November 30th, 2009

A Survey of Capital Allocation Metrics: Introduction

Posted at 1:00 AM ET

Susan Witcraft, Managing Director, Financial Intelligence Team, Instrat

Capital allocation is a discipline without consensus. Some believe in sticking strictly to allocating the cost of capital, while others believe in allocating capital itself. Meanwhile, the methods for allocating capital (and its attendant costs) vary, ranging from the simplest — standard deviation — through the increasingly complex covariance, co-xTVaR and shared assets approaches. The exercise becomes one of managing tradeoffs, as risk managers balance the simplicity of effort against the potential benefits of capital optimization.

There are two broad approaches to allocating capital: marginal and proportional. The former involves starting with a portfolio of risks, imposing an incremental change (e.g., an increase or decrease to a segment) and measuring the impact of the change on risk and reward metrics. The proportional method also starts with a portfolio of risks, but it then assesses the contributions of individual segments to overall portfolio risk metric without modifying the portfolio.

Marginal methods tend to be used for strategic decision making, such as reinsurance purchasing and acquisitions. They can be used for capital allocation, but theoretical issues (including order dependence) require post-process adjustments such as off-balancing. The proportional methods, on the other hand, tend to be used for true allocations, pricing and planning.

Based on the most common goals for capital allocation, we’ll focus on proportional approaches to capital allocation. The complexity and inconsistencies of marginal metrics outweigh their benefits.

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