A friend “volunteered” me to answer an insurance question from Aardvark on allocating economic capital across different insurance products. After writing a short response, I received the frighteningly useful message: “Error”.
Having written a brief summary of the different techniques used in this really important area, I thought I should use it as a blog post. Maybe “Daan d.” from Cape Town will stumble across this answer eventually.
The question:
What is the standard practice to allow for diversification benefits when allocating capital required between different insurance products?
My brief answer (this is a huge topic!):
There is no standard practice. It’s one of the more irritating and subjective aspects of allocating capital between imperfectly correlated product
Economic Capital doesn’t have to be calculated as VaR, but I will use VaR below as a generalisation. Banks are typically slightly more mature in their capital allocation processes so what I’m describing below is often used in the banking world, but applies equally to insurance (life and non-life / P&C).
Splitting the capital in proportion to the sum of the components is frequently used, but is flawed and usually doesn’t give good results unless speed and simplicity are primary objectives. Continue reading
