Dynamic capital allocation in general insurance

Abstract This paper provides a model for allocating capital to different insurance lines with varying development periods for a value‐maximizing insurance company. In our model, the company makes capitalization and exposure decisions considering its capital level and its relevant loss history. As in simpler settings, the optimal portfolio can be characterized via risk‐adjusted return ratios, although the model attaches different valuation weights to cash flows with different tenors. Numerical results show that our approach yields substantively different guidance relative to that obtained from conventional capital allocation approaches, particularly on the relative valuation of long‐tailed versus short‐tailed liabilities, since long‐tailed lines can provide a source of short‐term financing. We discuss robustness and implications of our findings.