Allocating Capital Using the Expected Value of Default

This paper develops a new method to allocating capital. First the expected value of default is allocated based on the economic value of payo to a policy, counting the cost of insolvency. Then the capital is allocated accordingly so that a policy's contribution to the default value equals its allocated default value. Only part of the capital is allocated to the policies, the rest is attributed to the risky assets. The allocated capitals are given in a simple, closed-form mathematical formula. The derivation of the formula is straightforward and is economically sound. A real world example illustrates the step-by-step calculation, which can be easily implemented in a spreadsheet.