No single approach to capital allocation is objectively superior. Those that are more effective require an investment of time and resources, while the simpler methods sacrifice accuracy. A tradeoff is required based on a (re)insurer’s priorities and capabilities. Before you make a choice, however, be sure you’re aware of the alternatives.
1. Marginal: start with a portfolio of risks, impose an incremental change (e.g., an increase or decrease to a segment), and measure the impact of the change on risk and reward metrics.
2. Proportional: start with a portfolio of risks, and then assess the contributions of the individual segments to the overall portfolio risk metric.
Pair proportional or marginal with any of the metrics below to create your customized capital allocation approach.
3. Standard Deviation: take the standard deviation of the underwriting result for each segment of your portfolio independently, and allocate capital to each in the same proportion as its standard deviation bears to the sum of all standard deviations.
4. Covariance: calculate the covariance between each segment’s underwriting result and the total result. Then, allocate capital to each segment in proportion with the covariances.
5. Co-xTVaR: calculate the amount by which each risk is worse than its expectation in situations in which all risks being modeled exceed expectations. The result is the amount by which a segment is “over budget” in scenarios where the company as a whole is “over budget” for risk-related losses.
5a. Shared Assets: allocate the cost of capital to line of business rather than capital itself. Use co-xTVaR to determine capital used and estimate the cost to replace capital at different levels of loss.