A capital allocation based on a solvency exchange option

In this paper we propose a new capital allocation method based on an idea of [Sherris, M., 2006. Solvency, capital allocation and fair rate of return in insurance. J. Risk Insurance 73 (1), 71-96]. The proposed method explicitly accommodates the notion of limited liability of the shareholders. We show how the allocated capital can be decomposed, so that each stakeholder can have a clearer understanding of their contribution. We also challenge the no undercut principle, one of the widely accepted allocation axioms, and assert that this axiom is merely a property that certain allocation methods may or may not meet.