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By Peter Durfee,CPA
Director of Finance
The Beacon Mutual Insurance Company, Rhode Island
At this time of the year, budgeting seems a long way off—thankfully. But the annual planning season will soon be here again, so I would like to talk about our budgeting process at The Beacon Mutual Insurance Company.
First, let me make some general comments about The Beacon as it relates to budgets. Like all AASCIF members, we are fortunate to be able to concentrate on one line of business and on one state. In The Beacon's particular situation, we also have the luxury of having a small company—240 employees—all housed in one location, and such a large percentage of the guaranteed risk market—76 percent—that our book of business is relatively stable and (relatively!) predictable.
I acknowledge this makes budgeting much easier for us than for some of you.
The mechanics
The Internal Reporting unit of the Finance Department has the responsibility for coordinating budget preparation. We use a multi-tabbed interactive Excel spreadsheet for our budget model with exhibits supporting each line item rolling forward to a budget income statement presented in annual statement format. We also budget a cash flow statement, but do not budget a balance sheet. Separate tabs exist for input areas and allocation calculations.
All information is kept in one workbook, with the exception of detailed salary information by department that is linked to a separate password-protected salary spreadsheet. All calculations are done via interactive spreadsheet formulas, so all (read: last minute) input changes are reflected immediately throughout the model.
Our budget process begins at the end of October with a review of the budget model. Each year we work to improve some aspect of the spreadsheet. This year we spent more time on allocations, particularly salary allocations. We also modify the spreadsheet mechanics for the upcoming year by updating loss payout patterns in the cash flow section and historical expense information throughout the model.
Budget philosophy
Our budgeting philosophy can be distilled into two basic ideas.
First, the budget is simply a numerical representation of what you want to accomplish and how you want to accomplish it, as articulated in your business plan.
Because these goals will change over time, even within the year, the budget numbers themselves are not as important as understanding the budget variances created during the year.
The senior staff reviews company strategy at an annual offsite meeting and develops initiatives for the new year. Via our attendance at the planning session and interviews with the senior staff, we seek to understand the business plan and draft an eight-to-10 page narrative describing the plan and initiatives before generating any numbers. We keep in mind that it is the plan that generates the numbers and not the other way around.
Second, we don't sweat the small stuff. This makes it easy to prioritize our efforts.
There are really only three insurance company income statement line items that involve significant assumptions: premiums, losses and investment income. These obviously get our attention.
But many large expenses are uncontrollable for budget purposes. In Rhode Island, our mandated assessments are a large percentage of written premiums. Most of our commissions are earned by a limited number of agents who are compensated according to contracts. Reinsurance and NCCI costs are also based upon contractual agreements.
So by concentrating significant energy on the detailed budgeting of salaries and benefits, equipment and professional fees, we cover nearly 75 percent of our controllable expenses. Most other expenses are relatively fixed or relatively small.
Developing budget numbers
Premiums. We budget written premiums in total—i.e., not by agent, industry or geographical region—based upon our current inforce business, adjusted for anticipated retention, new business, and pricing changes. We also look at policy counts and average premium detail to "sanity check" the budgeted volume. Ceded premiums are budgeted in accordance with our reinsurance agreements.
Losses. Direct, assumed and ceded loss ratios selected for the budget are reviewed by accident year and compared to original budget, current case incurred losses and current ultimate loss ratios held. We develop the split between case and IBNR reserve estimates and our paid estimate for cash flow purposes by using actuarial reporting patterns.
Unallocated loss adjustment expense reserves are calculated by accident year, also using actuarial assumptions. ULAE expenses paid are based upon allocations—100 percent where we can, with NAIC allocation methods by expense type used where necessary.
Salaries and benefits. Salaries are budgeted in detail by department. So many expenses are driven at least in part by salaries that department salary disks are distributed to the vice presidents early in the budget cycle. These disks calculate department salaries in monthly detail by individual based upon estimated merit/promotion increases. All open and new positions must be justified and approved by the president. Benefit costs are researched and historical participation percentages are used to budget benefits and payroll taxes.
Expenses. Professional fees include the normal accounting and actuarial relationships and in many cases, due to our relatively small in-house staff, will involve consultants to assist us with our initiatives. Equipment expenses are normally constant over time but are budgeted in vendor detail due to the fact that it is a relatively large line item.
Most other controllable or semi-variable expenses are developed on a companywide basis based upon either historical correlations with factors such as volume, headcount or square footage, or a review of prior years actual.
Investments. A cash flow model develops our estimate of investment income. To arrive at average invested assets, assumptions are made regarding the timing of collections and expenditures. Monthly non-loss payments are linked from the expense budget tabs. Loss payments are calculated using actuarial accident year payout pattern assumptions.
Once the monthly balance of invested assets is estimated, we look at historical rates of return by income category, bonds, stocks and money markets. We also estimate investment rates for "new money" based upon the duration and risk of anticipated purchases. Investment income is also calculated on the estimated cash portion of the generated investment income. Our investment fees are then budgeted according to our advisor contracts and, along with our building expenses, are an offset to investment income.
Approval process
The president approves the average merit increase, all budgeted headcount changes, all professional fees and, in conjunction with the CFO, selects all accident year loss ratios. And we review various ratios, including the combined ratio, to ascertain the reasonableness and internal consistency of the budget.
As a final internal verification process, we also list every assumption made in the budget, no matter how small, for the president, the CFO and the Internal Reporting staff review for reasonableness. Our review includes whether the numerical budget truly reflects the narrative business plan and whether there is internal consistency of the financial exhibits.
Finally, we prepare a detailed line-item-by-line-item narrative that explains some of the biggest assumptions underlying the budget. This explanation, along with the business plan narrative and the financial exhibits, together become the complete budget package given to the Finance Committee and ultimately the full board of directors for review and approval.
Variance reporting
Our on-going variance reporting reflects the same priorities as the budget, with large controllable expenses getting the most attention. A monthly headcount report compares actual to budget by department, while a companywide quarterly analysis is done on all expenses with significant variances.
We are currently working on an expense reporting system that will push down the variance analysis into the department level for all expenses that can be directly associated with a department.
Conclusion
Our budget process looks at fixed and semi-variable expenses from a high altitude, the main income statement accounts of premium and loss from a medium altitude, and investment income and the large controllable expense items such as salaries and benefits from a low altitude.
We feel this approach provides us with an accurate numerical representation of our business plan with a minimum amount of time and effort.
Peter Durfee can be reached at PDurfee@beaconmutual.com or (401) 825-2614.
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