Allocation of Capital in the Insurance Industry

ABSTRACT: This article discusses and critiques the methods that have been proposed for allocating capital in financial institutions, with an emphasis on applications in the insurance industry. The author discusses the rationale for allocating capital by line of business and explains how capital allocation can be used to maximize firm value. The implications for capital allocation of regulatory risk‐based capital and the capital asset pricing model are discussed. The advantages and disadvantages of using value‐at‐risk and insolvency put option criteria in capital allocation are analyzed. Finally, recently proposed methods of marginal capital allocation are evaluated. One conclusion is that using the insolvency put option is superior to value‐at‐risk for allocating capital but that both methods fail to account for diversification across lines in the multi‐line firm. The primary conclusion is that marginal capital allocation methodologies based on option‐pricing models that recognize the effects of diversification are the best approach for allocating capital in the financial industry.