Scottsdale Insurance Company Utilizes @RISK to Choose between Competing Opportunities
Two Properties, One Important Decision
For this analysis, Scottsdale Insurance Company used @RISK to determine Risk Adjusted Returns on Capital (RAROC), a framework for analyzing risk-adjusted financial performance. Accurate assessment of RAROC enables organizations to get a consistent view of profitability across businesses. RAROC also provides a clear assessment of the return on investment forecast, after accounting for expenditures required to cover potential risk.
In the Scottsdale Insurance Company model, a comparison between commercial properties in Arizona and in Florida might appear to be very similar at first glance, with both properties expected to have the same expected loss ratio, same expense ratio, same twelve month pay out and the same investment yield. In situations like these, risk analysis can play a crucial role in determining which property to insure.
About Scottsdale Insurance Company
Using @RISK to Determine Returns
The most concerning risk factor when comparing the two properties is the occurrence of catastrophic weather. To determine how much capital must be held in reserves to cover potential payouts, Scottsdale Insurance Company utilizes @RISK to simulate weather risk in each location. It is not surprising that the Florida property represented much higher coverage, given the likelihood of weather events such as hurricanes. However, would that amount surpass the Florida-based property’s initial return advantage?
To further assess the two properties’ RAROC, Scottsdale Insurance Company then used @RISK to determine how effectively each property would exceed a minimum return rate of 10 percent, or its “hurdle rate”. The analysis showed that both properties had a 64 percent chance of clearing the 10 percent hurdle rate. However, a deeper inspection of the numbers answered a very important question: When exceeding the hurdle rate, which property cleared it the highest? In simulations where the Arizona property cleared the hurdle rate, it offered a mean return of 18 percent, compared to the Florida property, which offered a mean return of just 11 percent. As a result, insuring the Arizona property would be a better choice to insure. While the Florida property showed a greater operating income, using @RISK, the insurance company could clearly assess that the Arizona property would free up more capital that the company could use to invest in additional opportunities.
Table 1: @RISK distribution illustrates the Arizona property earning an 18 percent return when clearing the initial hurdle rate
Table 2: Florida property offers a much smaller return, at just 11 percent
“We face a competitive environment where pricing is often unrealistic. An abundance of capital has driven rates lower while investment yields are at historic lows. Using @RISK allows us to choose between competing opportunities,” said Allan Smith, financial business advisor at Scottsdale Insurance. “I find the graphical outputs to be the most useful feature. Being able to compose a picture showing the range of outcomes is critical to analyzing our complex models and is extremely useful in presenting to senior executives, who do not have financial backgrounds.”