Management Control

System For General

Insurance Industry

BY:-

Aneesh Mehra
9132

Sant
osh Kr Sudhanshu 9147

Mohs
in Tamboli 9155

Sukh
ada Tamhankar 9156

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 MANAGEMENT CONTROL SYSTEM (MCS)

A management control system is a logical integration of techniques for

gathering and using information to make planning and control decisions, for
motivating employee behavior, and evaluating performance. The purposes of
a management control system are-

 to clearly communicate the organizations' goals to the employees

 to ensure that managers and employees understand the specific
actions required of them to achieve organizational goals
 to communicate results of actions across the organization
 to ensure the employee/managers can adjust to the changes in the
organization

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A well designed management control supports and coordinates the decision-
making process and motivates individuals throughout the organization to act
in concert. The first and most basic component in a management control
system is the organizations' goals. Because the focus of the management
control system is on motivating decisions that help achieve the organizations
goals. A basic adage of management control system is that "you get what
you measure". It means the measures of performance will influence
managers' decisions; therefore measure of performance should be consistent
with the organizations goals. To design the management control system that
meets the organizations' goals or organizations needs, the whole job of
designing is done in four stages. (Fig-1)

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 Fig 1: Management Control System

Stage 1: Identifying Responsibility Centers

Under this stage the whole organization is divided into responsibility centers
and for every responsibility center their goals are decided and

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responsibilities are also fixed.

Stage 2: Developing Performance Measures

For every responsibility center the performance measures are fixed. Means if
some responsibility has been assigned then the method of their
measurements are developed at this stage. Unless we measure the
performance, no objectivity could be introduced in the system. To practically
implement this performance measures, Key Performance Indicators (KPI's)
should be developed for every responsibility center. KPI's are measurement
of the performance in a very clear cut and quantifiable terms.

Stage 3: Monitoring & Reporting

After having fixed the responsibility centers and having placed the KPI's in
place the job of MCS just begins. Because this system needs continuous
reporting and monitoring so that it is ensured that everyone follows the
system to the fullest and if there seems to be any need of improvements in
the MCS itself that could also be introduced.

Stage 4: Rendering of Rewards and making people take corrective

actions
After having gone through the first three stages up to the reporting the next
obvious stage is to render rewards to those who perform better than
expected. Besides this the next step is taking corrective actions for those
who performances are found to be low and taking the decision of even firing
to those who are either far below expectations or are not having the scope of
improvement at all.

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 General Insurance Sector

Overview

In India, Insurance is a national matter, in which life and general insurance is

yet a booming sector with huge possibilities for different global companies,
as life insurance premiums account to 2.5% and general insurance premiums
account to 0.65% of India's GDP. The Indian Insurance sector has gone
through several phases and changes, especially after 1999, when the Govt.
of India opened up the insurance sector for private companies to solicit
insurance, allowing FDI up to 26%. Since then, the Insurance sector in India is
considered as a flourishing market amongst global insurance companies.
However, the largest life insurance company in India is still owned by the
government.

The history of Insurance in India dates back to 1818, when Oriental Life
Insurance Company was established by Europeans in Kolkata to cater to their
requirements. Nevertheless, there was discrimination among the life of
foreigners and Indians, as higher premiums were charged from the latter. In

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1870, Indians took a sigh of relief when Bombay Mutual Life Assurance
Society, the first Indian insurance company covered Indian lives at normal
rates. Onset of the 20th century brought a drastic change in the Insurance
sector.

In 1912, the Govt. of India passed two acts - the Life Insurance Companies
Act, and the Provident Fund Act - to regulate the insurance business.
National Insurance Company Ltd, founded in 1906, is the oldest existing
insurance company in India. Earlier, the Insurance sector had only two state
insurers - Life Insurers i.e. Life Insurance Corporation of India (LIC), and
General Insurers i.e. General Insurance Corporation of India (GIC). In
December 2000, these subsidiaries were de-linked from parent company and
were declared independent insurance companies: Oriental Insurance
Company Limited, New India Assurance Company Limited, National Insurance
Company Limited and United India Insurance Company Limited.

Since the privatization of general insurance in 2000, the industry has grown
from 4 public sector companies to 22 companies at present. Gross Written
Premiums of the industry, excluding the specialized insurers, grew from Rs.
124 Billion in 2001-02 to Rs 347 Billion in 2009-10. During 2009-10, GWP
grew by 13.4 %.

Rs. Million 2009-10 2008-09 % Change

Private 142,267 126,106 12.8 %
Public 205,285 180,313 13.8 %
Market 347,552 306,419 13.4 %

Return on Equity:-

2008-09 2007-08 2006-07

Private -2.30 % 1.4 % 11.1%

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Public 1.30 % 5.1 % 7.30%
Market 0.90% 4.9 % 7.50%

Organizational Chart

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 Cost Center

Finance Department

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A finance department records operating activities, tracks changes
in business conditions and predicts operating indicators. The role of the
Finance Department is like a skilled technician who takes measures of a
company’s health and writes a report. Financial managers examine the data
prepared by accountants and make recommendations to top management
regarding strategies for improving the company’s financial strength.
The basic functions to be performed by Finance Department are:

1. Acquiring funds for the firm, managing funds within the firm, and
planning for the expenditure of funds on various assets.
2. Collecting overdue payments and minimizing bad debts.
3. As tax laws change, finance specialists must carefully analyze the
tax implications of various decisions in an attempt to minimize taxes
paid.
4. Internal Audit
5. Developing Budgets
6. Cash Flow Forecast is a prediction of cash inflows and outflows in
future periods, usually months or quarters
7. The Capital Budget highlights a firm’s spending plans for major
assets purchased that required large sums of money.
8. The Cash Budget estimates a firm’s projected cash balance at the
end of given period.
9. The Operating Budget, or Master Budget, ties together all of a firm’s
other budgets; it is the projection of dollar allocations to various
costs and expenses needed to run the business
10. Financial Control is a process in which a firm periodically compares
its actual revenues, costs, and expenses to those projected
11. Decisions over borrowings from banks and other institutions and
advances to various parties.
12. Risk Management for covering liabilities

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In General Insurance Industry, finance department does not add to creation
or delivering the insurance policies needed by the client/customers. Thus it
does not add directly to creation of revenue or profits. Despite this fact
Insurance industry has to pay for the cost incurred on the finance
department which majorly consists of salary of the employees in finance
department and fixed assets like infrastructure etc.

Hence industry accurse cost of finance department even when it does not
contribute to the profit. As a result Finance department is considered as cost
centre.

Marketing Department

In order to be successful, insurance companies have to be able to convince

their clients of the usefulness of their products and of the solidity of their
businesses.

Trust is a vital element for the insurance industry and even if on short term,
liquidity is the target, as it ensures survival, on long and medium term the
objective has to be the consolidation of the trust of consumers in insurance
companies and the goal of the managers must be to win customer loyalty.

The success of an insurance company is based on the quality of the long

term relationship established between the company and its “partners”:
customers, employees, broker dealers, banks.

Most organizations has a marketing division responsible for marketing

strategy, advertising, researching, promoting, conducting customer surveys,
branding, public relations and creating of corporate style. All these

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responsibilities can be gathered in several main functions of the marketing
department.

• Advertising
Conveying information regarding new products to customers

•Sales forecasting
Identify customer needs and convey them to research and
development department

• Formulating marketing mix wherein deciding upon Product, Price, Place

and Promotion

• Market Survey

• Emphasis on market segmentation

• Focus on Market Research

Marketing department is also considered as cost centre in the industry.

Marketing department is responsible for all the marketing and advertising
activities that are carried out by the company. All these activities may help a
company to acquire a client but does not add to profitability.

Administration and Human Resource Department

Administrators, broadly speaking, engage in a common set of functions to
meet the organization's goals.
• Planning is deciding in advance what to do, how to do it, when to do it,
and who should do it. It maps the path from where the organization is to
where it wants to be.
• Organizing involves identifying responsibilities to be performed,
grouping responsibilities into departments or divisions, and specifying
organizational relationships. The purpose is to achieve coordinated effort
among all the elements in the organization (Coordinating). Organizing

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 must take into account delegation of authority and responsibility and span
of control within supervisory units.
• Controlling is a function that evaluates quality in all areas and detects
potential or actual deviations from the organization's plan. This ensures
high-quality performance and satisfactory results while maintaining an
orderly and problem-free environment. Controlling includes information
management, measurement of performance, and institution of corrective
actions.
• Storage of important data and retrieving it whenever required.
• Cleanliness and maintenance in the office premises
• Also doing the purchasing activity on behalf of the company which mainly
includes purchase of inventories needed for departments like stationary,
etc.

In Insurance industry administration department is a cost centre. Admin

department has to look after various duties like mailing documents,
housekeeping, etc. Also this adds to the cost only but does not help in
generating profits. Hence, it is a cost center.

Human Resource Department

Human resources is a term used to describe the individuals who comprise
the workforce of an organization, although it is also applied in labor
economics to, for example, business sectors or even whole nations. Human
resources is also the name of the function within an organization charged
with the overall responsibility for implementing strategies and policies
relating to the management of individuals (i.e. the human resources). This
function title is often abbreviated to the initials ‘HR’.

The Human Resources Management (HRM) function includes a variety of

activities, and key among them is deciding what staffing needs you have

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 and whether to use independent contractors or hire employees to fill
these needs, recruiting and training the best employees, ensuring they
are high performers, dealing with performance issues, and ensuring your
personnel and management practices conform to various regulations.
Activities also include managing your approach to employee benefits and
compensation, employee records and personnel policies.HR is responsible
for the following

• Recruitment, selection and on boarding

• Training and Development
• Compensation, rewards and benefits management
• Competency Mapping
• Performance Management
• Core HR activities
• Employee and Industry Relations
• Employee Engagement
• Recruitment, selection, and on boarding (resourcing)

• Organizational design and development

• Business transformation and change management

• Performance, conduct and behavior management

• Human resources (workforce) analysis and workforce personnel

data management

In Insurance industry engagement and training of Agents / Brokers is one of

the most important functions. Most of the revenue in terms of premiums
comes through Agents only. Therefore training, engagement, their retention
with company and payment of commission is very vital in good performance
of an Insurance company.

Implementation of such policies, processes or standards may be directly

managed by the HR function itself, or the function may indirectly supervise

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the implementation of such activities by managers, other business functions
or via third-party external partner organizations.

All the activities of Human Resource group do not directly to the profit of the
organization. As a result it is classified as Cost Centre.

IT Department

The IT architecture and the systems that support the business processes are
the backbone of an organization. IT department heads have to facilitate the
understanding and implementation of the controls, policies, and procedures
that will ensure underlying systems store and produce accurate and
complete financial data.

The aim of IT department is to provide technological support to the whole

organization wherever needed. IT department also keeps on searching new
tools and software which may enhance the efficiency of the organization.

IT management typically sets policies, procedures, and controls to govern

database management and report creation to help ensure the effectiveness
and usefulness of the organization.

IT department is responsible for the following:-

1. Facilitate the management of the business

2. Provide management with an adequate decision support system by

providing information that is timely, accurate, consistent, complete,
and relevant.

3. Deliver complex material throughout the institution.

4. Ensure the integrity and availability of data

5. Enhance communication among customers.

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 6. Keeping record of online payments and forwarding them to Finance
department

7. Tracking system for claim settlement procedure

Claims committee
Underwriting and claims settlement are the two most important aspect of the
functioning of an insurance company. Out of any insurance contract, the
customer has the following expectations:
1. Adequate insurance coverage, which does not leave him high and dry
in time of
need, with right pricing.
2. Timely delivery of defect free policy documents with relevant
endorsements /
warranties / conditions / guidelines.
3. Should a claim happen, quick settlement to his satisfaction.

Unlike life insurance, where all policies necessarily result in claims – either
maturity or death – in general insurance not all policies result in claim.
Approximately around 15% policies in general insurance result in claim. The
claim settlements in general insurance thus have their own peculiarities and
therefore need proper handling. Also how 15% policy holders are
attended is of great importance. The services being rendered will determine
the attitude of
the customers.
The procedure through which claim is handled is:
1. As soon as a claim is reported, the insurance company checks as to
whether the
cover was in force at the time of loss and whether the peril is covered
under the
policy.

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 2. A surveyor is appointed who visits the spot, do the assessment and
submits the
report.
3. Insurance company examines the report, calls for relevant supporting
documents.
4. On receipt of survey report and documents, the same are examined.
The claim file
is processed and settlement is offered.

General insurance being a market driven service industry, the customer has
to be kept satisfied. With so many options available, a customer once lost is
most likely a loss forever. Claim settlement can be used as a marketing tool.
Brining in a new customer is much more costly than retaining the existing
ones.
In a de-tariffed market, pricing will be the key factor. Proper claims
management - quick settlement at optimal cost will help keep the price
competitive.
A dissatisfied customer is a bad publicity. It has all the potential to damage
the reputation of the company. It is an accepted fact that most of the
customers complaint relate to claims. It should be the endeavor of any
insurance company to ensure that such complaints do not occur in the first
place and in some cases if they do occur it is attended promptly, efficiently
and transparently.
IRDA guidelines on ‘protection of policyholders’ interest’ stipulate certain
obligation on the part of insurance company including time limit for claim
settlement. This is a regulatory requirement and insurance company
personnel at every level must understand its implication. Delayed claim
settlement generally result in higher claims cost. Claims cost is a very
important factor vis-à-vis profitability.
Claims files must be monitored as they progress. A little time spent thinking
clearly right from the beginning will avoid lot of unnecessary and time

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consuming patch-ups and straightening out later on. Unpleasant decisions
conveyed timely with proper justification of the decision is better than
procrastination which is bound to create more problems and unpleasant
situations.
Lot of time / energy / money is spent when claim cases go to Ombudsman /
Consumer Forum/ Court. Besides, adverse comment bring bad name, when
insurance companies are held liable. Insurance companies are invariably at
the receiving end.
Claims-settlement has a social service angle which is to be met. In times of
natural calamity lot of bad publicity comes to insurance company for delay in
settlement of claims. This is in spite of the fact that in such situation
insurance companies goes out of their way to settle claims. In any case
claims relating to the assets of weaker section needs to be attended on
priority. So do the health / medical related claims.

In view of the above, it is necessary that

• Insurance companies manage the claims rather than handling them.

• Insurance companies have a corporate claims management philosophy

There is another angle to this procedure. Out of the total outgo on account of
claims it is estimated that around 10 to 15 % is because of leakages, frauds
and inflated claims. In absolute terms this will be a quite substantial amount.
If this can be effectively checked, the benefit can be passed on to the
customer by way of reduced premium rates.

Settlement of claims is the biggest expenditure for a company. The amount

covered under the scheme has to be given to the policyholder in case claim
is approved. Therefore, claims department is a cost center for the company.

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 INVESTMENT CENTRE

Research and Development

For a company to prosper and grow it must do more than keep up with its
competitors and it must in fact get ahead of them whenever possible.
Getting ahead means innovation which hinges on research and development
(R & D).Research seeks to make basic discoveries and uncover new
principles or facts so far unknown or unrecognized.
Industry is aware that tomorrow’s profit depends to a large extent on today’s
research and the fact that money invested now in R & D probably will not
generate income for several years to come. One thing for sure is that without
R &D effort, there may not be any future for the company.

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When researching and developing new products, both the R&D managers
and their staff take responsibility of performing the following key tasks:

1. To uncover new product ideas which will meet the requirements of

current as well as prospective customers.
2. To achieve an increased understanding of the subject matter, this
refers to systematic, objective collection and analysis of data about a
particular target market, competition.
3. What are the commercial and national economic profitability
prospects?
4. Researching the product according to allocated budget.

Currently Insurance industry is facing huge competition. Under such

condition R&D only can help Insurance industry to move up in the value
chain model and also dominate the market. But for R&D companies have to
invest huge amounts upfront and the companies can gain rich dividends from
this over a period of time. Due to this reasons in Insurance industry R&D is
an investment centre in which companies must invest.

Customer Relationship Management

CRM is the broadly recognized and implemented strategy for managing and
nurturing a company’s interaction with customers and clients for sale’s
prospects. It involves using technology to organize, automate and
synchronize business process.

Role of CRM in Insurance sector

1. integration of marketing with other operations

2. increased insurance market share

3. guarantee of lead management

4. claims and application queries can be answered sooner

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 5. renewal of policies can be reminded to customers on time

6. new policies and schemes can be informed to target customer

7. Communicating with loyal customers can be maintained properly due

to data available at fingertips for mails, SMS, telephonic calls, etc.

In Insurance sector CRM plays an important role as the company can keep
track of pricing the product, impact of changes in pricing, analysis of
geographical variations in performance and most importantly
performance of agents in various categories.

CRM is a systematic approach towards using information and ongoing

dialogue to build long lasting mutually beneficial customer relationship.

As no revenue is generated from CRM activity but it is a constant process

of building customer relations, which finally transfers into sales and
revenue, CRM is an investment center.

Profit Centre

Fund Management
Insurance companies get their revenues in terms of premiums collected from
policy holders. This is termed as gross premium. The probability of an event
happening for which insurance cover has been taken, is calculated. This
probability is considered for a huge group of insured people i.e. policy
holders. This is called as pooling of risk. Depending upon the risk, pricing of
the policy is done i.e. premium to be paid is decided.

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When operating cost such as expenditure over human capital, fees to be paid
to advisors and experts, expenses for various assets to be bought, etc is
deducted from the total gross premium collected, the fund left with
insurance company is called as net premium.
This sum of net premium is the amount which has to be managed cautiously
to keep liquidity of funds in place and earning return on it at a good rate,
both at the same time. There are certain finance managers allotted for this
function in the insurance company called as Fund Managers.
The various options Fund Managers have for investments are listed below. A
fund manager has to maintain balance between low risk options which give
regular return and high risk options for investments which give higher
returns.

1. Investments in Bank Fixed Deposits (FD)

Fixed Deposit or FD is accrues about 8.5% of yearly profits, depending on
the bank's tenure and guidelines, which makes it's widely sought after
and safe investment alternative. Banks also give special rates for deposits
for institutional investors like Insurance companies.

2. Investments in National Saving Certificate (NSC)

National Saving Certificate (NSC) is subsidized and supported by
government of India as is a secure investment technique with a lock in
tenure of 6 years. There is no utmost limit in this investment option while
the highest amount is estimated as Rs 100. The investor is entitled for the
calculated interest of 8% which is forfeited two times in a year.

3. Government Bonds and Treasury Bills

The long term bonds issued by RBI on behalf of the government of India,
is another safe option for investments. Treasury bills or T-Bills are

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 generally considered for a very short term investment, usually to meet
liquidity needs and generating some profit out of interest.

4. Investments in Stock Market

Investing in share market yields higher profits. Influenced by
unanticipated turn of market events, stock market to some extent cannot
be considered as the safest investment options. However, to accrue
higher gains, an investor must update himself on the recent stock market
news and events.

5. Investments in Mutual Funds

Mutual Fund firms accumulate cash from willing investors and invest it in
share market. Like stock market, mutual fund investment are also entitled
for various market risks but with a fair share of profits.

6. Investments in Gold Deposit Scheme

Controlled by SBI, Gold Deposit Scheme was instigated in the year 1999.
Investments in this scheme are open for trusts, firms and HUFs with no
specific upper limit. The investor can deposit invest minimum of 200 gm
in exchange for gold bonds holding a tariff free rate of interest of 3% - 4%
on the basis of the period of the bond varying with a lock in period of 3 to
7 years. The returns on this scheme totally depends upon the
international market gold rates and fluctuations in its value.

7. Investments in Real Estate

Indian real estate industry has huge prospects in sectors like commercial,
housing, hospitality, retail, manufacturing, healthcare etc. Calculated
realty demand for IT/ITES industry in 2010 is estimated at 150mn sq.ft.
around the chief Indian cities. Termed as the "money making industry",
realty sector of India promises annual profits of 30% to 100% through real
estate investments. Therefore, investment in real estate is another great
option for fund managers.

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8. Investments in Equity
Private Equity is expanding at a fast pace. India acquired US $13.5 billion
in 2008 under equity shares and featured among the top 7 nations in the
world. In 2010, the total equity investment is predicted to increase up to
USD 20 billion. Indian equities promise satisfactory returns and have more
than 365 equity investments firms functioning under it.

Moreover Fund Management as a function can also be outsourced

completely to a third party. This fund management company has
expertise in their business which helps the insurance company gain better
results.

As Fund Management Department generates profits for the organization by

managing its funds it is a profit center.

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Revenue Centre

Sales
An insurance cover is an intangible product evidenced by a written contract
known as the ‘policy’. Insurers market various insurance covers either
directly or through various distribution channels—individual agents,
corporate agents and Brokers. The marketer in the distribution network is in
direct interface with the prospect and the customer.
General insurance products are sold through individual agents, corporate
agents and brokers.
Distribution channels such as agents are licensed by the IRDA. To get an
agency licence, one has to have certain minimum qualifications; practical
training in insurance subjects and pass an examination conducted by the
Insurance Institute of India.
Certain Insurance companies have corporate tie ups with financial
institutions like banks and mutual funds wherein sales of policies can be
done through these channels as well. This happens in cases where in the
parent company for bank and insurance is the same. For eg. SBI.
Sales on personal level are done by
• Insurance agents
• Insurance brokers
• Corporate agents

In recent years, consumers have come to expect a wide range of choices in

how they purchase products and services. The insurance industry, due to the
complexity of its offerings, has been somewhat insulated from this trend. But
it may not be long before the industry faces a tipping point where the
internet and other direct sales channels are a basic requirement for doing

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business. That’s not to suggest insurance companies should abandon the
traditional producer model involving agents. In most cases, the right answer
will be a hybrid approach that combines the best of both worlds.

The new channels through which sales are made are :

• Online policy selling
• Insurance covers on the move
• Combining insurance policies sale with some other product like as a
gift with new purchase, etc. can be done.

Sales get revenue for insurance company by demanding premiums for

insurance coverage from policy holders i.e. customers. The premium
collected is the revenue used for funding all other operations of an insurance
company.
Therefore, a sale through any channel is a Revenue center for an Insurance
company.

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 Balanced Score Card

The balanced scorecard (BSC) is a strategic planning and management

system that has wide applications in manufacturing and service industries.
The main goals of BSC are to align business activities to the vision and
strategy of the organization, improve internal and external communications,
and monitor organization performance against strategic goals. In this study,
performance measurement is defined as an evaluation of the past activities
with respect to the desired goals. First a balanced scorecard based
performance measurement system is proposed for insurance companies.
Then perspectives that were obtained from BSC approach are quantified by
Analytical Network Process (ANP).

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The balanced scorecard is a customer-based planning and process
improvement system aimed at focusing and driving an organization's change
process. It is an integral part of the mission identification, strategy
formulation, and execution processes, with a focus on translating strategy
into an integrated set of financial and non-financial measures. As such, the
balanced scorecard plays a major role in communicating the organizational
strategy to the members and providing feedback to guide actions toward the
attainment of objectives.

The scorecard can be used at different levels: throughout the total

organization, in a subunit, or even at the individual employee level as a
"personal scorecard." For each level, the balanced scorecard approach
involves identifying the key components of operations, setting goals for
them, and then finding ways to measure progress toward achieving these
goals. Taken together, the measures provide a holistic view of what is
happening both inside and outside that organization or level, thus allowing
each constituent of the organization to see how their activities contribute to
attainment of the organization's overall mission.

Because the balanced scorecard is directly linked to mission and strategy,

the relevant components and measures will vary across organizations
depending on their specific goals and circumstances.

The balanced scorecard (BSC) is a strategic planning and management

system that has wide applications in manufacturing and service industries.
The main goals of BSC are to align business activities with the vision and
strategy of the organization, improve internal and external communications,
and monitor organization performance against strategic goals. It was first
introduced by Kaplan and Norton in 1992.
We consider four perspectives for calculations:-
 Financial Perspectives

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• Total revenue
• Cost reduction percentage
• Profit rate (percentage)
• Return on investment (percentage)
 Customer Perspectives
• Customer satisfaction rate (percentage)
• Cross selling percentage
• New customer acquisition rate (percentage)
• Customer retention rate (percentage)
 Internal Business Process Perspectives
• Number of new products
• Service error rate (percentage)
• Mean-time response to a service call (hours)
• Customer complaints rate (percentage)
 Learning and Growth Perspectives
• Implementation rate for strategic plans (percentage)
• Mean-time to re-skilling per employee (hours)
• Investment rate in information technology and systems
• Customer satisfaction rate (percentage)

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 TRANSFER PRICING

Transfer pricing is simply the act of pricing of goods and services or

intangibles when the

same is given for use or consumption to a related party (e.g. Subsidiary)

There can be internal and external reasons for transfer pricing. Internal
include

motivating managers and monitoring performance, e.g. by putting a cost to

imported

inputs. External would be taxes and tariffs.

In our organizations, intermediate products or services are transferred from
one subunit to another within the organization. The price at which the
product or service is transferred determines the profitability of the particular
subunit. This in turn can affect management compensation, and may be used
for performance measurement evaluations through the company’s
management control system.

The management accounting themes of cost behaviour (variable to fixed)

and time frame (short-term to long-term) are particularly important, as

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transfer pricing is based on a straightforward distinction between variable
and fixed costs.

Transfer pricing helps manage the flow of goods and services in companies
that are divided into responsibility centres. Although transfer prices are
usually set between profit and investment centres, in practice transfer
pricing can take the form of transferring costs from cost centres to other
divisions.

There is no single pricing policy to cover all transfer situations. Here are the
three main general methods:

1. Market-based transfer prices

Available in the general market to third-party outside buyers and sellers,

market-based transfer prices are used to determine internal transfer
prices.

Using market-based transfer prices generally leads to the most optimal

pricing decision for a company. Under conditions of perfectly competitive
markets — when there are homogeneous products where neither buyer nor
seller can influence the pricing structure of the market — interdependence
between subunits is minimal, and there are no additional costs or benefits of
using market prices.The objectives of goal congruence, evaluation of
management effort, optimal subunit performance, and subunit autonomy can
be achieved using market-based transfer prices.

2. Cost-based transfer prices

Based on the cost (either budget or actual) of producing the specific product.
Cost can be defined as either straight variable cost, manufacturing

Department of Management Sciences, (PUMBA) Page 31

(absorption) cost, or full cost (production plus other costs such as
distribution, marketing, and so on).

When market-based prices are not readily available, such as with specialty or
unique products, internal cost-based transfer prices may be an alternative.
Companies can choose a variety of cost-based transfer prices including
variable cost, full absorption cost, or cost-plus pricing (with a markup over
either variable or full-absorption costing), or opt for a dual-pricing transfer
cost strategy.

3. Negotiated transfer prices

Negotiated transfer prices are used as a training ground for managers. The
ability of each manager to negotiate, in addition to the relative bargaining
strengths of the buying and selling division, are used to determine a transfer
price between the minimum variable cost for the selling division and the
market price for the buying division.

Negotiating transfer prices can sometimes lead to conflicts between

managers, especially when management compensation is based on
profitability of the divisions. In such cases, the senior management can
either step in or have an arbitration hearing to hear both sides.

We will be implementing Market Based Transfer Pricing as Insurance

products are available at competitive prices in the market. This leads to the most
optimal pricing decision for a company.
In Insurance industry buyers and sellers cannot influence pricing. Therefore, market based
transfer pricing is the method which we follow.

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