Strategic Uses of Value at Risk: Long-Term Capital Management for Property/Casualty Insurers

In contrast to alternative measures of risk, value at risk (VaR) has important virtues—intelligibility, comparability, and practicality—that make it a potentially valuable tool for strategic decision making and capital management in a wide variety of industries. However, capital-management decisions in most industries—including financial services, such as property/casualty insurance— have time horizons far longer than the one-day horizon that prevails in commercial and investment banking, where the use of VaR is now concentrated. For VaR to be usefully applied to long-horizon decisions, it must address three fundamental problems unique to that context: estimation risk, adaptive risk modification, and franchise risk. This paper describes each of these problems, shows how they can be solved, and provides examples applicable to property/casualty insurance.