Risk Adjusted Return On Capital
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Introduction
Allan Smith Scottsdale Group A Division of Nationwide Insurance Financial Business Advisor Advise business partners on product profitability ITT Technical Institute Adjunct Instructor Microeconomics Macroeconomics Environmental Issues Research Methods U Mass, Amherst BBA – Finance WP Carey School @ ASU MBA – Finance MS - Economics
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Scenario
2 potential opportunities: Commercial Property Insurance in Arizona or Florida $100M total premium (revenue) 60% Expected Loss Ratio 35% Expense Ratio 12 months average duration (to pay out 50% of losses) 5% Investment Yield Which do we choose?
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Income Statement
$000’s Arizona Florida Property Property Comments
Premium 100,000 100,000 Ultimate Loss Ratio 60% 60% Ultimate Loss 60,000 60,000 Premium * Loss Ratio Expense Ratio 35% 35% Expenses 35,000 35,000 Premium * Expense Ratio
Underwriting Gain (Loss) 5,000 5,000 Premium - Losses - Expenses
TCR (Trade Combined Ratio) 95% 95% Loss Ratio + Expense Ratio
Duration (months) 12 12 How long to payout half
Investable Assets 102,350 143,750 Premium - Expenses + Capital
Yield 5.0% 5.0%
Investment Income 5,118 7,188 Inv Assets * Duration/12 * Yield
Operating Income 10,118 12,188
Underwriting gain + Inv Income
RAROC
Total Return
Underwriting Gain (Loss)
Investment Income
Capital
Non Investment
risk
Investment Risk
Risk Adjusted Return
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Capital
$000’s Non Investment Risk
Bucket Driver Arizona Property
Florida Property Factor
CAT Volatility
Arizona Capital
Florida Capital
CAT CAT Premium 0 100,000 30.0% - 30,000
Reserving Reserves 60,000 60,000 10.0% 100% 6,000 12,000
Operating Premium 100,000 100,000 5.0% 5,000 5,000
Guaranty Fund Premium 100,000 100,000 0.5% 500 500
Unknown Mass Tort Premium 100,000 100,000 5.0% 5,000 5,000
Pricing Premium 100,000 100,000 7.5% 7,500 7,500 24,000 60,000
Asset Risk
Equity Investable Assets 89,000 125,000 5% 4,450 6,250
Fixed Income Investable Assets 89,000 125,000 5% 4,450 6,250
Credit Investable Assets 89,000 125,000 5% 4,450 6,250 13,350 18,750
Total 37,350 78,750
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Risk Adjusted Return
$000’s Arizona Florida Property Property Comments
Premium 100,000 100,000 Ultimate Loss Ratio 60% 60% Ultimate Loss 60,000 60,000 Premium * Loss Ratio Expense Ratio 35% 35% Expenses 35,000 35,000 Premium * Expense Ratio Underwriting Gain (Loss) 5,000 5,000 Premium - Losses - Expenses
TCR (Trade Combined Ratio) 95% 95% Loss Ratio + Expense Ratio
Duration (months) 12 12 How long to payout half
Investable Assets 102,350 143,750 Premium - Expenses + Capital Yield 5.0% 5.0% Investment Income 5,118 7,188 Inv Assets * Duration/12 * Yield
Operating Income 10,118 12,188 Underwriting gain + Inv Income
Economic Capital 37,350 78,750
RAROC 17.6% 10.1% Total Return (after tax) / Capital
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Inputs
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Arizona Results
Mean = 18%
Hurdle Rate
64% chance of exceeding 10% hurdle rate
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Florida Results
Mean = 10% Mean = 11%
Hurdle Rate
64% chance of exceeding 10% hurdle rate
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Arizona Results
Mean = 18%
31.0% 58.8%
5% 15%
- 2 . 0
- 1 . 5
- 1 . 0
- 0 . 5
0 . 0
0 . 5
1 . 0
1 . 5
RAROC / Arizona
RAROC / Arizona
Minimum -167% Maximum 110% Mean 18% Std Dev 34% Values 10,000
Mean = 18%
31% of our results do not meet our hurdle rate 59% exceed
10% are too close to call
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Florida Results
Mean = 18%
31.1% 58.7%
5% 15%
- 2 . 0
- 1 . 5
- 1 . 0
- 0 . 5
0 . 0
0 . 5
1 . 0
RAROC / Florida
RAROC / Florida
Minimum -183% Maximum 81% Mean 11% Std Dev 34% Values 10,000
31% of our results do not meet our hurdle rate 59% exceed
10% are too close to call
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Drivers
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Recap
AZ Property Operating Income $10,100 FL Property Operating Income $12,200 FL appears to be better option Risk Adjusted: AZ Property 18% FL Property 10% Operating income leads to the wrong result Risk adjusted return gives the correct result
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Recap
@Risk gives us a probability based outcome showing how different variables affect the decision making process
The Arizona property ties up less capital, allowing us to
deploy the additional capital ($40M) in other opportunities
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Q&A
Questions
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