Review of "Capital Allocation for Insurance Companies" by Steward C. Myers and James R. Read Jr. Practical Considerations for Implementation the Myers-Read Model

With their paper, "Capital Allocation for Insurance Companies," Stewart Myers and James Read have added a great contribution to the finance literature relating to the property and casualty insurance industry. On its face, and taking as given that capital allocation is necessary, the Myers-Read methodology is intuitively appealing and mathematically elegant. Myers and Read propose a capital allocation methodology based on an options pricing framework. In their model, it is acknowledged that the insurance contract cannot provide a 100% guarantee of indemnification for loss; there is a certain level of default risk. Imagine that the insurance company could purchase an option to put any remaining liabilities to a third party in the event of a default, and that the cost of this put option was related to the volume of risky insurance liabilities as a cost per unit. Myers and Read propose to allocated all of the insurance company's capital to each of the lines of business of the insurance company, with each line receiving the amount of capital that would equalize the cost of that unit's default option per unit of liabilities.