Risk-adjusted performance metrics are now ubiquitous across both the banking and insurance industries. The reason is simple: in contrast to other industries, both banking and insurance are risk-based, capital-intensive businesses and therefore need performance measures which explicitly recognize both the risks taken as well as the capital deployed.
This chapter describes at a high level the evolution of RAPMs within the banking and insurance industries, differentiating between RAPMs used to support tactical applications such as loan or insurance pricing and those used to evaluate business unit performance.
No other industry has devoted so much effort to developing and using RAPMs.1 This is because banking and insurance differ from other industries in four distinct ways.
We sell products whose ultimate profit contribution is uncertain at the time of sale, with the uncertainty stemming from risk underwriting and future market developments.
When a publisher or shoe manufacturer sells a book or a pair of shoes, the value created at the time of sale is reasonably easy to calculate and, once sold, the ties between buyer and seller are limited.2 Because of this, value creation can be determined reasonably well at the time of sale by deducting the cost of goods sold from the sales price.
The products offered by financial services firms are different. First, they represent future ...