Holistic Principle for Risk Aggregation and Capital Allocation

30 Pages Posted: 23 Mar 2020 Last revised: 28 Jan 2021

See all articles by Wing Fung Chong

Wing Fung Chong

University of Illinois at Urbana-Champaign - Department of Mathematics; University of Illinois at Urbana-Champaign - Department of Statistics

Runhuan Feng

University of Illinois at Urbana-Champaign

Longhao Jin

University of Illinois at Urbana-Champaign

Date Written: February 25, 2020

Abstract

Risk aggregation and capital allocation are of paramount importance in business, as they play critical roles in pricing, risk management, project financing, performance management, regulatory supervision, etc. The state-of-the-art practice often includes two steps: (i) determine standalone capital requirements for individual business lines and aggregate them at a corporate level; and (ii) allocate the total capital back to individual lines of business or at more granular levels. There are three pitfalls with such a practice, namely, lack of consistency, negligence of cost of capital, and disentanglement of allocated capitals from standalone capitals.

In this paper, we introduce a holistic approach that aims to strike a balance of optimality by taking into account competing interests of various stakeholders and conflicting priorities in a corporate hierarchy. While unconventional in its objective, the new approach results in an allocation of diversification benefit, which conforms to the diversification strategy of many risk management frameworks including regulatory capital and economic capital. The holistic capital setting and allocation principle provides a remedy to aforementioned problems with the existing two-step industry practice.

Keywords: Risk Management, Risk Aggregation, Capital Allocation, Pareto Optimality, Diversification Benefit

Suggested Citation

Chong, Wing Fung and Feng, Runhuan and Jin, Longhao, Holistic Principle for Risk Aggregation and Capital Allocation (February 25, 2020). Available at SSRN: https://ssrn.com/abstract=3544525 or http://dx.doi.org/10.2139/ssrn.3544525

Wing Fung Chong (Contact Author)

University of Illinois at Urbana-Champaign - Department of Mathematics ( email )

1409 W. Green Street
Urbana, IL 61801
United States

University of Illinois at Urbana-Champaign - Department of Statistics ( email )

725 S Wright
Champaign, IL 61820
United States

Runhuan Feng

University of Illinois at Urbana-Champaign ( email )

601 E John St
Champaign, IL 61820
United States

Longhao Jin

University of Illinois at Urbana-Champaign ( email )

601 E John St
Champaign, IL 61820
United States

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