Expected Loss Method
The expected loss method is an approach to pricing, measuring and managing risk. The method takes into account all expected losses from a given group of risks, as well as all associated costs. This method is a useful tool for both individuals and organizations, as it allows them to measure and manage risk in an effective manner.
The expected loss method was first proposed by the Austrian economist J. J. Heilbronner in the 1950s. The concept was then developed further by American economist Robert Merton. Since then, the approach has been used by many governments and organizations across the world. The concept behind the expected loss method is based on the idea that the cost of a risk-management strategy should be in accordance with the potential losses associated with the risk. This means that the cost should be proportional to the expected loss.
For example, when setting automobile insurance premiums, the insurer will consider the type and model of the car, the probability of an accident occurring, and the potential costs associated with the accident. Based on this information, the insurer can determine the expected losses from insuring the car, and set the premium accordingly.
The expected loss method is widely used in the finance industry, particularly when making portfolio investments. Investors will assess the risk of each security in the portfolio, including the likelihood of a decline in value, and the expected loss in case of a decline. This process is then repeated for each security, in order to calculate the overall risk in the portfolio, and the expected loss.
The expected loss method can also be used to calculate the cost of capital. In this situation, the expected losses associated with investment in a particular project, are compared to the expected gain. The higher the expected losses, the higher the cost of capital will be.
The expected loss method is a useful tool for risk-management. It allows organizations and individuals to determine the expected losses associated with a given risk, and to price and manage the risk accordingly. By using this approach, organizations can minimize the potential losses associated with any given risk, and can establish a cost-effective risk-management strategy.
