The cost of risk

by Admin
Updated: November 3, 2018

The cost of risk is something that can be accurately calculated - it is not the same as the risk itself.

The cost of taking a risk can - and should - be quantified. It will generally comprise all the costs of research & administration, protection (insurance), professional fees & taxes. It may also include cost of losses depending upon rationale.

In my opinion, the most useful approach to calculating the cost of risk is to account for costs that are unchanged whether the result is win or lose.

Cost of admin

The cost of risk includes all the time & expenses relating to initial due diligence as well as ongoing management of the investment or venture.

When evaluating multiple investments or ventures, the costs of researching the ones that are rejected should be added to the costs of the ones that are adopted.

Cost of protection

The most obvious cost of protection is insurance, but this is often an oversimplification.

The critical issue is to limit exposure in the event of a catastrophic failure and this is done with failsafe measure and legal contracts as well as adequate insurance cover.

Other costs - things like upgrades and security - should also not be overlooked.

For example, it might be considered that locks are a normal expense relating to fixed assets. However, in a completely honest society they would not be necessary so I would argue that such things are better allocated to a risk account.

Investing in something valuable and/or sensitive may require upgraded security & environment - a cost that wouldn’t otherwise be necessary.

Cost of fees & taxes

The cost of fees & taxes are most conveniently grouped with admin expenses for practical purposes. However, they must usually be accounted for separately because they may be subject to different accounting rules.

Cost of losses

If insurance is your business, the cost of risk is a large part of your total cost of doing business.

When this is the case, the cost of anticipated losses must be included in a calculation of the Total Cost of Risk (TCOR) which can then be used to determine the insurance premiums charged to customers.

For most entrepreneurs who are not in the business of providing insurance, this is not useful and is also impossible to know accurately in advance. Arguably, the cost of losses pertains to the risk itself, not the cost of taking that risk.

For example, if I risk $10,000 and lose half of it, the cost of losses is $5,000. If, instead, my return is $15,000, I have either not made a loss at all or my “loss” is negative $5,000. Including this cost of losses can therefore yield three different answers for the same risk.

A cost of losses can be included when there is historical data to support the assessment.

For example, if I invest $10,000 every month in the anticipation of turning it into $15,000, but every third month I only get back $9,000, I know that my cost of risk attributable to losses is, on average, $2,000 per transaction: Over 3 months, if I risk $30k for $45 I can expect to get back only $15+15+9 = $39k which is the same as investing 3×($15-2).

Summary

  1. An accurate TCOR - one that includes all losses - can only be known retrospectively.
  2. An potential TCOR - one that includes anticipated losses - can only be estimated.
  3. An accurate cost of risk can be calculated in advance only if possible losses are not included.

More info

“Total Cost of Risk - Definition” at analyticbroker.com.

“What’s your Total Cost of Risk (TCOR)?” at csoonline.com.

“Balancing the cost of risk and uncertainty” at asq.org.

Internal links

Take a risk Project planning Failstorming Go to Articles
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