Optimal capital allocation principles

Winner of the 2011 Lloyd's Science of Risk Prize, in the category of Insurance Markets and Operations.

This paper develops a unifying framework for allocating the aggregate capital of a financial firm to its business units.

Introduction to new research by Andreas Tsanakas, Senior Lecturer in Actuarial Science at Cass Business School.
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Financial firms, such as insurance companies or banks, need to hold a level of safely invested risk capital to protect themselves against unexpected losses. It is common practice to allocate the total required capital for the portfolio to its constituent parts, e.g. lines of insurance business. Capital allocation, often linked to return-on-equity arguments, provides a useful method for assessing and comparing the performance of different sub-portfolios. Allocating capital may also help to identify areas of risk consumption and support decision-making concerning business expansions, reductions or even eliminations.

Because of portfolio diversification effects, there is no single way in which to carry out such a capital allocation exercise. Some of the methods used in practice or proposed in the literature are underpinned by very different arguments, while others are remain quite arbitrary. In an insurance world dominated by Solvency II, linking capital allocation to internal processes, such as performance measurement, pricing, and portfolio optimisation, is an emerging tough requirement. It is hard to envisage such exercises being successful, when the methods used are not explicitly linked to management's thinking and formulated risk appetite.

Our own contribution to that debate is to, first, provide a unifying framework for capital allocation methods, which covers most known approaches; and, second, give a business-driven interpretation of these methods, thus enabling the formulation of an explicit link between risk appetite and decision-making.

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