Risk Based Capital and Capital Allocation in Insurance

Abstract

The science of capital allocation has made significant advances. Yet there is limited theoretical guidance for the selection of risk measure which is consistent with value maximisation frame. Different firms and regulations use different risk measures and there is no clear agreement on the appropriate risk measure. Risk measures vary for different risks, different lines of business, products and divisions. For insurer price of risk should vary with the type of risk under consideration, yet most risk based capital approaches implicitly use a common pricing method of risk based on a firm wide expected cost of capital. Developments in capital allocation of risk capital for solvency and by-line pricing provide new insights. This paper highlights the importance of risk measure and discusses the importance of the insolvency default option value, which is linked to the concept of credit default swap. It also discusses allocation by line and fair pricing, frictional costs and market imperfections in addition to issues of risk based capital in a value maximizing framework.