Capital Allocation Techniques: Review and Comparison

Abstract

Capital allocation is an essential task for risk pricing and performance measurement of insurance business lines. This paper provides a survey of existing capital allocation methods, including common approaches based on the gradients of risk measures and economic allocation arising from counterparty risk aversion. We implement all methods in two example settings: binomial losses and loss realizations from a catastrophe reinsurer. We assess stability based on sensitivity analysis with regard to losses. Our results show that capital allocations appear to be intrinsically (geometrically) related, although the stability varies considerably. We find stark differences between common and “economic” capital allocations. This paper was funded through Casualty Actuarial Society sponsored research on “Allocation of Costs of Holding Capital”. Address for Correspondence: qguo@bsu.edu