Capital Allocation for Insurance Companies: Issues and Methods

Abstract

We address some key issues related to risk and capital allocation in insurance companies. We argue that the Froot-Stein approach to risk is relevant to a number of important problems in the daily management of an insurance portfolio and that - taken to its consequence - this approach will lead to a close co-operation between actuarial and financial departments with a particular view to the actuaries ability to separate financial risk from insurance risk and the ability of the finance department to hedge the right amount of their complicated financial risk at a good price. Further, we introduce a new capital allocation principle based on the solvency of the entire company and we claim that this principle is more robust than traditional methods. We also introduce a new way of combining capital allocation and pricing of insurance policies. Through a performance measure of return on capital, we suggest a way of evaluating the price of capital for a single policy, that this money is held as a reserve and that this reserve should run off in such a way that old underwriting does not harm the performance of any given business line.