, Volume 63, Issue 2, pp 659-671
Date: 13 May 2012

Default risk-based probabilistic decision model for risk management and control

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Abstract

This study describes how risk-based risk control allocation models work. We begin by discussing the economic rationale for allocating risk control in a diversified organization such as an enterprise. For a probability model for risk control decision making under uncertainty and risk, we propose a model involving stochastic total loss amount constraints with respect to various tolerable default levels. Our main objective is to develop a method that will allow shaping of the risk associated with risk control outcomes. The direct and indirect losses caused by simulated disasters can be estimated using an engineering and financial analysis model. Based on this model, we can generate an exceeding probability curve and then calculate how much of the loss can be eliminated or transferred to other entities should funds be allocated to risk control. The optimal natural disaster risk control arrangement with a probabilistic formulation is explained in this paper. Results from the proposed formulations are compared in case studies. The model attempts to apply risk-based budget guidelines to risk reduction measurement within a portfolio-based risk framework.