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Economic capital and RAROC in a dynamic model

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  • Bauer, Daniel
  • Zanjani, George

Abstract

We revisit the foundations of economic capital and RAROC calculations prevalent in the insurance industry by extending the canonical static setting to a dynamic model with different ways of raising capital. The dynamic results suggest two important modifications to the conventional approach to risk measurement and capital allocation. First, “capital” should be defined broadly to include the continuation value of the firm. Second, cash flow valuations must reflect risk adjustments to account for company effective risk aversion. We illustrate these results in a calibrated version of our model using data from a catastrophe reinsurer. We find that the dynamic modifications are practically significant—although static approximations with a properly calibrated company risk aversion are quite accurate.

Suggested Citation

  • Bauer, Daniel & Zanjani, George, 2021. "Economic capital and RAROC in a dynamic model," Journal of Banking & Finance, Elsevier, vol. 125(C).
    • Handle: RePEc:eee:jbfina:v:125:y:2021:i:c:s0378426621000297
    DOI: 10.1016/j.jbankfin.2021.106071
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    Cited by:

    1. Hansjörg Albrecher & Karl‐Theodor Eisele & Mogens Steffensen & Mario V. Wüthrich, 2022. "On the cost‐of‐capital rate under incomplete market valuation," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 89(4), pages 1139-1158, December.
    2. Albrecher, Hansjörg & Dacorogna, Michel M, 2024. "Allocating Capital to Time: Introducing Credit Migration for Measuring Time-Related Risks," MPRA Paper 122323, University Library of Munich, Germany.

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    More about this item

    Keywords

    Risk management; Economic capital; Catastrophe reinsurance; RAROC;
    All these keywords.

    JEL classification:

    • G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies; Actuarial Studies
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • C63 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computational Techniques

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