Academic journal article Journal of Risk and Insurance

Capital Allocation for Insurance Companies-What Good Is It?

Academic journal article Journal of Risk and Insurance

Capital Allocation for Insurance Companies-What Good Is It?

Article excerpt

ABSTRACT

In their 2001 Journal of Risk and Insurance article, Stewart C. Myers and James A. Read Jr. propose to use a specific capital allocation method for pricing insurance contracts. We show that in their model framework no capital allocation to lines of business is needed for pricing insurance contracts. In the case of having to cover frictional costs, the suggested allocation method may even lead to inappropriate insurance prices. Beside the purpose of pricing insurance contracts, capital allocation methods proposed in the literature and used in insurance practice are typically intended to help derive capital budgeting decisions in insurance companies, such as expanding or contracting lines of business. We also show that net present value analyses provide better capital budgeting decisions than capital allocation in general.

INTRODUCTION

The usefulness of capital allocation methods, i.e., ways that allocate the equity capital of an (insurance) company to different lines of business, can be assessed only in the context of the company's economic goals. Although this statement sounds so obvious, failure to consider context is precisely the current state of affairs in capital allocation discussion. Articles about capital allocation typically begin by listing certain properties that an allocation method should possess, (1) the most prominent of which are: adding-up property, no undercut, symmetry, and consistency. (2) Capital allocation is supposed to be useful in accomplishing the goals of competitive pricing of insurance contracts and making optimal capital budgeting decisions, (3) but instead of analyzing whether various allocation methods are appropriate in certain situations, the literature focuses almost exclusively on whether the proposed allocation methods encompass the above-listed "essential" properties.

Stewart Myers and James Read (4) have proposed an important capital allocation method for insurance companies. They discovered "a unique and non arbitrary" (5) allocation method that leads to an "adding-up" property; i.e., the equity capital allocated to the single lines of business "adds up" to the overall equity capital of the insurance company. Using option-pricing techniques, the allocation depends on the marginal contribution of a contract in a single line of business to the default value of the whole firm. (6) Myers and Read propose using their capital allocation method in pricing insurance contracts. In particular, they propose using it to determine correct loadings on fair premiums in cases where there are frictional costs of holding equity capital. (7)

The Myers and Read article won the 2002 ARIA best paper prize and has since been widely discussed in the academic literature. For example, Kneuer (2003), Ruhm and Mango (2003), Vrieze and Brehm (2003), and Mildenhall (2004) analyze the technical requirements, especially concerning distributional assumptions, and the practical limitations of the Myers and Read approach. Meyers (2003) argues that for the question of expanding or contracting lines of business, capital allocation, including the Myers and Read approach, is not necessary, a finding in line with Phillips, Cummins, and Allen (1998), if no frictional costs are taken into account. Because of the huge number of possible risk measures and allocation methods, Venter (2003, 2004) does not believe the approach will give clear guidance about the profitability of different lines of business or help in making capital budgeting decisions, (8) but does think the method is appropriate for the purpose of pricing insurance contracts. (9) Cummins, Lin, and Phillips (2005) find, on an empirical basis, that the Myers and Read way of allocating the frictional cost of capital is reflected in the insurance premiums observed.

The first goal of this paper is to show that capital allocation to lines of business based on the Myers and Read approach is either not necessary for insurance rate making (in the case of no frictional costs) or even leads to incorrect loadings (when frictional costs are considered). …

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