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Chapter 8 Incorporation of cost of capital in business planning…
Chapter 8
Incorporation of cost of capital in business planning
Capital model should
consistent with capital modelled for whole business
reflect the risk of individual business segments relative to one another and business as a whole
reflect the interrelationship between risks and different business segments
be justifiable and consistent
Components of capital cost
Capacity occupation cost (non-consumptive)
Capital call cost (consumptive)
To allocate capital we need a risk measure, and capital allocation method
desirable characteristics of a risk measure
easy to communicate and apply
observable, measureable and not prone to manipulation
consistent with management's perception of risk
quantifies risk in a manner understood by the decision maker
consistent with basis to establish aggregate capital requirement
results in internally consistent allocation of diversification benefits; that is, additivity in allocations
results in a coherent allocation
coherence of risk measures
monotonicity - if one portfolio is always worth more than another it cannot be riskier
linear homogeneity - scaling a portfolio by a constant will change the risk by the same proportion
sub-additivity - combining two portfolios should not create more risk
translation invariance - adding a risk-free portfolio to an existing portfolio creates no change in risk
Example or risk measure:
variance / standard deviation / semi-variance
VaR and T-VaR
expected policyholder benefit
transformed loss measures
Capital allocation methods
proportional
marginal last in
game theory
equalise relative risk
co-measures
option pricing framework
Coherency of capital allocation principles
Diversification benefit
Symmetry
Risk-free allocation
Main benefits of capital models
ensure premiums cover the cost of capital
help with risk selection
assist with performance measurement and benchmarking
attribute performance to assist in remuneration
assist with strategic decision making