This paper studies multi-line pricing and capital allocation by insurance companies when solvency matters to consumers, capital is costly to hold, and the average loss is uncertain. In this environment, product quality concerns lead firms to diversify across markets and charge high prices for risk that threatens company solvency, even if the risk is unrelated to other asset risk. Price differences across markets are traced to differences in capital required at the margin to maintain solvency. Finally, the paper shows that capital costs have significant effects on catastrophe insurance markets because of high marginal capital requirements.

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.