A capital allocation based on a solvency exchange option
In this paper we propose a new capital allocation method based on an idea of [Sherris, M., 2006. Solvency, capital allocation and fair rate of return in insurance. J. Risk Insurance 73 (1), 71-96]. The proposed method explicitly accommodates the notion of limited liability of the shareholders. We show how the allocated capital can be decomposed, so that each stakeholder can have a clearer understanding of their contribution. We also challenge the no undercut principle, one of the widely accepted allocation axioms, and assert that this axiom is merely a property that certain allocation methods may or may not meet.
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- Robert C. Merton & André Perold, 1993. "Theory Of Risk Capital In Financial Firms," Journal of Applied Corporate Finance, Morgan Stanley, vol. 6(3), pages 16-32.
- Michael Sherris, 2006. "Solvency, Capital Allocation, and Fair Rate of Return in Insurance," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 73(1), pages 71-96.
- Zanjani, George, 2002. "Pricing and capital allocation in catastrophe insurance," Journal of Financial Economics, Elsevier, vol. 65(2), pages 283-305, August.
- 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, 03.
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