Yep Doug has it right, the penalty is designed to equalize the combatants.
In practice it doesn't actually penalize the attacker that badly, from my observations.
For example, if the attacker sends 100k attack points against a defender who only has 50k defense, and say the defender is 80% KS, the attacker is still overpowering the defender by 30k more attack points, so the defender still gets overwhelmingly crushed/zeroed out.
That's why most of the reports we get are from defenders that complain the penalty wasn't harsh enough. While on the flip side, an attacker that sends a comparable/equal sized army against someone smaller will have more apparent losses. Which is how it would be without the paltry penalty as well.
The attacker can still win even if heavy losses, as long as they reach the win calc rules.
I can look at the detailed report later, but what I'm guessing happened is the orc lost heavy casualties in the ranged phase, and had bad luck for their shadow warriors in the melee roll so they failed to hide resulting in their extermination.
