Preference robust distortion risk measure and its application

Distortion risk measure (DRM) plays a crucial role in management science and finance particularly actuarial science. Various DRMs have been introduced but little is discussed on which DRM at hand should be chosen to address a decision maker's (DM's) risk preference. This paper aims to fill out the gap. Specifically, we consider a situation where the true distortion function is unknown either because it is difficult to identify/elicit and/or because the DM's risk preference is ambiguous. We introduce a preference robust distortion risk measure (PRDRM), which is based on the worst‐case distortion function from an ambiguity set of distortion functions to mitigate the impact arising from the ambiguity. The ambiguity set is constructed under well‐known general principles such as concavity and inverse S‐shapedness of distortion functions (overweighting on events from impossible to possible or possible to certainty and underweighting on those from possible to more possible) as well as new user‐specific information such as sensitivity to tail losses, confidence intervals to some lotteries, and preferences to certain lotteries over others. To calculate the proposed PRDRM, we use the convex and/or concave envelope of a set of points to characterize the curvature of the distortion function and derive a tractable reformulation of the PRDRM when the underlying random loss is discretely distributed. Moreover, we show that the worst‐case distortion function is a nondecreasing piecewise linear function and can be determined by solving a linear programming problem. Finally, we apply the proposed PRDRM to a risk capital allocation problem and carry out some numerical tests to examine the efficiency of the PRDRM model.