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Capital Allocation In Insurance

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  • Michael Sherris
  • John van der Hoek

Abstract

The determination and allocation of economic capital is important for pricing, risk management, and related insurer financial decision making. This paper considers the allocation of economic capital to lines of business in insurance. We show how to derive closed-form results for the complete markets, arbitrage-free allocation of the insurer default option value, or insolvency exchange option, to lines of business for an insurer balance sheet. We assume that individual lines of business and the surplus ratio are joint log-normal although the method we adopt allows other assumptions. The allocation of the default option value is required for fair pricing in the multiline insurer. We discuss and illustrate other methods of capital allocation, including Myers-Read, and give numerical examples for the capital allocation of the default option value based on explicit payoffs by line.

Suggested Citation

  • Michael Sherris & John van der Hoek, 2006. "Capital Allocation In Insurance," North American Actuarial Journal, Taylor & Francis Journals, vol. 10(2), pages 39-61.
    • Handle: RePEc:taf:uaajxx:v:10:y:2006:i:2:p:39-61
    DOI: 10.1080/10920277.2006.10596247
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    Cited by:

    1. Gatzert, Nadine & Schmeiser, Hato, 2008. "Combining fair pricing and capital requirements for non-life insurance companies," Journal of Banking & Finance, Elsevier, vol. 32(12), pages 2589-2596, December.

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