Risk based capital and capital allocation in insurance (original) (raw)

The science of capital allocation has made significant advances in our understanding of allocation and use of risk based capital. Yet there is limited theoretical guidance on which risk measure is consistent with value maximisation and no well developed economic theory underlying the risk measures. Different firms use different risk measures and there is no agreement on the appropriate risk measure. Risk measures are applied inconsistently for different risks, different lines of business, products and divisions. For insurer pricing the price of risk should vary with the type of risk under consideration yet most risk based capital approaches implicitly use a common price of risk based on a firm wide expected cost of capital for pricing. Recent developments in capital allocation of risk capital for solvency and by-line pricing indicate a new direction is required. This paper highlights the importance of risk measure and discusses the insolvency default option value. It also discusses allocation by line and fair pricing, frictional costs and market imperfections and issues of risk based capital in a value maximizing framework.