Legal defense case study: Allstate's seven-step process for selecting operational audit topics

Internal Auditor, April, 1994

The legal defense process begins when an insurance claimant files a personal property or casualty suit against an Allstate policyholder. Allstate is contractually obligated to provide legal defense counsel for the policyholder. Some personal property and casualty suits are assigned to Allstate staff attorneys; others are assigned to outside attorneys.

Step 1: Recognize Operational Audit Opportunities

While performing a routine, preliminary analysis of the expenses incurred in a regional office, the auditor observed that legal expenses appeared exceptionally high.

This observation prompted several inquiries to the regional office controller. Did the controller believe the amount was excessive? Why were legal expenses so high? Was the office receiving appropriate value for the dollars spent?

The controller replied, with great interest, that legal defense expenditures had not been scrutinized previously. In his opinion, the amount of legal fees expended was excessive relative to the legal services received. At this point, an operational audit idea was conceived.

Step 2: Specify the Operational Audit Topic

The operational audit topic identified in this case was the cost management of legal defense expenses. Specific audit concerns included the controller's perceptions that staff attorneys spent excessive time defending personal property and casualty suits brought against Allstate policyholders, and that outside counsel provided more efficient service at a comparable hourly rate.

In accordance with the corporate-wide focus on continuous process improvement, Allstate managers and auditors alike were well aware of the fact that "time is money," especially in the case of high-priced professionals such as attorneys.

Step 3: Define the Assertions to Be Tested

In this case, no established standard specified the amount of time attorneys should spend defending personal property and casualty suits filed against Allstate policyholders. However, a basis for quantitative comparison and assessment did exist. The time spent by staff attorneys defending personal property and casualty suits could be compared with the time spent by outside attorneys. The auditor believed the two groups would use comparable amounts of time to defend similar suits if both groups were operating efficiently. Alternatively, evidence that one group spent considerably more time than the other group might indicate inefficient performance by the slower group.

Step 4: Assess the Business Consequences Should the Assertion Prove False

The time spent defending suits is the relevant measure in this case. Wasted time reflects inefficient use of resources. If staff attorneys in this regional office spent considerably more time than necessary to defend personal property and casualty claims, then the office spent substantially more money than necessary. If excessive resources were used in each regional office, then the amount of money wasted might be very significant to Allstate as a whole.

Step 5: Assess the Likelihood That the Assertion May Be False

Although the time and expense required to defend personal property and casualty suits had been measured and recorded by both staff attorneys and outside attorneys, no operational control procedures were in place to prevent wasted time, or to detect it on a timely basis. Management had never critically examined the time spent defending legal suits, and a detailed audit of the legal defense process had never been performed. Neither the auditors nor management had directly compared the performance of staff attorneys with the performance of outside attorneys.

Based on these factors, the auditor concluded that the risk of inefficiencies in the legal defense process at this regional office was relatively high. Although there was no compelling reason to think staff attorneys operated more or less efficiently than the outside attorneys, the auditor believed a detailed analysis and comparison of the time spent defending suits by the two groups would be worthwhile. Corroborative evidence of inefficient performance by either the staff attorneys or outside attorneys would be valuable. The amount of time wasted in the legal defense process in this office could be used to estimate the amount of time wasted in legal defense processes throughout Allstate.

Step 6: Decide Whether the Assertion Can Be Audited Effectively and Efficiently

Audit evidence (i.e., time to defend suits, categorized by specific activity) did exist. This evidence was contained in the billing activity statements from outside attorneys and in the daily time logs of the staff attorneys. However, extraction of evidence required extensive detail work, because the raw data was in two different forms at two separate locations. Comparable suits needed to be identified and two statistically valid samples selected. A reconciliation process was required before a direct comparison of the time spent by the staff attorneys and the outside attorneys could be made.

The audit task did not require extraordinary audit knowledge or skills. The requisite level of knowledge about the legal defense process was obtained from the auditee. Once the samples of legal and claim files were identified and obtained, the audit tests were performed at the auditor's office.