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The Business Case for Quantified Loss Estimation

Thomas Kellogg

Updated: Oct 23, 2024


Many organizations assess default-related risks using labels like "high," "medium," or "low." We see red and become concerned, while green gives us comfort. However, these terms—and their associated colors—are relative, and businesses do not earn fees or incur expenses in the amounts of "high," "medium," or "low." Although these labels are easy to understand, they often lack the precision needed for sound business decision-making. By quantifying risks in dollar amounts, businesses can more accurately compare potential losses with potential savings and determine when the reward justifies the risk.

 

Modality statements, color-coded levels, and letter grades for risk are quick and easy to digest but come with significant shortcomings. Subjective assessments can introduce bias and may overlook or underweight important quantifiable facts. For example, when a long-standing relationship exists between the Construction Manager/General Contractor (CM/GC) and a subcontractor, the relationship's value might be overestimated while the objective numbers are ignored. Additionally, what one person sees as a "medium" risk might be acceptable, while another may consider it excessive. Without precise, objective measurements, these relative terms can lead to misalignment and poor decision-making.

 

Quantifying risks by translating them into dollar values and probabilities allows businesses to objectively compare potential losses with possible rewards. Percentages and dollar amounts are undeniably objective in ways that modality statements or grades can never be. This approach helps businesses identify when the reward exceeds the risk, leading to a more calculated approach to risk-taking. For instance, if the potential reward in cost savings outweighs the risk—such as the cost of rectifying a default—it is a good risk to take. If not, the exposure is not worth it without additional compensation. Instead of relying on a “gut feeling” or judgment call, businesses can use numbers to identify the risk and then apply collective experience to determine the best course of action.

 

Understanding the full cost of risk also enables businesses to plan financially, ensuring they have the resources to manage the risk if it materializes. In industries like construction, default-related losses are inevitable. The question is not if but when and how much. Ignoring the "how much" leads to confusion and contention when losses occur. By knowing the cost upfront, CM/GCs can make informed decisions on whether or how much to invest in preventive measures, such as operational risk management plans, or whether to insulate the company from each risk through internal reserves, Subcontractor Default Insurance (SDI), or surety bonds. The practical goal is not necessarily to avoid all risks, but to ensure the company is prepared to manage them or minimize their monetary impact, while maintaining fees that align with the degree of risk accepted.

 

Subjective risk assessments, while convenient, can introduce bias and overlook critical, quantifiable details. By focusing on objective measurements—specifically by translating risk into dollar amounts—companies can better compare risks to rewards, plan financially, and make more informed decisions. The goal is not to eliminate risk, but to ensure that the risks taken align with the company's risk tolerance and that the company is equipped to manage them effectively.





 


 

Completely Unrelated Trivia Treasure: The largest organism on Earth is a 2,400+ year old fungus in Oregon that spans 2,384 acres.

 



Maple Insight offers default-related risk quantification and probability of default estimation using predictive analytics. Our services assess and estimate the value of all primary, secondary, and tertiary effects of a default, whether there is insurance or surety products in place or not.

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