CapitalAllocationintheProperty-LiabilityInsuranceIndustry.pdfVIP

Capital Allocation in the Property- Liability Insurance Industry by Stephen P. D’Arcy ABSTRACT Capital allocation is a theoretical exercise, since all of a firm’s capital could be depleted to cover a significant loss arising from any one segment. However, firms do need to allocate capital for pricing, risk management, and performance evaluation. One versatile allocation method, the Ruhm-Mango-Kreps algorithm, has several key advantages: additivity, simplicity, and flexibil- ity. However, the approach is so flexible that it can be used to produce many different values instead of a single answer. In this paper, the cost of capital in financial markets is incorpo- rated into the Ruhm-Mango-Kreps algorithm to yield one allo- cation that reflects the true cost of capital an insurer would face. KEYWORDS Capital allocation, dynamic financial analysis, quantifying risks, risk-based capital, enterprise risk management This project has been funded by The Actuarial Foundation and the Casualty Actuarial Society. VOLUME 5/ISSUE 2 CASUALTY ACTUARIAL SOCIETY 141 Variance Advancing the Science of Risk 1. Introduction annual premium written. As liability insurance grew in importance and insurers began to operate as mul- Financial firms have developed economic capital tiline carriers, this rule was relaxed to allow a 3:1 models to determine the level of financial resources premium to statutory surplus ratio. The National As- they need to have in order to remain solvent over the sociation of Insurance Commissioners (NAIC) Early next year at a