Risk Adjusted Return On Capital
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
2
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?
3
Income Statement
$000’s
Arizona
Property
100,000
60%
60,000
35%
35,000
Florida
Property
100,000
60%
60,000
35%
35,000
Underwriting Gain (Loss)
5,000
5,000
Premium * Expense Ratio
Premium - Losses Expenses
TCR (Trade Combined Ratio)
95%
95%
Loss Ratio + Expense Ratio
12
12
Premium
Ultimate Loss Ratio
Ultimate Loss
Expense Ratio
Expenses
Duration (months)
Investable Assets
Yield
Investment Income
Operating Income
4
Comments
Premium * Loss Ratio
How long to payout half
Premium - Expenses +
Capital
102,350
5.0%
143,750
5.0%
5,118
7,188
Inv Assets * Duration/12 *
Yield
12,188
Underwriting gain + Inv
Income
10,118
Risk Adjusted Return
Underwriting
Gain (Loss)
Total Return
Investment
Income
Non
Investment
risk
Investment
Risk
RAROC
Capital
Capital
$000’s
Non Investment Risk
Bucket
CAT
Driver
CAT Premium
Reserving
Reserves
60,000
60,000
10.0%
Operating
Premium
100,000
100,000
Guaranty Fund
Premium
100,000
Unknown Mass Tort
Premium
Pricing
Arizona Florida
CAT
Arizona
Property Property Factor Volatility Capital
0
100,000 30.0%
100%
Florida
Capital
30,000
6,000
12,000
5.0%
5,000
5,000
100,000
0.5%
500
500
100,000
100,000
5.0%
5,000
5,000
Premium
100,000
100,000
7.5%
7,500
24,000
7,500
60,000
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
13,350
6,250
18,750
Total
37,350
78,750
Asset Risk
6
Risk Adjusted Return
$000’s
Premium
Ultimate Loss Ratio
Ultimate Loss
Expense Ratio
Expenses
Underwriting Gain (Loss)
TCR (Trade Combined Ratio)
7
Arizona Florida
Property Property
100,000 100,000
60%
60%
60,000
60,000
35%
35%
35,000
35,000
5,000
5,000
Comments
Premium * Loss Ratio
Premium * Expense Ratio
Premium - Losses - Expenses
95%
95%
Loss Ratio + Expense Ratio
Duration (months)
12
12
Investable Assets
Yield
Investment Income
102,350
5.0%
5,118
143,750
5.0%
7,188
Premium - Expenses + Capital
Operating Income
10,118
12,188
Underwriting gain + Inv Income
Economic Capital
37,350
78,750
RAROC
17.6%
10.1%
How long to payout half
Inv Assets * Duration/12 * Yield
Total Return (after tax) / Capital
Inputs
8
Arizona Results
Hurdle Rate
Mean = 18%
64% chance of exceeding 10% hurdle rate
9
Florida Results
Hurdle Rate
Mean = 11%
Mean = 10%
64% chance of exceeding 10% hurdle rate
10
Arizona Results
RAROC / Arizona
5%
15%
31.0%
58.8%
RAROC / Arizona
Minimum
110%
Mean
18%
Std Dev
Values
31% of our results do not meet our hurdle rate
59% exceed
10% are too close to call
11
1.5
1.0
0.5
0.0
-0 . 5
-1 . 0
-1 . 5
-2 . 0
Mean =
18%
Mean = 18%
-167%
Maximum
34%
10,000
Florida Results
RAROC / Florida
5%
15%
31.1%
58.7%
RAROC / Florida
Minimum
-183%
Maximum
81%
Mean
11%
Std Dev
Values
12
31% of our results do not meet our hurdle rate
59% exceed
10% are too close to call
1.0
0.5
0.0
-0 . 5
-1 . 0
-1 . 5
-2 . 0
Mean = 18%
34%
10,000
Drivers
13
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
14
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
15
Q&A
Questions
16