Product-Line Profitability and Overhead Allocation
Summit Life's management committee is reviewing product-line profitability. Fixed overhead of $48 million is allocated to product lines in proportion to direct premium. Term life has $300 million of premium and shows a $4 million loss after allocation; whole life has $900 million of premium and shows a $176 million profit; annuities have $600 million of premium and show a $104 million profit. Term's direct expenses excluding overhead are $106 million and death benefits are $190 million. Whole life's direct expenses are $180 million and benefits are $520 million. Annuities' direct expenses are $70 million and benefits are $410 million. The committee is considering exiting term, which would free up $12 million of fixed costs but reduce overhead absorption for the other lines. The head of distribution argues that term is a gateway product that brings in younger customers.
1. Recompute each line's contribution margin before overhead allocation. What does this reveal about the term line?
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Term: $300M premium − $190M benefits − $106M direct expenses = $4M contribution margin. Whole life: $900M − $520M − $180M = $200M. Annuities: $600M − $410M − $70M = $120M. Total contribution is $324 million, and total overhead is $48 million, leaving $276 million of pre-tax profit.
The term line is not inherently unprofitable: it covers its direct benefits and expenses and contributes $4 million. Its reported $4 million loss comes entirely from the $8 million of allocated overhead ($48M × $300M / $1,800M). The allocation makes term look like a loser, but the contribution margin shows that it is marginally positive. That does not prove Summit should keep term, because $4 million may not compensate for the risk capital and distribution resources it consumes, but it does show that an exit decision based on fully allocated profit would be distorted.
2. Should Summit exit the term line? Quantify the incremental effect and discuss the strategic considerations.
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On a short-term incremental basis, exiting term loses the $4 million contribution but saves $12 million of avoidable fixed costs, for a net pre-tax improvement of $8 million. That arithmetic favors exit if the $12 million savings are truly avoidable and if no other line grows to absorb the freed capacity.
However, the $4 million contribution is thin and sensitive to mortality, persistency, and expense assumptions. The strategic case for keeping term includes cross-selling whole life and annuities to younger policyholders, maintaining distribution relationships, and preserving a source of future underwriting data. The committee should request customer-lifetime-value analysis and a breakdown of the $12 million avoidable costs. A conditional recommendation is to exit only if the $12 million is verifiable and if the distribution channel can retain the customer relationships without term. Otherwise, retain term but stop allocating fixed overhead to it for decision-making.
3. Recommend an improved cost allocation and profitability framework for Summit.
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Summit should separate contribution margin from fully allocated profit. The first layer is premium minus benefits, direct expenses, and variable commissions. The second layer subtracts avoidable fixed costs traceable to the product line. Only after those layers should shared overhead be allocated, and it should be allocated using activity drivers such as policy count, transaction volume, or IT usage rather than premium volume.
A better framework would also charge each line for the risk capital it consumes, producing a risk-adjusted return on capital. That would address the weakness in the term line's $4 million contribution: term may consume disproportionate capital relative to its margin. The committee should use marginal or incremental cost for exit decisions, and fully allocated cost only for pricing and external reporting. This prevents cross-subsidy debates from driving product exits.