Asset Allocation and RBC

[freshwoman]

I'm trying to figure out the right way to think about this. Basically looking at a bunch of different asset classes and their returns versus RBC requirements to determine optimal asset allocation from a risk adjusted capital perspective.

For example if a bond yields 4% and is an NAIC 2, versus a hedge fund investment that has returned 10-15% last year but has a 40% capital charge.

I first considered doing yield less a RBC weighted cost of capital analysis. So for my hedge fund example it would be 10% - 0.6 * cost of capital. The problem was I'm not quite sure what to use as a cost of capital for a mutual.

Then I considered looking at the ratio of RBC to assets and seeing how that changes under different asset allocation methodologies. Then I think I can translate this back to a ratio of capital and surplus to assets as per the used methodology here - which gives me a rough idea of for a extra 1% allocation to an asset class what the additional yield has to be:

http://www.casact.org/pubs/forum/02sforum/02sf175.pdf

Does anyone have a better thought on how to look at asset allocation on an RBC basis? I'm assuming I'm not the only one that has been asked this.

[eagle_halo]

I am not sure if this is the right way to look at cost/return of capital.

If you just want to look at return on capital for your asset portfolio only, then all you need to do is to determine what is your cost of capital. Any investment that has return on capital exceeds cost of capital would be a good asset class (in theory). Obviously you need to account for risk appetite of the company etc...

To determine the cost of capital, I would look at the composition of the available capital of your company (even mutual has available capital). Obviously you cannot determine the cost of shareholder equity in a mutual company, but you can look to the historical (or target) profit that refunds back to the policyholders as a guideline to determine the cost of shareholder equity. The rest of the capital structure is just market yield of the instrument.

I think the best way to look at a block of business should be the distributable earnings divided by required capital. If you can get a projection of the distributable earnings and required capital over the life time of the business, then you can see what is the return of capital of this block of business. Comparing this to the cost of capital can give you an idea if this block of business is doing well or not. Looking at the asset side can only give you so much information.