Optimal allocation of diversification benefits

In recent years within Insurance companies measures like RAROC (Risk Adjusted Return on Capital) have become more popular for Balance Sheet Management purposes. RAROC is a performance measure that quantifies the amount of return per unit of risk that can be obtained by a certain entity.

Measures like RAROC are often used by a holding company to base investment or risk budgeting decisions on. It is believed that when one increases the investments in or the risk budget of an entity with a high RAROC the risk vs. return profile of the holding company improves. Whether this is actually the case depends on the characteristics of the risks of the subsidiaries of the holding company and the design of the RAROC measure. This paper discusses how the RAROC measure should be designed in order to give the optimal incentives.