Enterprise Risk Management Through Strategic Allocation of Capital

Journal of Risk and Insurance, Forthcoming

35 Pages Posted: 15 May 2011 Last revised: 24 May 2011

Jing Ai

University of Hawaii at Manoa - Shidler College of Business

Patrick L. Brockett

University of Texas at Austin - Department of Information, Risk and Operations Management

William W. Cooper

University of Texas at Austin - McCombs School of Business

Linda L. Golden

University of Texas at Austin - Red McCombs School of Business

Multiple version iconThere are 2 versions of this paper

Date Written: January 1, 2011

Abstract

This article presents a conceptual framework for operationalizing strategic enterprise risk management (ERM) in a general firm. We employ a risk-constrained optimization approach to study the capital allocation decisions under ERM. Given the decision maker’s risk appetite, the problem of holistically managing enterprise-wide hazard, financial, operational, and real project risks is treated by maximizing the expected total return on capital, while trading off risks simultaneously in Value-at-Risk type of constraints. This approach explicitly quantifies the concepts of risk appetite and risk prioritization in light of the firm’s default and financial distress avoidance reflected in its target credit rating. Our framework also allows the firm to consider a multi-period planning horizon so that changing business environments can be accounted for. We illustrate the implementation of the framework through a numerical example. As an initial conceptual advancement, our formulation is capable of facilitating more general ERM modeling within a consistent strategic framework, where idiosyncratic variations of firms and different modeling assumptions can be accommodated. Managerial implications are also discussed.

Suggested Citation

Ai, Jing and Brockett, Patrick L. and Cooper, William W. and Golden, Linda L., Enterprise Risk Management Through Strategic Allocation of Capital (January 1, 2011). Journal of Risk and Insurance, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1841807

Jing Ai (Contact Author)

University of Hawaii at Manoa - Shidler College of Business ( email )

2404 Maile Way
Honolulu, HI 96822
United States

Patrick L. Brockett

University of Texas at Austin - Department of Information, Risk and Operations Management ( email )

CBA 5.202
Austin, TX 78712
United States

William W. Cooper

University of Texas at Austin - McCombs School of Business ( email )

Austin, TX 78712
United States

Linda L. Golden

University of Texas at Austin - Red McCombs School of Business ( email )

Austin, TX 78712
United States

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