What Is Anchoring and Adjustment?

Anchoring and adjustment is a phenomenon wherein an individual bases their initial ideas and responses on one point of information and makes changes driven by that starting point. The anchoring and adjustment heuristic describes cases in which a person uses a specific target number or value as a starting point, known as an anchor, and subsequently adjusts that information until an acceptable value is reached over time. Often, those adjustments are inadequate and remain too close to the original anchor, which is a problem when the anchor is very different from the true answer.

Understanding Anchoring and Adjustment

Anchoring is a cognitive bias described by behavioral finance in which individuals fixate on a target number or value—usually, the first one they get, such as an expected price or economic forecast. Unlike the conservatism bias, which has similar effects but is based on how investors relate new information to old information, anchoring occurs when an individual makes new decisions based on the old, anchor number. Giving new information thorough consideration to determine its impact on the original forecast or opinion might help mitigate the effects of anchoring and adjustment, but the characteristics of the decision-maker are as important as conscious consideration.

The problem with anchoring and adjustment is that if the value of the initial anchor is not the true value, then all subsequent adjustments will be systematically biased toward the anchor and away from the true value. However, if the anchor is close to the true value then there is essentially no problem.

One of the issues with adjustments is that they may be influenced by irrelevant information that the individual may be thinking about and drawing unfounded connections to the actual target value. For instance, suppose an individual is shown a random number, then asked an unrelated question that seeks an answer in the form of an estimated value or requires a mathematical equation to be performed quickly. Even though the random number they were shown has nothing to do with the answer sought, it might be taken as a visual cue and become an anchor for their responses. Anchor values can be self-generated, be the output of a pricing model or forecasting tool, or be suggested by an outside individual.

Studies have shown that some factors can influence anchoring, but it is difficult to avoid, even when people are made aware of it and deliberately try to avoid it. In experimental studies, telling people about anchoring, cautioning them that it can bias their judgment, and even offering them monetary incentives to avoid anchoring can reduce, but not eliminate, the effect of anchoring.

Higher levels of experience and skill in a specific field can help reduce the impact of anchoring in that subject area, and higher general cognitive ability may reduce anchoring effects in general. Personality and emotion can also play a role. A depressed mood increases anchoring, as do the personality traits of agreeableness, conscientiousness, introversion, and openness.

Anchoring and Adjustment in Business and Finance

In sales, price, and wage negotiations, anchoring and adjustment can be a powerful tool. Studies have shown that setting an anchor at the outset of a negotiation can have more effect on the final outcome than the intervening negotiation process. Setting a deliberate starting point can affect the range of all subsequent counteroffers.

For example, a used car salesman (or any salesman) can offer a very high price to start negotiations that are arguably well above the fair value. Because the high price is an anchor, the final price will tend to be higher than if the car salesman had offered a fair or low price to start. A similar technique may be applied in hiring negotiations when a hiring manager or prospective hire proposes an initial salary. Either party may then push the discussion to that starting point, hoping to reach an agreeable amount that was derived from the anchor.

In finance, the output of a pricing model or from an economic forecasting tool may become the anchor for an analyst. One possible way to counteract this is to look at multiple, diverse models or strands of evidence. Social psychology researcher Phillip Tetlock has found that forecasters who make predictions based on many different ideas or perspectives (“foxes”) tend to make better forecasts than those who focus on only a single model or a few big ideas (“hedgehogs”). Considering several different models and a range of different forecasts may make an analyst’s work less vulnerable to anchoring effects.

What Are Allocated Loss Adjustment Expenses (ALAE)?

Allocated loss adjustment expenses (ALAE) are costs attributed to the processing of a specific insurance claim. ALAE is part of an insurer’s expense reserves. It is one of the largest expenses for which an insurer has to set aside funds, along with contingent commissions.

Understanding Allocated Loss Adjustment Expenses (ALAE)

Allocated loss adjustment expenses, along with unallocated loss adjustment expenses (ULAE), represent an insurer’s estimate of the money it will pay out in claims and expenses. Insurers set aside reserves for these expenses to ensure claims aren’t made fraudulently and to process legitimate claims quickly.

ALAEs link directly to the processing of a specific claim. These costs may include payments to third parties for activities like investigating claims, acting as loss adjusters, or as legal counsel for the insurer. Expenses associated with ULAE are more general and may include overhead, investigations, and salaries.

Life insurance companies that use in-house employees for field adjustments would report that expense as an unallocated loss adjustment expense.

Special Considerations

Some commercial liability policies contain endorsements, which require the policyholder to reimburse its insurance company for loss adjustment expenses (ALAE or ULAE). Adjusting a loss is “the process of ascertaining the value of a loss or negotiating a settlement.”

Therefore, loss adjustment expenses are most often those costs incurred by an insurance company in defending or settling a liability claim brought against its policyholder. These expenses can include fees charged by attorneys, investigators, experts, arbitrators, mediators, and other fees or expenses incidental to adjusting a claim.

It is important to carefully read the endorsement language, which may say that a loss adjustment expense is not intended to include the policyholder’s attorney fees and costs if an insurer denies coverage and a policyholder successfully sues the insurer. In this situation, where the insurance company has done no actual “adjusting” of the claim, it should not be entitled to apply its deductible to the expenses incurred by the policyholder in defending the claim abandoned by the insurance company.

ALAE vs. Unallocated Loss Adjustment Expenses (ULAE)

Insurers have gradually shifted from categorizing expenses as ULAE to categorizing them as ALAE. This is primarily because insurers are more sophisticated in how they treat claims and have more tools at their disposal to manage the costs associated with claims.

Small, straightforward claims are the easiest for an insurance company to settle and often require less ALAE when compared to claims that may take years to settle. Claims that could result in substantial losses are the most likely to receive extra scrutiny by insurers and may involve in-depth investigations, settlement offers, and litigation. With greater scrutiny comes greater cost.

Analysts can tell how accurate an insurance company has been at estimating its reserves by examining its loss reserve development. Loss reserve development involves an insurer adjusting estimates to its loss and loss adjustment expense reserves over a period of time.

What Is an Allowance for Bad Debt?

An allowance for bad debt is a valuation account used to estimate the amount of a firm’s receivables that may ultimately be uncollectible. It is also known as an allowance for doubtful accounts. When a borrower defaults on a loan, the allowance for bad debt account and the loan receivable balance are both reduced for the book value of the loan.

How an Allowance for Bad Debt Works

Lenders use an allowance for bad debt because the face value of a firm’s total accounts receivable is not the actual balance that is ultimately collected. Ultimately, a portion of the receivables will not be paid. When a customer never pays the principal or interest amount due on a receivable, the business must eventually write it off entirely.

Methods of Estimating an Allowance for Bad Debt

There are two primary ways to calculate the allowance for bad debt. One method is based on sales, while the other is based on accounts receivable.

Sales Method

The sales method estimates the bad debt allowance as a percentage of credit sales as they occur. Suppose that a firm makes $1,000,000 in credit sales but knows from experience that 1.5% never pay. Then, the sales method estimate of the allowance for bad debt would be $15,000.

Accounts Receivable Method

The accounts receivable method is considerably more sophisticated and takes advantage of the aging of receivables to provide better estimates of the allowance for bad debts. The basic idea is that the longer a debt goes unpaid, the more likely it is that the debt will never pay. In this case, perhaps only 1% of initial sales would be added to the allowance for bad debt.

However, 10% of receivables that had not paid after 30 days might be added to the allowance for bad debt. After 90 days, it could rise to 50%. Finally, the debts might be written off after one year.

Requirements for an Allowance for Bad Debt

According to generally accepted accounting principles (GAAP), the main requirement for an allowance for bad debt is that it accurately reflects the firm’s collections history. If $2,100 out of $100,000 in credit sales did not pay last year, then 2.1% is a suitable sales method estimate of the allowance for bad debt this year. This estimation process is easy when the firm has been operating for a few years. New businesses must use industry averages, rules of thumb, or numbers from another business.

Default Considerations

When a lender confirms that a specific loan balance is in default, the company reduces the allowance for doubtful accounts balance. It also reduces the loan receivable balance, because the loan default is no longer simply part of a bad debt estimate.

Adjustment Considerations

The allowance for bad debt always reflects the current balance of loans that are expected to default, and the balance is adjusted over time to show that balance. Suppose that a lender estimates $2 million of the loan balance is at risk of default, and the allowance account already has a $1 million balance. Then, the adjusting entry to bad debt expense and the increase to the allowance account is an additional $1 million.