Allocation of Capital between Assets and Liabilities

We propose a capital allocation method for insurance companies. The amount of capital is directly related to the default risk. The expected value of default can be distributed among the liabilities based on the rule of asset payoff at the time of default. We derive a capital allocation scheme from this allocation of the expected default. Assets, liabilities, and other risky items on the balance sheet are treated in a uniform framework. The insurer’s capital is allocated among all these risk contributors. The allocated capitals are given in closed-form formulas, which have straightforward interpretations and are easy to compute. Connections with other allocation methods are also discussed.

Keywords: Capital allocation, expected value of default.