A multi‐year risk capital concept for internal models and enterprise risk management

Abstract

PurposeThe purpose of this paper is to illustrate how risk capital can be calculated and allocated in a multi‐year context. This is an important issue, since strategic management and decision making within insurance companies require a multi‐year time horizon (instead of a one‐year time horizon, as set out in solvency models).Design/methodology/approachAfter defining risk capital in a multi‐year context, the paper discusses the different properties of the multi‐year risk capital concept. The paper also presents an allocation rule of how to allocate the multi‐year risk capital to individual years as well as to individual segments. The paper applies the author's model framework in an application study to illustrate the different effects.FindingsThe paper shows how multi‐year risk capital can be used as a basis for analyzing different management strategies within risk and return indicators in the context of value‐based management. Furthermore, the paper demonstrates the effect of allocating risk capital in a multi‐year context.Originality/valueThe analysis provides new and relevant information to insurance companies' management. Whereas usually solvency rules set out a time horizon of one year, in the context of internal risk models a multi‐year planning horizon is taken into account. Management needs to get an idea of how much risk capital is necessary in order to survive the next five years without external capital supply. The paper presents an answer to these questions.