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Allocation of Capital in the Insurance Industry

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  • J. David Cummins

Abstract

ABSTRACT: This article discusses and critiques the methods that have been proposed for allocating capital in financial institutions, with an emphasis on applications in the insurance industry. The author discusses the rationale for allocating capital by line of business and explains how capital allocation can be used to maximize firm value. The implications for capital allocation of regulatory risk‐based capital and the capital asset pricing model are discussed. The advantages and disadvantages of using value‐at‐risk and insolvency put option criteria in capital allocation are analyzed. Finally, recently proposed methods of marginal capital allocation are evaluated. One conclusion is that using the insolvency put option is superior to value‐at‐risk for allocating capital but that both methods fail to account for diversification across lines in the multi‐line firm. The primary conclusion is that marginal capital allocation methodologies based on option‐pricing models that recognize the effects of diversification are the best approach for allocating capital in the financial industry.

Suggested Citation

  • J. David Cummins, 2000. "Allocation of Capital in the Insurance Industry," Risk Management and Insurance Review, American Risk and Insurance Association, vol. 3(1), pages 7-27, March.
    • Handle: RePEc:bla:rmgtin:v:3:y:2000:i:1:p:7-27
    DOI: j.1540-6296.2000.tb00013.x
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    File URL: https://doi.org/10.1111/j.1540-6296.2000.tb00013.x
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    1. Edward Zaik & John Walter & Gabriela Retting & Christopher James, 1996. "Raroc At Bank Of America: From Theory To Practice," Journal of Applied Corporate Finance, Morgan Stanley, vol. 9(2), pages 83-93, June.
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    Citations

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    Cited by:

    1. Karabey, Uǧur & Kleinow, Torsten & Cairns, Andrew J.G., 2014. "Factor risk quantification in annuity models," Insurance: Mathematics and Economics, Elsevier, vol. 58(C), pages 34-45.
    2. Pablo Durán-Santomil & Luís Otero-González, 2022. "Capital Allocation Methods under Solvency II: A Comparative Analysis," Mathematics, MDPI, vol. 10(3), pages 1-14, January.
    3. John A. Major & Stephen J. Mildenhall, 2020. "Pricing and Capital Allocation for Multiline Insurance Firms With Finite Assets in an Imperfect Market," Papers 2008.12427, arXiv.org.
    4. Dóra Balog, 2017. "Capital Allocation in the Insurance Sector," Financial and Economic Review, Magyar Nemzeti Bank (Central Bank of Hungary), vol. 16(3), pages 74-97.
    5. G. Christodoulakis & E. Mamatzakis, 2010. "Return attribution analysis of the UK insurance portfolios," Annals of Finance, Springer, vol. 6(3), pages 405-420, July.
    6. Albrecht, Peter, 2003. "Risk based capital allocation," Papers 03-02, Sonderforschungsbreich 504.
    7. Stephen J. Mildenhall, 2017. "Actuarial Geometry," Risks, MDPI, vol. 5(2), pages 1-44, June.
    8. Benjamin Lorent, 2006. "Raisons fondamentales d'une régulation prudentielle du secteur des assurances," Brussels Economic Review, ULB -- Universite Libre de Bruxelles, vol. 49(3), pages 203-244.
    9. Pan Xiaoqing & Li Xiaohu, 2017. "On capital allocation for stochastic arrangement increasing actuarial risks," Dependence Modeling, De Gruyter, vol. 5(1), pages 145-153, January.
    10. Hirbod Assa & Manuel Morales & Hassan Omidi Firouzi, 2016. "On the Capital Allocation Problem for a New Coherent Risk Measure in Collective Risk Theory," Risks, MDPI, vol. 4(3), pages 1-20, August.
    11. Gildas Ratovomirija, 2015. "Multivariate Stop loss Mixed Erlang Reinsurance risk: Aggregation, Capital allocation and Default risk," Papers 1501.07297, arXiv.org.
    12. Kim, Joseph H.T. & Hardy, Mary R., 2009. "A capital allocation based on a solvency exchange option," Insurance: Mathematics and Economics, Elsevier, vol. 44(3), pages 357-366, June.
    13. Schradin, Heinrich R. & Willmes, Oliver M., 2001. "Risk and return in industrial Insurance," Mitteilungen 3/2001, University of Cologne, Institute of Insurance Science.
    14. Kamil J. Mizgier & Joseph M. Pasia, 2016. "Multiobjective optimization of credit capital allocation in financial institutions," Central European Journal of Operations Research, Springer;Slovak Society for Operations Research;Hungarian Operational Research Society;Czech Society for Operations Research;Österr. Gesellschaft für Operations Research (ÖGOR);Slovenian Society Informatika - Section for Operational Research;Croatian Operational Research Society, vol. 24(4), pages 801-817, December.
    15. Eamonn M. McAlea & Martin Mullins & Finbarr Murphy & Syed A.M. Tofail & Anthony G. Carroll, 2016. "Engineered nanomaterials: risk perception, regulation and insurance," Journal of Risk Research, Taylor & Francis Journals, vol. 19(4), pages 444-460, April.
    16. Guusje Delsing & Michel Mandjes & Peter Spreij & Erik Winands, 2021. "On Capital Allocation for a Risk Measure Derived from Ruin Theory," Papers 2103.16264, arXiv.org.

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