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Economic capital and RAROC in a dynamic model

Daniel Bauer and George Zanjani

Journal of Banking & Finance, 2021, vol. 125, issue C

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.

Keywords: Risk management; Economic capital; Catastrophe reinsurance; RAROC (search for similar items in EconPapers)
JEL-codes: C63 G22 G32 (search for similar items in EconPapers)
Date: 2021
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DOI: 10.1016/j.jbankfin.2021.106071

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Handle: RePEc:eee:jbfina:v:125:y:2021:i:c:s0378426621000297