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Enterprise Risk Management Through Strategic Allocation of Capital
Author(s) -
Ai Jing,
Brockett Patrick L.,
Cooper William W.,
Golden Linda L.
Publication year - 2012
Publication title -
journal of risk and insurance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.055
H-Index - 63
eISSN - 1539-6975
pISSN - 0022-4367
DOI - 10.1111/j.1539-6975.2010.01403.x
Subject(s) - risk appetite , enterprise risk management , business , operationalization , economic capital , operational risk , financial risk management , time horizon , enterprise value , risk management , risk analysis (engineering) , finance , microeconomics , economics , profit (economics) , philosophy , epistemology
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 multiperiod 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.