How to Calculate Expected Loss for Legal Contingencies

When managing litigation exposure, CFOs often face a fundamental question: How do I turn uncertain legal outcomes into numbers I can defend to auditors and the board?

The answer lies in probability-weighted expected value — a method that transforms uncertain outcomes into defensible financial estimates. This guide walks through the calculation step by step.

What Is Expected Loss?

Expected loss is the probability-weighted average of potential outcomes. For litigation, it accounts for the fact that you might lose (and pay damages) or win (and pay only defence costs, or nothing at all).

The basic formula:

Expected Loss = Potential Loss × Probability of Loss

For a claim with €1,000,000 exposure and a 70% probability of an adverse outcome:

Expected Loss = €1,000,000 × 0.70 = €700,000

This doesn’t mean you’ll pay exactly €700,000. You’ll either pay significantly more (if you lose) or significantly less (if you win). But €700,000 represents the statistically expected value across many similar cases.

Why Use Probability-Weighted Values?

Several reasons make this approach both practical and defensible:

1. Accounting standards support it

IAS 37 specifically mentions the expected value method when outcomes are continuous or when no single outcome is more likely than others. For portfolios of litigation, expected value provides a rational basis for provisioning.

2. It’s actuarially sound

Insurance companies and risk professionals have used probability-weighted expected values for centuries. The methodology is well-established and auditors understand it.

3. It communicates uncertainty honestly

Rather than picking an arbitrary “best estimate,” expected loss explicitly incorporates the probability of different outcomes. This provides better information for decision-making.

4. It aggregates sensibly

When you have multiple matters, expected losses can be summed to give a portfolio-level view. This isn’t true of simple point estimates.

The Calculation Step by Step

Let’s work through a complete example:

Step 1: Estimate Potential Exposure

This is the maximum realistic loss if the case goes badly. Include:

Judgment exposure: Damages, compensation, penalties
Adverse costs: Opposing party’s legal costs (if applicable in your jurisdiction)
Defence costs: Your own legal fees to complete the case

Example:

Judgment exposure: €500,000
Potential adverse costs: €75,000
Defence costs to completion: €100,000
Total potential exposure: €675,000

Step 2: Assess Probability

Assign a probability to the adverse outcome. This is the critical judgment step.

For IAS 37 compliance, many companies use probability midpoints:

Band	Definition	Midpoint
Remote	Very unlikely	10%
Reasonably Possible	Neither probable nor remote	45%
Probable	More likely than not	85%

Example: Legal counsel assesses this case as “Reasonably Possible”

Probability: 45%

Step 3: Calculate Expected Loss

Apply the probability to each component:

Expected judgment: €500,000 × 45% = €225,000 Expected adverse costs: €75,000 × 45% = €33,750 Defence costs: €100,000 × 100% = €100,000 (these are incurred regardless)

Total expected loss: €358,750

Step 4: Consider Scenarios

For more sophisticated analysis, consider multiple scenarios:

Scenario	Probability	Total Outflow	Expected Value
Win (no damages)	55%	€100,000	€55,000
Lose (full damages)	30%	€675,000	€202,500
Settle	15%	€350,000	€52,500
Total	100%		€310,000

This multi-scenario approach often provides a more nuanced view than simple probability bands.

Defence Costs: A Special Case

Defence costs deserve special attention because they’re often incurred regardless of outcome:

Sunk costs: Legal fees already incurred are not part of the provision — they’re already expensed.

Costs to completion: Future legal fees should be estimated and included. These are typically more certain than judgment outcomes.

Probability treatment:

Defence costs incurred regardless of outcome: Include at 100%
Additional costs only if case continues: Probability-weight appropriately

Portfolio Aggregation

With multiple matters, expected losses can be summed:

Matter	Exposure	Probability	Expected Loss
Smith v. Company	€500,000	85%	€425,000
IP Dispute	€1,200,000	45%	€540,000
Contract Claim	€300,000	10%	€30,000
Portfolio Total	€2,000,000		€995,000

The portfolio expected loss (€995,000) is more meaningful than the gross exposure (€2,000,000) for financial planning.

Common Mistakes

1. Ignoring Defence Costs

Many calculations focus only on judgment exposure. In some cases, defence costs exceed potential damages.

2. Using Inconsistent Probability Bands

Different assessors using different definitions of “probable” creates inconsistency. Establish clear criteria.

3. Not Updating Assessments

A 45% probability assessed six months ago may be 80% today. Review regularly.

4. Treating Expected Loss as the Provision

Under IAS 37, the provision should be the best estimate — which may be expected value or may be a single most likely outcome. Understand when each applies.

5. Overcomplicating Scenarios

More scenarios doesn’t mean better analysis. Focus on materially different outcomes.

Practical Tips

Document the rationale: For each probability assessment, record why you chose that band. “Legal counsel advises…” or “Based on similar cases…”

Use ranges: Where uncertain, calculate expected loss at both ends of a probability range. This shows sensitivity.

Separate judgment from costs: Track these separately for better analysis and clearer audit documentation.

Build in reviews: Establish triggers (case developments, time passage) for reassessment.

Track outcomes: Compare actual results to predictions over time. This improves calibration.

Using the Reserve Calculator

For quick calculations, try our free Reserve Calculator. It:

Applies standard probability midpoints
Calculates expected loss automatically
Separates judgment exposure and defence costs
Indicates the recommended accounting treatment

For portfolio management across multiple matters, Contingent automates these calculations and maintains the audit trail auditors require.

Conclusion

Probability-weighted expected loss transforms uncertain litigation outcomes into defensible financial estimates. The methodology is straightforward:

Estimate the potential exposure
Assess the probability of adverse outcome
Multiply and sum the components
Document your rationale

Done consistently, this approach provides CFOs with reliable numbers for financial reporting while maintaining the documentation auditors expect.

Try our Reserve Calculator to calculate expected loss for a single matter.