Enterprise Risk Management, Insurer Pricing, and Capital Allocation

For insurers and reinsurers, economic capital has become central to enterprise risk management and is used in financial decision-making including by-line pricing and capital allocation. The Value-at-Risk (VaR) measure is widely used for determining economic capital. In this paper we use a shareholder and total firm value maximizing model of an insurer incorporating taxes, agency costs, financial distress costs, policyholder preference for financial quality, and by-line price elasticities. We determine optimal value maximizing pricing strategies and capitalizations for an insurer under varying assumptions for a realistic model of a multi-line insurer. We evaluate the performance of VaR-based methods for allocating capital and incorporating the cost of capital into pricing insurance. We find that with imperfectly elastic policyholder demand, capitalization, and pricing are strongly influenced by policyholder sensitivity to price and preferences for financial quality. Incorporating costs of capital using VaR must be carefully implemented if it is to be consistent with value maximizing pricing strategies.