Capital Allocation in the Insurance Sector

Capital allocation plays a key role in the enterprise risk management system of insurance undertakings: when applied during performance measurement, it creates a link between risk and business. In addition to performance measurement, capital allocation may also have a role in pricing decisions and in the preparation of strategic business decisions. With the entering into force of the Solvency II regulation the consistent application of capital allocation has become a regulatory expectation in the insurance sector which lands relevance to our topic. The available literature is extremely rich; however, the applicable methods have been designed based on theoretic axioms rather than the needs of the practitioners, so the gap between theoretic research and real-life application is significant. Our objective is to translate the rather abstract formulation of the problem of capital allocation, customary in the literature, to the practical questions arising during implementation by insurance companies; thereby, providing some guidance for choosing the theoretically applicable methods. In this study, we will review the issues arising in connection with the implementation of capital allocation: what needs to be allocated for what specific purposes and how such allocation should take place.