Optimal capital allocation in a hierarchical corporate structure

Zaks, Y. & Tsanakas, A. (2014). Optimal capital allocation in a hierarchical corporate structure. Insurance: Mathematics and Economics, 56, pp. 48-55. doi: 10.1016/j.insmatheco.2014.02.009

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Abstract

We consider capital allocation in a hierarchical corporate structure where stakeholders at two organizational levels (e.g., board members vs line managers) may have conflicting objectives, preferences, and beliefs about risk. Capital allocation is considered as the solution to an optimization problem whereby a quadratic deviation measure between individual losses (at both levels) and allocated capital amounts is minimized. Thus, this paper generalizes the framework of Dhaene et al. (2012), by allowing potentially diverging risk preferences in a hierarchical structure. An explicit unique solution to this optimization problem is given. In several examples, it is shown how the optimal capital allocation achieves a compromise between conflicting views of risk within the organization.

Item Type: Article
Additional Information: NOTICE: this is the author’s version of a work that was accepted for publication in Insurance: Mathematics and Economics. Changes resulting from the publishing process, such as peer review, editing, corrections, structural formatting, and other quality control mechanisms may not be reflected in this document. Changes may have been made to this work since it was submitted for publication. A definitive version was subsequently published in Insurance: Mathematics and Economics, Volume 56, May 2014, Pages 48–55, http://dx.doi.org/10.1016/j.insmatheco.2014.02.009.
Uncontrolled Keywords: Capital allocation; Solvency II; Basel II; Weighted capital allocation; Hierarchical firms
Subjects: H Social Sciences > HF Commerce
Divisions: Cass Business School > Faculty of Actuarial Science & Insurance
Related URLs:
URI: http://openaccess.city.ac.uk/id/eprint/5939

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