Faculty of Economics and Business Administration Publications Database

Capital Allocation for Insurance Companies - What Good is it?

Schmeiser, Hato
Volume: 74
Number: 2
Pages: 301 - 317
Month: June
ISSN-Print: 0022-4367
Link External Source: Online Version
Year: 2007
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.