Alarm System for Insurance Companies: A Strategy for Capital Allocation

TL;DR

This paper proposes an early alarm system for insurance companies to optimize capital allocation and prevent ruin, combining analytical methods and simulations to improve risk management strategies.

Contribution

It introduces a novel alarm-based approach for capital augmentation in insurance risk management, with analytical and simulation validation.

Findings

Alarm system effectively reduces ruin probability.

Strategic capital augmentation improves survivability.

Analytical results align with simulation outcomes.

Abstract

One possible way of risk management for an insurance company is to develop an early and appropriate alarm system before the possible ruin. The ruin is defined through the status of the aggregate risk process, which in turn is determined by premium accumulation as well as claim settlement outgo for the insurance company. The main purpose of this work is to design an effective alarm system, i.e. to define alarm times and to recommend augmentation of capital of suitable magnitude at those points to prevent or reduce the chance of ruin. To draw a fair measure of effectiveness of alarm system, comparison is drawn between an alarm system, with capital being added at the sound of every alarm, and the corresponding system without any alarm, but an equivalently higher initial capital. Analytical results are obtained in general setup and this is backed up by simulated performances with various types of loss severity distributions. This provides a strategy for suitably spreading out the capital and yet addressing survivability concerns at satisfactory level.