What Is Value of Risk (VOR)?
Let me explain Value of Risk (VOR) directly: it's the financial benefit that comes from any risk-taking activity in your organization, benefiting the stakeholders. You need to figure out if that activity pushes your organization closer to its goals.
Key Takeaways
Value of Risk (VOR) boils down to the financial upside for stakeholders from risks your company takes. Every move, whether it's breaking into a new market or launching a product, involves some level of risk—how much depends on the activity and the odds of recovering your costs. With VOR, you look at the different parts of risk costs and handle them like investment choices. Remember, these calculations depend entirely on the quality of your data and assumptions.
Understanding Value of Risk (VOR)
In financial theory, corporations themselves don't have risk preferences, but their stakeholders certainly do, and the aim is usually to generate profits without being reckless. As someone managing a company, you know that using resources wisely can secure your position and increase investor wealth. Doing nothing means missing opportunities, which is like burning potential profits. But every gain involves some pain—decisions come with risks that you must examine closely before proceeding.
All company activities carry risk, from market entry to product development, with the extent varying by type and the chance of not recouping costs. At the same time, committing to one path means opportunity costs—the benefits you forgo by not choosing alternatives.
Value of Risk (VOR) Method
To apply Value of Risk (VOR), you examine the components of risk costs: actual losses, expenses for bonds, insurance, or reinsurance, costs to mitigate potential risks, and the administration of risk management programs. VOR treats each of these as an investment, just like stocks or bonds, expecting them to provide a return on investment (ROI).
Examples of Value of Risk (VOR)
Consider a company setting up a risk management department— that's a big personnel cost. You expect that department to cut down on losses by handling insurance, spotting threats, and creating ways to reduce exposure. If it fails, it's not adding to shareholder value. But if the company's earnings exceed the risk reduction costs, then it's a worthwhile investment.
On the flip side, take a company that entered the smart luggage market with bags featuring microchips and batteries for tracking. They assumed airlines and regulators would approve, but they were wrong—U.S. bans due to battery fire risks led to liquidation. Everything hinged on that one factor, and if they'd properly assessed the high probability of rejection, they likely would have avoided the business altogether.
Important Note on VOR
Keep this in mind: Value of Risk (VOR) calculations are only as reliable as the data and assumptions you input.
Limitations of Value of Risk (VOR)
Many businesses, particularly in finance, calculate VOR for almost every activity, including confidence levels on whether the risk pays off. It seems straightforward, but it's full of complications. Calculations often rely on subjective assumptions that can overlook issues or change over time. In a perfect scenario, you'd account for judgment errors and cover all angles objectively, using multiple sources.
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