Optimal Capital Allocation

This paper starts with primitive assumptions on consumer preferences and then derives prices consistent with a social optimum within an insurance company and the capital allocation implied therein. The implied allocation “adds up” to the total capital of the …rm (a result echoing …ndings in the congestion pricing literature— where optimal tolls exactly cover the rental cost of the highway). The allocation follows each consumer’s share of recoveries in states where the insurer defaults, weighted by the severity (in terms of consumer welfare impact) of the default. However, the paper goes on to argue that the economic approach employed supports a broader conception of allocation— beyond that based on the marginal impact of each consumer’s risk: Speci…cally, it argues that allocation based on relative consumer valuations of all units of capital— both marginal and inframarginal— may yield more stable and equitable assignment of cost responsibility. I thank Michael Suher for research assistance. Errors are mine. The views expressed in this article are those of the author and do not necessarily re‡ect the position of the Federal Reserve Bank of New York or the Federal Reserve System.