Budget and Budgetary Control in Insurance
Plan the numbers, then compare what happened. That is the whole chapter in one line.
A budget is a plan for the year written in money: expected premium, claims, commission and running costs. Budgetary control is the habit of comparing actual results with that plan every month, finding the reasons for each gap (the variance) and acting on them.
For an insurer, the budget is not optional paperwork. IRDAI's 2024 expenses of management regulations require a Board-approved annual business plan before each financial year starts, and the Board must monitor it through the year.
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Key Terms
- Master budget
- The original budget set before the period starts, for the volume the company planned to write.
- Fixed budget
- A budget prepared for one level of activity that does not change when actual volume differs. The master budget works this way.
- Flexible budget
- A budget tailored to actual results, built from standard costs or prices for the volume actually achieved. It is the primary benchmark for judging performance.
- Variable budgeting
- Allowing more budget money for more work, based on the cost of an extra unit. It is a fairer test of a manager who cannot control volume.
- Responsibility centre
- A department or unit whose head plans its work load and is held accountable for its budget.
- Variance
- The difference between actual and budget. Favourable (F) if it helps profit, unfavourable (U) if it hurts.
How an Insurer's Budget Is Built and Controlled
- 1
Forecast premium
The premium income forecast is prepared first. Production or marketing plans let each responsibility centre work out its own work load.
- 2
Departments estimate costs
Work load converts into staff needed, then into rupees. Salaries, increases and overtime are the bulk of budgetable expense; travel, supplies, postage, fees and equipment rental make up the rest. Service users send their needs before service departments set their own loads.
- 3
Review and approve
The next higher level of management reviews each centre's budget, separating this year's profit goals from longer-range work. The head must accept the adjusted budget and is held accountable for it.
- 4
Report monthly
Actual expenses and output are compared with plan every month. Significant variances are investigated and acted on. Reports roll upward, so the chief executive sees each department head's results.
- 5
Revise when duties change
If a department is given new responsibilities mid-year, its budget should be adjusted. Savings in one department are not taken away to cover another's overspend.
What Goes in a Departmental Budget
A manager is charged only with costs he or she can actually authorise.
- check_circleThe claims department head is not charged with the department's rent; rent sits in the finance officer's budget. A branch manager who signs the branch lease does carry that rent.
- check_circleLosses, allocated claim expenses, licences and fees, assessments and dues, and commissions are kept out of departmental budgets, because no department controls them. They appear on the master budget as an agreed percentage of estimated premium income.
- check_circleCentral services (such as typing pools or printing) are charged back to the departments that use them, at a set rate per unit of work, so users have a reason to stay within estimate.
- check_circleThe main costs of producing insurance business are commission and salaries. Commission varies with the volume written.
Variance Formulas for Variable Items
From a Casualty Actuarial Society paper on budget variances. "Exposures" means units of business written; "price" means the premium rate (or, for losses, the loss ratio).
Price variance
Formula
Actual exposures × (actual price − standard price)
What it isolates
Rate charged (or loss ratio) versus budget, holding volume at actual
Quantity variance
Formula
Standard price × (actual exposures − standard exposures)
What it isolates
Volume difference, holding price at budget
Flexible budget variance
Formula
Price variance + quantity variance
What it isolates
Performance against the flexible budget
Budget adjustment variance
Formula
Standard price × (standard exposures − original exposures)
What it isolates
Flexible budget versus master budget: how effective the operation was
Overall variance
Formula
Flexible budget variance + budget adjustment variance
What it isolates
Actual versus master budget
Pure price variance
Formula
Standard exposures × (actual price − standard price)
What it isolates
Price effect at budgeted volume; the rest of the price variance is a joint price-quantity effect
| Variance | Formula | What it isolates |
|---|---|---|
| Price variance | Actual exposures × (actual price − standard price) | Rate charged (or loss ratio) versus budget, holding volume at actual |
| Quantity variance | Standard price × (actual exposures − standard exposures) | Volume difference, holding price at budget |
| Flexible budget variance | Price variance + quantity variance | Performance against the flexible budget |
| Budget adjustment variance | Standard price × (standard exposures − original exposures) | Flexible budget versus master budget: how effective the operation was |
| Overall variance | Flexible budget variance + budget adjustment variance | Actual versus master budget |
| Pure price variance | Standard exposures × (actual price − standard price) | Price effect at budgeted volume; the rest of the price variance is a joint price-quantity effect |
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Fixed Costs: Spending and Denominator Variances
Fixed costs are monitored differently, by fixed-overhead application. The fixed-overhead rate is budgeted fixed costs divided by the best measure of capacity for the period, called the denominator level. In the paper's example, capacity is twice policyholders' surplus (a Kenney rule): surplus of $1,750 gives a denominator level of $3,500, and $140 of budgeted fixed cost gives a rate of $0.04 per dollar of capacity.
Actual fixed costs were $150. Spending variance (the budget variance for fixed costs): $150 − $140 = $10 unfavourable. Standard capacity for the premium actually written was $2,500, so overhead applied was $2,500 × 0.04 = $100. Denominator variance: $140 − $100 = $40 unfavourable. Total underapplied overhead: $50 unfavourable. Fixed-cost analysis has no quantity variance; the denominator variance takes its place as a rough measure of efficiency.
Committed vs Discretionary Fixed Costs
- check_circleCommitted fixed costs, such as depreciation, real estate taxes and insurance, are likely independent of short-term changes in volume. An unexpected rise in property tax assessment is the paper's example of a shock here.
- check_circleDiscretionary fixed costs come from short-term decisions and are more likely to rise with growth. The paper's example is a management development programme started after a surge in premium.
- check_circleInflation or poor cost estimates can also cause fixed-cost differences, so the causes of every spending variance should be examined.
Where IRDAI Comes In
IRDAI's expenses of management regulations (2024 extract) turn budgeting into a Board duty.
- check_circleEvery insurer must formulate an annual business plan before the financial year begins, approved by its Board.
- check_circleThe plan must project capital requirements for the year, solvency margin quarter by quarter, and expenses of management in rupees and as a percentage of gross premium written in India, with a statement of compliance with the limits.
- check_circleThe Board must monitor the plan at regular intervals.
- check_circleA separate Board-approved policy on expenses of management, approved annually, must set measures for cost effectiveness and annual reduction of expenses, and how expenses are allocated across business segments. The Appointed Actuary and the Chief Financial Officer are responsible for that allocation.
Exam Traps in This Chapter
The flexible budget, not the master budget, is the benchmark for performance. Price variance uses actual exposures; pure price variance uses standard exposures; quantity variance uses the standard price. Fixed costs have spending and denominator variances, not price and quantity. Commission and losses are not controllable departmental items. An unfavourable loss variance is not always bad: it may come from justified reserve strengthening. Expense allocation belongs to the Appointed Actuary and CFO, not the Chief Risk Officer.
FAQs
What is budgetary control in insurance?expand_more
Setting a budget for premium and costs, comparing actual results with it regularly, investigating significant variances and acting on them. If variances are not investigated or taken seriously, the system has little value.
What is the difference between a master budget and a flexible budget?expand_more
The master budget is set before the period for the planned volume. The flexible budget restates costs and income at standard rates for the volume actually achieved, so it is the fairer benchmark for performance.
Why are commissions and claims kept out of departmental budgets?expand_more
No department head controls them. They appear on the master budget as an agreed percentage of estimated premium income, and managers are held accountable only for costs they can authorise.
What is a denominator variance?expand_more
In fixed-cost analysis, the gap between the fixed-cost budget and the fixed overhead applied at actual volume. It replaces the quantity variance and gives an approximate measure of efficiency.
Does IRDAI require insurers to prepare a budget?expand_more
Its 2024 expenses of management regulations require a Board-approved annual business plan before the financial year starts, projecting capital, quarterly solvency margin and expenses of management, which the Board must monitor.
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