Can a regulatory risk measure induce profit-maximizing risk capital allocations? The case of Conditional Tail Expectation (2102.05003v3)

Abstract: Risk capital allocations (RCAs) are an important tool in quantitative risk management, where they are utilized to, e.g., gauge the profitability of distinct business units, determine the price of a new product, and conduct the marginal economic capital analysis. Nevertheless, the notion of RCA has been living in the shadow of another, closely related notion, of risk measure (RM) in the sense that the latter notion often shapes the fashion in which the former notion is implemented. In fact, as the majority of the RCAs known nowadays are induced by RMs, the popularity of the two are apparently very much correlated. As a result, it is the RCA that is induced by the Conditional Tail Expectation (CTE) RM that has arguably prevailed in scholarly literature and applications. Admittedly, the CTE RM is a sound mathematical object and an important regulatory RM, but its appropriateness is controversial in, e.g., profitability analysis and pricing. In this paper, we address the question as to whether or not the RCA induced by the CTE RM may concur with alternatives that arise from the context of profit maximization. More specifically, we provide exhaustive description of all those probabilistic model settings, in which the mathematical and regulatory CTE RM may also reflect the risk perception of a profit-maximizing insurer.