An Economic Approach to Capital Allocation

This article starts with primitive assumptions on preferences and risk. It then derives prices consistent with a social optimum within an insurance company and the consumer-level capital allocation implied therein. The allocation “adds up” to the total capital of the firm (a result echoing findings in the congestion pricing literature—where optimal tolls exactly cover the rental cost of the highway). The allocation follows each consumer's share of recoveries in states of insurer default, weighted by the severity of the default in terms of welfare impact. However, the article argues that an economic approach technically restricts only the capital allocated to marginal units of coverage: inframarginal units could in principle receive different allocations.

Keywords Capital Allocation