Capital Consumption: An Alternative Methodology for Pricing Reinsurance

This paper introduces a capital consumption methodology for the price evaluation of reinsurance in a stochastic environment. It differs from the common practice of risk-based capital allocation and release by: (i) evaluating the actual contract cash flows at the scenario level; (ii) eliminating the need for contract-level supporting capital allocation and release; (iii) evaluating each scenario’s operating deficits as contingent capital calls on the company capital pool; and (iv) reflecting the expected cost of contingent capital calls as an expense load. This method eliminates the need for capital allocation and release; creates scenarios that more closely model actual contract capital usage; allows more flexibility in stochastic modeling; and makes risk-return preferences an explicit part of the pricing decision.

Keywords: capital consumption, reinsurance pricing, utility theory, risk preferences.