A Financial Approach for Determining Capital Adequacy and Allocating Capital for Insurance Companies

There are several methods companies use to determine the appropriate amount of capital required to support their insurance operations. In general these models focus on the downside risk arising from the existing book of liabilities, such as the l-in-100 or l-in-500 underwriting loss. Unfortunately, many of the methods either ignore the risk arising from their investment portfolio or use a method that is disconnected from their liability risk analysis. Further complicating the issue is the question of how to allocate the company’s capital back down to the separate profit centers or operating units.

In this paper we will explore the use of an economic approach to capital adequacy and capital allocation. We will utilize a dynamic financial analysis (DFA) model that incorporates asset, liability and capital market risk factors into both the capital adequacy and allocation formulae. The paper includes a case study to illustrate the DFA approach and the resulting outcomes.

Keywords: Dynamic financial analysis (DFA), Risk-adjusted capital, Regulatory-required capital, Shapely values