Distortion Risk Measure

A distortion risk measure is a mathematical tool used to evaluate the risk of financial portfolios by adjusting probability distributions to reflect different levels of risk aversion. It distorts the actual probability of outcomes, placing more weight on extreme losses (tail risk) and less weight on moderate outcomes. This approach helps investors and risk managers understand the potential for catastrophic losses and make better-informed decisions about risk management. By using distortion risk measures, companies can more effectively hedge against unlikely risks that could cause significant financial damage.

Example

When calculating its reinsurance needs, an insurance company uses a distortion risk measure to weigh potential catastrophic losses more heavily.