1. 3 reasons to allocate capital
    • Pricing, UW & other decision making could be enhanced by thinking of capital as being allocated
    • Allocation could help tie together certain financial decisions and regulatory risk-based capital rules
    • Concepts like RAROC and EVA make use of capital allocation for performance measurement
  2. 2 approaches to maximize value of firm
    • RAROC: risk-adjusted return on capital. (1) allocate total capital of firm, (2) compare alllocated capital to after tax PV, and (3) compute RAROC
    • EVA: economic value added: income is reduced by the product of the allocated capital and the target rate. If EVA > 0 value is increased
  3. Capital Allocation Techniques
    • Regulatory (NAIC) risk-based capital
    • CAPM
    • VaR
    • Insolvency Put Options (EPD)
    • Marginal Capital Alllocation (Merton & Perold)
    • Marginal Capital Allocation (Myers Read)
  4. Capital Allocation Techniques
    Regulatory (NAIC) risk-based capital
    • Charges are applied to various balance sheet and income statement items to measure the risk in 6 categories; (1) equity holding of subsidiaries, (2) credit-related losses, (3) loss reserves, (4) loss on NB, (5) credit risk on agent's balance, and (6) off-balance sheet risks.
    • Critics: charges are inaccurate, based on book value, ignore some risk sources, based on industry data, but serves as legitimate constraints regardless of approach
  5. Capital Allocation Techniques
    • Determine each line's contribution to firmwide required profits.
    • Critics: CAPM is modeled on systematic risk from perspective of diversified investor, (2) data limitations make it difficult to estimate β by LOB, and (3) CAPM may not even be a good model for equity prices
  6. Capital Allocation Techniques
    • Capital is allocated by determining the stand-alone VaR for each business
    • Critics: (1) firms may not have enough capital in total, (2) difficult to reflect diversification, and (3) ignores amt by which losses exceed available capital
  7. Capital Allocation Techniques
    Insolvency Put Option (EPD)
    • Equate EPD ratios, choosing an arbitrary target
    • Critics: improvement over VaR, but still fails to take diversification into account
  8. Capital Allocation Techniques
    Marginal Capital Allocation (Merton & Perold)
    • Calculate total required capital, incl diversification effect, and then compute firmwide capital w/o one LOB. The difference is the amt of marginal capital for this LOB
    • Critics: there will always be some unallocated capital
  9. Capital Allocation Techniques
    Marginal Capital Allocation (Myers Read)
    • Examine capital for a particular LOB by determining the effect of a small increase in the size of line
    • Critics: better than M-P method because there will be no unallocated capital
  10. Economic Cost of Capital
    Reflects the actual cost associated w/ and ins company holding capital: (1) agency cost (incurred when xtra cash is used for superficial things that don't add value for SH), (2) double taxation (when earned & when paid as div), and (3) regulatory costs (restrictions may result in inefficient and sub-optimal investment of the capital)
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