Capital Allocation

Overview

One of the common frameworks that insurance companies use to measure performance is capital allocation. That is, once ecoonomic capital has been calculated for the firm as a whole, the managers allocate the capital to the various company divisions or products. Once a division has been allocated capital, the firm can then measure a risk performace measure for the division, such as RAROC by dividing the divisions profits by the capital allocated to it.

Methodologies

Capital allocation is in some sense a form of attribution and suffers from its problems. In particular, the amount of VAR of the bank as a whole is not the sum of the VAR's of the individual divisions, there are interactions between divisions that creates diversification. This creates a complexity that is often ignored.

Because of the complexities of capital allocation, there is no single agreed upon method. The simplest method of allocation would be to the allocate total capital proportional to the individual VARs of each division.

Most risk measures are homongenous of degree 1, and therefore can be decomposed using Eulers Theorem. See risk attribution.