Capital Allocation in the Property-Liability Insurance Industry

Capital allocation is a theoretical exercise because all of a firm’s capital could be depleted to cover a significant loss arising from any one segment. However, firms do need to allocate capital for pricing, risk management and performance evaluation. One versatile allocation method, the Ruhm-Mango-Kreps algorithm, has several key advantages: additivity, simplicity and flexibility. However, the approach is so flexible it can be used to produce many different values instead of having a single answer. In this paper, the cost of capital in financial markets is incorporated into the Ruhm-Mango-Kreps algorithm to yield one allocation that reflects the true cost of capital an insurer would face.