Glossary term
Expected Loss (EL)
Subject: Risk Management, Risk Assessment and Quantification
Also known as: EL, Anticipated loss
Expected loss is the average loss a lender or insurer anticipates over a period from a portfolio, usually calculated as probability of default times loss given default times exposure at default.
Explanation
Some losses are a normal cost of doing business. Expected loss puts a number on that cost. For credit, it multiplies three things: the chance the borrower defaults (PD), the share of the exposure lost if it does (LGD), and the amount owed at that moment (EAD). Add the figures across loans for a portfolio view. Because it is an average, it is meant to be absorbed by pricing and provisions, not by capital. The loss above this average is unexpected loss, which capital covers. Accounting provisioning models such as expected credit loss build on the same idea but add forward-looking adjustments. A lender that prices loans below this figure will book a steady shortfall, however carefully it picks borrowers.
Example
A lender advances 1,000 to a borrower with a 2% chance of default over a year. If the borrower defaults, it expects to recover 60%, so loss given default is 40%. Expected loss is 2% times 40% times 1,000, which is 8, and that amount is built into the loan's interest rate.
Not to be confused with
- Expected Credit Loss (ECL)
- ECL is an accounting provision measure with forward-looking adjustments. Expected loss is the underlying statistical average, often used for pricing and capital.