Practical Application of the Risk-Adjusted Return on Capital Framework

This paper applies a risk-adjusted return on capital (RAROC) framework to the financial analysis of the risk and performance of an insurance company. A case study is presented for a diversified insurer with both property & casualty and life insurance business segments. The approach first quantifies the probability distributions of the different types of risk the institution faces: non-catastrophe liability risk, catastrophe risk, life risk, asset-liability mismatch (ALM) risk, credit risk, market risk, and operating risk. These risk type distributions are then aggregated to create an integrated risk distribution for the institution. Economic Capital and RAROC are then calculated using this risk distribution in conjunction with income statement analysis to produce performance metrics and insights at both the line of business and total company level that support strategic as well as tactical decisions. Exhibits providing the case study numerical examples accompany the discussion of methodology throughout the paper.