Capital Allocation assists with value maximization

2) metrics

• if RAROC is greater than cost, should grow in the line. If less, actions such as tighting UW standards  may be reqired.
• EVA (economic value added)

EVA_i = Net Income_i - r_iC_i 

where r_i = cost of capital for line i . 

1. Can determine cost of capital for monoline firm
2. Peform regression on data of multiline insurers to derive

1. Agency and Informational Costs - management may fail to achieve owners goal of value maximization
2. double taxation - investing in securities via insurance companies produces lower after tax returns
3. Various regulations may force the insurer to hold inefficent investments

RBC - level of capital required to avoid regulatory intervention.

(3) problems

1) factors used are of questionable accuracy

2) calculations are often based on book value, not market

3)RBC ignores several important sources of risk

approach is to weight lines by probablity line exceeds threshold

1. firm may not have enough capital to acheive exceedence probability
2. does not consider diversification
3. does not reflect amount by which losses exceed

Value = Le^-rt - P(A,L,r,τ,σ) where Le^-rt is the PV of claim if default risk where 0, and

P() is value of put option.

Allocate capital to achieve equivalent ratios across lines. Doesn't account for diversifaction