The Economics of Capital Allocation

On the surface, capital allocation sounds contradictory to the states purpose of insurance, which is diversifying risk. In spite of that, it is commonly used as a tool by insurers to manage their underwriting risk. This paper examines the economics underlying how insurers might use capital allocation when capital is scarce and has a price. Starting from a risk-based capital framework, the paper establishes strategies for increasing the insurer's expected return on capital. It then derives capital allocation methods that are consistent with these economic strategies.