Asset Allocation to Optimise Life Insurance Annuity Firm Economic Capital and Risk Adjusted Performance

With the advent of new risk-based regulations for financial services firms, specifically Basel 2 for banks

and Solvency 2 for insurers, there is now a heightened focus on the practical implementation of

quantitative risk management techniques for firms operating within the financial services industry.

In particular, financial services firms are now expected to self assess and quantify the amount of capital

that they need, to cover the risks they are running. This self assessed quantum of capital is commonly

termed risk, or economic, capital.

This talk is concerned with two important questions:

Question 1: How should a capital constrained firm allocate its assets to minimise its economic capital

requirement?

Question 2: How should a firm allocate its assets to optimise its risk adjusted performance?

The talk will focus on the impact that asset allocation has on the economic capital and the risk adjusted

performance of financial services firms. A stochastic approach, using graphical models, is used in

conjunction with a life insurance annuity firm as an illustrative example. It is shown that traditional

solvency-driven deterministic approaches to financial services firm asset allocation can yield suboptimal

results in terms of minimising economic capital or maximising risk adjusted performance.

Our results challenge the conventional wisdom that the assets backing life insurance annuities and

financial services firm capital should be invested in low risk, bond type, assets. Implications for firms,

customers, capital providers and regulators are also considered.