First loss risk is not as risky as it sounds

Structuring asset backed securities with first loss risk notes

First-loss risk component is in fact second loss, because it generally covers unexpected losses, with expected losses covered by originators’ risk management modelling.

It is possible to draw a comparison on first loss risk structure to a property insurance policies that comes with a “first loss” option (or "first loss cover") where the policyholder and the insurer agree to insurance coverage which is lower than the actual value of the insured property. As an example: household’s property is valued at $125,000 whilst the first-loss policy has a maximum benefit of $100,000, or 80 percent of the asset’s value. In this case, in the event of a total loss, the policy would only cover 80 percent of losses. However, if the policy is also against external theft (on a first-loss basis), the insured will still be compensated for 100% of eligible losses, minus deductible and up to the maximum benefit.

Asset backed securities first loss risk structures are conceptually same, since they cover a deductible for an unexpected loss provision, they may provide conditional protection if an asset underperforms and 100% protection should the originator of the underlying asset fail.

It’s worth mentioning that the actual structure of first risk loss notes is far more complex that that of property insurance.