4.4.Cummins

• 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

• 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

• Regulatory (NAIC) risk-based capital
• CAPM
• VaR
• Insolvency Put Options (EPD)
• Marginal Capital Alllocation (Merton & Perold)
• Marginal Capital Allocation (Myers Read)

• 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

• 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

• 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

• Equate EPD ratios, choosing an arbitrary target
• Critics: improvement over VaR, but still fails to take diversification into account

• 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

• 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

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)