5. Allocation of Capital

In order to fully account for diversification, risk capital is typically calculated for the company as a whole. From a management perspective, it would however be advantageous to allocate risk capital to the individual lines of business or functions of the insurance company. Because of the diversification effect, there cannot be a unique “correct” method to do so, but there are various approaches of different plausibility and complexity. We introduce the most common capital allocation methods. Then we present the approach of Kalkbrener who starts from an axiomatic system that describes the properties a good capital allocation algorithm should have. It turns out that his approach puts restrictions on the choice of risk measures, which are however satisfied by coherent risk measures. An implementation of his algorithm typical requires Monte Carlo methods, but the algorithm is easier to communicate than most other methods.