Abstract: Capital allocation is used widely within the financial industry for purposes of pricing and performance measurement. In this paper, we consider the theoretical impact of extending the canonical model of a profit maximizing insurer beyond a single period and, in particular, consider the effect of having opportunities to raise external financing in future periods. We show that in this setting, outside of special cases, capital allocation as currently conceived cannot be done in a way to produce prices consistent with marginal cost. We go on to evaluate economically correct capital allocations based on the model in the context of an international catastrophe reinsurer with four lines of business. We find that traditional techniques can be resurrected with 1) an appropriate definition of capital, 2) a broader conception of the cost of underwriting, and 3) an appropriate risk measure connected to the fundamentals of the underlying business.
This seminar series is jointly sponsored by the Departments of Mathematics, Finance, Industrial Enterprise and Systems Engineering.