Integrated Financial Risk Management: Capital Allocation Issues

A strategic optimization model provides the ideal setting for allocating the scarce capital of a financial intermediary such as an insurance company. The goal of management is to maximize shareholder value. Capital allocation serves three primary purposes: to compare managerial performance across business units, to provide a risk indicator for regulators and other stakeholders, and to develop a common basis for major decisions, including investment and underwriting strategies, and setting the corporate structure. Capital allocation puts diverse activities on an equal footing by adjusting profits and revenues for risks. We show that optimal allocation rules can be readily retrieved from the solution to a special dynamic financial analysis model of the firm.