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It is a basic economic principle that capital goes where it is needed and stays where it is appreciated. Double entendre intended!
There is little argument about this when applied to the stock market generally. An investor decides to invest his/her capital and buys shares of a company. If the market price of the stock appreciates, the investor is appreciative and likely to leave the capital invested. If the stock price goes nowhere, or worse falls, the investor is likely to remove the capital by selling the shares.
Market prices are, of course, volatile and affected by a multitude of factors, many of which are independent of the performance of the subject company. Excluding these independent variables, market capitalization or market value (i.e. share price times the number of shares) most generally reflects the combination of a company's net worth plus the investor's opinion of the quality and amount of future earnings. Growth of earnings, usually on a per share basis, is an obvious and important element in any investor's assessment. However, companies that can demonstrate growth of earnings at a level which represents an acceptable return on the underlying capital (ROE) are generally afforded higher values. Thus, if a company expects to attract capital and keep the support of investors, it must recognize the importance of maintaining the company's earnings at an acceptable ROE over time.
What is an acceptable ROE? Obviously, investors will have different requirements. Whether expecting to fund growth through an internal accretion of capital or by appealing to outside sources, a company will have to deliver earnings at returns at least equal to others who are seeking capital from the same sources. This suggests minimum returns in the range of 15% of average capital and surplus. An article in the August 21, 1995, edition of Business Insurance cited the success of a number of industry leaders in this regard. An annual study of small capitalization insurance companies done by The Manhattan Group indicates that successful smaller companies are regularly reporting ROE's higher than 15%.
In our experience, too few companies use ROE as a measure of internal (i.e. line of business or product) performance. Classic insurance company managements cling stubbornly to historic measures of performance; often without recognizing that these standards mask the reason they are not succeeding either in raising money in the capital markets or in accreting capital internally fast enough to support growth. Too many managers fail to recognize that a 95% combined ratio equates with failure if it doesn't result in an adequate return on the capital assigned to support a product or line.
Similarly, an equal number of managers still proudly trumpet their record of earnings growth while not recognizing that the returns on the capital under their stewardship continue at unacceptably low levels.
The principal implication of incorporating ROE into your management process is that you'll almost certainly have to change the thinking patterns of your principal managers. Some suggestions?
Start by having a discussion of the merits of ROE as a management standard and how you might introduce it to your organization. You might even get your management team to challenge this paper. The discussion itself will be educational!
Calculate your company's return on equity (net income divided by average capital & surplus) for each of the last five years. Challenge your management team to determine a realistic performance level, hopefully not less than 15%, and to recommend strategies which will enable you to keep it above that level.
Calculate the return on equity for each of your major product lines. The results usually surprise even the most experienced managers and will lead to management discussion especially as to the allocation of capital and investment income. It is our experience that the internal discussion alone will result in smarter managers.
Begin putting less emphasis on classic measures of success such as combined ratio or growth of premiums. (Neither provides insight into manageable actions anyway - as a future In Brief will suggest) Every time a manager suggests that the loss or combined ratio is 'terrific,' ask what it translates into in terms of ROE.
In principle, and in law, the officers and directors of a company are the stewards of the capital invested in it. As such, they may claim success if their investors receive a satisfactory return on the capital they have invested. Likewise, they must accept criticism, and occasionally worse, for an unsatisfactory return on the capital for which they are responsible.
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