What Is the Value of Risk?
Value of risk (VOR) is the financial benefit that a risk-taking activity will bring to the stakeholders of an organization. It requires the organization to determine whether an activity will help to move it closer to completing its objectives.
Understanding Value of Risk (VOR)
In financial theory, corporations don’t have any risk preferences, but the shareholders and stakeholders of the corporation do. All activities that a company may undertake, from entering a new market to developing a new product, carry risk. The amount of risk depends on the type of activity and the likelihood that the company will not be able to recoup costs, with the added knowledge that spending money on one activity carries with it an opportunity cost — i.e. the company cannot use that money on something else.
Risk of Failure
Value of risk requires a company to examine the various components of the cost of risk. These components include the actual costs for losses incurred; the cost of bonds, insurance, or reinsurance to fund losses; the costs of mitigating the risks that could cause the company to experience a loss; and the cost of administering a risk management and loss mitigation program. Value of risk treats each component of the cost of risk as an investment option. Just as with a stock or a bond, the components must show a return on investment.
For example, a company that starts a risk management department is incurring a substantial personnel expense. The department would be expected to reduce the company’s loss exposure by managing insurance and reinsurance portfolios, identifying potential threats, and developing methods for reducing risk exposure. If the risk management department is unable to do this, then it is not contributing to shareholder value. If a company's expected earnings are higher than the cost incurred to reduce risk, then the risk reduction investment is a positive one.
Many businesses, especially financial ones, calculate a value of risk for nearly all their activities, along with estimated confidence levels that the risk taken will be worth the reward. But these calculations are only as good as the data and assumptions imputed.
For example, companies that got into the smart luggage business — making baggage with imbedded microchips and batteries that track location and more — were betting that the airlines and regulatory agencies would have no problem with customers checking in these bags. They bet wrong, and the smart bags were banned in the U.S. amid fears about battery fires, causing the companies to liquidate. For them, everything was at risk on that one factor and surely none of the baggage makers assessed the possibility of rejection at a high percentage of probability or they would have never entered the business.