New capital allocation procedures finally, it seemed, gave insurance managers information that has eluded the industry for years—an accounting of the inputs to (capital) and the output from (returns) the production of their firm. Balance sheets and income statements can now be prepared for business segments based on their share of the firm’s capital and their corresponding operating results. Business units, lines of business and/or regions, can now be run and managed as autonomous entities yet still benefit from the diversifying safety net of the firm’s other operations and capital.
We will illustrate a current approach to capital allocation, referred to herein as the “tail contribution analysis” (TCA), using TCA to evaluate the impact of changes in an insurer’s operations by allocating capital to individual lines of business. We will highlight a common problem in the implementation of the procedure arising from reserve volatility and briefly note the failure of the methodology to account for a firm’s changing levels of risk under various strategies.
We will then introduce an alternative method for analyzing business segments and strategies called “economic profit analysis” (EPA). We will discuss EPA’s key feature, “volatility replication,” an intuitively appealing process of building investor expectations and capital market information into the risk and return measurements used to evaluate strategic decisions. Finally, we will illustrate the benefit of EPA in overcoming the problems of TCA and thereby providing concise reliable information for business decision-making.
