What is Unexpected Loss?
Unexpected loss refers to the amount that a company could lose in addition to its average (anticipated) loss possibilities.Because unexpected losses are, by definition, unexpected, forecasting them poses a significant problem. The unexpected loss is the average total loss over and above the mean loss. It is calculated as a standard deviation from the mean at a certain confidence level. It is also referred to as Credit VaR.
Example of Unexpected Loss:
The expected portfolio loss is not computed by aggregating the unexpected losses of individual assets, unlike expected loss. This is because the standard deviation of the total will not be the same as the sum of the standard deviation unless there is a perfect correlation. Consider a commercial loan portfolio focused on loans to automotive manufacturing companies. During an economic expansion that favours such companies (because individuals have more disposable income to spend on items such as automobiles), the lender will realise very few, if any, loan defaults.
Why is unexpected loss significant?
The volatility of credit losses around their predicted loss is known as unexpected loss. When a bank estimates how much money it expects to lose, it sets aside credit reserves. However, in an unexpected loss, the bank must assess the required excess capital reserves based on a specified level of confidence.