The Use of Risk Adjusted Capital to Support Business Decision-Making

This is partially a conceptual paper about the reasons why an insurance company should address risk and capital issues in a methodical manner and about the problems encountered doing so. But it also offers some mathematical methods for dealing with some of the problems. We do not offer the reader the final answer, since we certainly don't have it. But we do offer some ideas and some procedures for obtaining useful measurements. Without reasonably accurate parameter estimation, the most sophisticated dynamic financial analysis model is simply a black box mapping information according to the "garbage in, gospel out"-syndrome (let us all bow down to our computers and worship their unarguable output!). Modelers of insurance risk may find value in the discussion of modeling man-made major catastrophes via the construction of threat scenarios. The section on modeling investment risk discusses possible ways of using the prevailing Value at Risk model and some problems in doing so. The section on credit risk outlines the modeling problems encountered here. The reader may find the discussion of capital allocation to be particularly enlightening. In the section on managing risk adjusted capital (RAC), we attempt to show, as simply as possible, how the concept of RAC can be used by management to steer the course of business decision-making. The Bibliography lists some references which the reader can use to learn more about the ideas presented in this paper. And the Appendices contain more mathematics about some of the models and their estimation. At this stage we also want to mention that the overall capital estimation and allocation methodology described in this paper is intended for a company's internal risk management. It cannot be used in the same way by external parties such as regulators, rating agencies, etc. These external parties need a standard model for the whole industry, and they must rely only upon publicly available information.