Distributing Diversification Benefits

At each level of aggregation within a business diversification benefits accrue, representing the capacity to leverage the risk capital against a larger range of non-perfectly correlated risks. How should these diversification benefits be distributed to the various businesses?

This is not an academic matter, as the residual risk capital attributed to each business segment is critical in determining its shareholder value creation and thus its strategic worth to the enterprise. Getting this wrong could lead the organisation to discourage its better value creating segments and encourage ones that dissipate shareholder value.

Getting it right before one's competitors, on the other hand, would allow the organisation an advantage in identifying and stealing better business from them while offering "lesser" business in return.

The simplest is the pro-rata approach which distributes the diversification benefits on a pro-rata basis down the various segment hierarchies (organisational unit, product, customer segment etc).

A more accurate approach that can be built into the Monte Carlo simulation is the contributory method which takes into account the extent to which a segment of the organisation's business is correlated with or contrary to the major risks that make up the Group's overall risk. This rewards countercyclical businesses and others that diversify the Group's risk profile.

Both of these approaches to distributing diversification benefits assume an ongoing and unchanged Group entity. They are consistent with and akin to average cost allocations on the return dimension of risk adjusted performance.

To move to a consideration of dynamic change in the organisation, including mergers, acquisitions and sales of businesses requires an additional marginal analysis.

To Organisational change

Last updated:16/5/07

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