Chapter 5
It’s easy to say that a company prices its products to achieve at least a minimum rate of return on equity. In reality, it is not that easy. The hardest part is to allocate capital to individual contracts or lines of business; capital is not really divisible by line of business. It is available, in its entirety, to any one contract or line of business, if that contract or line produces enough losses. That being said, it is useful to think about capital as divisible, at least for pricing purposes. Since the purpose of capital is to absorb adverse deviations from expected, any method to allocate capital is acceptable so long as it differentiates among contracts or lines of business based on the risk of adverse deviation. A method that is arbitrary and does not differentiate between risks is not a viable way to allocate capital. While it might mechanically allow someone to look at rates of return on equity, it will not provide any meaningful insight as to whether a particular contract or line of business provides an attractive return for the risk taken to achieve that return.
