All financial institutions are faced with a basic business question: What is the best use of available funds? Historically, within the insurance industry, this issue of capital allocation has been addressed using some very basic projections of future balance sheets and profit-and-loss statements, with capital projections based on regulatory capital requirements.Global insurers-as well as regulators and rating agencies-are warming to the principle that capital requirements should be based on an assessment of the true underlying risks to the business. Only then can a proper decision be made as to whether one strategic option may be better than another. Without such an analysis, a company might adopt a particular strategy that, over time, eats away at capital and results in a very inefficient use of available funds.
One suggested solution is to model and gauge the risk/return profile of all the strategies available to an insurer. This way, the decision-making process is not one that seeks only to maximize return, but one that maximizes return within an acceptable level of risk.
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