance, underwriting, and actuarial to understand the minutia underlying the assumptions upon which budgets are built.
> Strategic matters such as the portfolio mix effect on profitability 4 quarters down the line or the reinsurance structure's effect on solvency and capitalization require as much laser-focus on the numbers as well as a bit of detachment and looking at the big picture every once in a while.
> To that end, I encourage you to split the budgering process over time. Ask your teams to take a break. A real break, where everyone commits not to look at the numbers for, say, a week or two, preferably after they have gone on holiday in July or August and came back with a fresh set of eyes and a more critical, understanding, sober, calm, and open spirit.
> Finally, mandate a meeting of the minds and eyes of underwriters, finance, HR, claims, sales, actuarial, risk engineering, etc. folks during the budgeting process. Without this type of face to face collaboration you could be missing an opportunity that can make you hugely competitive in the marketplace or a blind spot that could bankrupt your firm.