Insurance premium allocation and loss prevention in a large firm. A principal agent analysis

Faced with increased insurance costs, large firms are turning to a more systematic allocation of premium costs to 'subsidiaries' - an approach which capitalizes on economies of scale in a corporate-wide management of aggregated risks (risk pooled across divisions as well as subsidiaries). Such practice however, raises a number of problems: (i) What part of the aggregate risk should the firm self-insure, (ii) How should premium costs be allocated between subsidiaries, (iii) How much effort should subsidiaries invest in loss prevention programs and how should they manage claims (i.e. co-insure themselves), (iv) How can the parent firm induce managers of subsidiaries to control subsidiaries' risk, thereby reducing future premium payments and moral hazard. Or what premium incentive scheme can the firm devise to penalize (or compensate) subsidiaries investing less than an optimal effort in loss prevention. To deal with these problems, a conceptual framework, based on a principal-agents analysis and the definition of a liability account for each subsidiary is developed which is used to reduce the problems of moral hazard due to a less than perfect (or indirect) monitoring system. Specifically assumption regarding the premium allocation incentive scheme are made and explicit solutions are obtained for the control of subsidiaries loss prevention effort allocation.