Glossary
Expected Loss (EL)
Expected loss (EL) is the average credit loss a lender or investor anticipates on an exposure over a given period. It equals the probability of default multiplied by loss given default and exposure at default. Expected loss is a cost of doing business that should be covered by pricing and loss allowances, not by capital.
Formula
Example
A lender makes a $1,000,000 loan with an estimated 2% annual probability of default and 40% loss given default. Assuming the full $1,000,000 is outstanding at default, expected loss = 2% x 40% x $1,000,000 = $8,000 per year, or 0.8% of the balance. The loan's pricing must cover that $8,000, plus funding and operating costs and a return on capital, to be profitable.
How it is used in underwriting
Expected loss connects underwriting judgments to pricing and reserves. Risk ratings map to probability of default, collateral and structure determine loss given default, and the commitment and draw pattern determine exposure at default. Lenders use EL to price loans, comparing the credit spread with expected losses; to set the allowance for credit losses under accounting rules; and to compare risk across very different exposures. In insurance, the analogous concept is expected loss cost, the average claims a policy is expected to generate, which forms the base of premium before expenses and profit loads.
Expected loss is an average, not a worst case. Actual losses vary around it, sometimes substantially, and that variability is unexpected loss, which capital is held to absorb. A portfolio with low expected loss can still produce large losses in a downturn if exposures are correlated or concentrated. Common mistakes include using through-the-cycle default rates in a deteriorating economy, estimating LGD from current rather than stressed collateral values, and ignoring the undrawn portion of credit lines in EAD. For pools of loans, CDR and loss severity assumptions produce the same calculation at portfolio level.
Frequently asked questions
What is the difference between expected and unexpected loss?
Expected loss is the average loss anticipated over time and should be covered by pricing and loss reserves. Unexpected loss is the variability of actual losses around that average, especially in bad years. Lenders and insurers hold capital to absorb unexpected losses, since they cannot be priced away in any single period.
How is expected loss used in loan pricing?
Lenders add expected loss to funding costs, operating costs and a required return on capital to set the minimum acceptable interest rate or spread. A loan whose spread does not cover its expected loss plus these costs destroys value, even if it performs as expected on average.
What is exposure at default?
Exposure at default is the amount a lender is owed when a borrower defaults. For a term loan, it is roughly the outstanding balance. For a revolving line, it includes the drawn balance plus an estimate of additional draws before default, since borrowers often draw more on credit lines when they are under financial stress.
Related terms
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