Two Properties, One Important Decision
The decision to insure or decline coverage must be considered prudently. Accurately assessing the risks that could affect losses is one of the key factors when making such a decision. To illustrate the significance of assessing risk, Scottsdale Insurance Company used Palisade’s @RISK to portray how the insurer would decide which commercial property which would have a higher return on capital to insure, when comparing two different commercial properties.

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
A subsidiary of Nationwide, Scottsdale Insurance Company began operations in 1982. The office opened with twelve employees. Today, it is one of the largest excess and surplus (E&S) and specialty lines carriers in the nation. The company has 1,350 associates and annual sales of more than $2 billion in premium. Scottsdale Insurance Company accepts commercial and personal property and casualty risks, in addition to a wide range of lines that many standard companies reject.

Using @RISK to Determine Returns
There are many factors that can decrease an insurer’s RAROC, which is contingent upon total return (underwriting gain and investment income) and divided by capital (non-investment risk and investment risk). Before considering any risk factors, the Florida property seems to present the best initial return with a larger operating income, as compared to the property in Arizona. On the surface, the decision seems fairly obvious. However, utilizing @RISK’s log-normal distributions, a different consideration appears.

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.”

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