Probable maximum loss is a term used in both the insurance and commercial real estate industries to designate the value of the largest loss that could result from a disaster.
Examples of these disasters include fires, floods, and earthquakes.
Here’s what you should know if you’re interested in what probable maximum loss means and how it’s calculated.
1. What is probable maximum loss (PML)
Probable maximum loss refers to the maximum loss that an insurer would be expected to incur on a policy.
Often, PML is associated with insurance policies on properties.
For example, if the property has fire insurance, it is the maximum loss expected at a given location in the event of a fire there.
PML represents a worst-case scenario from the insurer’s perspective.
It assumes that there is no failure of existing safeguards like fire sprinklers (in the event of a fire) or flood barriers (in the event of a flood).
PML is normally lower than the maximum foreseeable loss, which represents the potential damage if safeguards fail.
Probable maximum loss is expressed in dollars or as a percentage of total values.
2. How does probable maximum loss work?
When determining the risk associated with a new insurance policy, insurance companies use various data sets.
These data sets include PML.
They review the past loss experience for similar perils along with any industry information or demographic and geographic risk profiles.
All this information helps set the premium.
Insurers know that some policies will incur losses but most policies will not.
It must keep this in mind, so it has enough money to pay out on claims.
PML is a critical factor in determining how much money insurers should set aside just in case.
3. Are there different definitions of PML?
Yes, depending on the insurer, there are some differences in what probable maximum loss means.
Here are three core approaches to PML.
Approach #1: The maximum percentage of risk that could be subject to a loss at a given point in time
Approach #2: The maximum amount of loss that an insurer could handle in a particular area before being insolvent
Approach #3: The total loss that the insurer would expect to incur on a specific policy
4. How do commercial insurance underwriters use probable maximum loss?
This role uses PML to estimate the highest maximum claim that a business will (most likely) file compared to what it could file for damages related to a catastrophic event.
They’ll use statistical formulas and frequency distribution charts to estimate the PML.
This information can be used as a starting point in negotiating favorable commercial insurance rates.
5. How do you calculate probable maximum loss?
Step 1: Find the dollar value of the property.
This will help you find the potential financial loss from a catastrophic event if the entire property was destroyed.
Step 2: Define the risk factors that prompt an event and lead to damage or loss of the property.
Examples of risk factors include location, building materials, etc.
Step 3: Consider risk mitigation factors that can prevent damage or loss.
For example, for fires, these could include the proximity to a fire station, alarms, and sprinklers.
Step 4: Perform a risk analysis to determine the scale at which mitigating factors will reduce the probability of an event that would lead to damage or loss of the property.
Step 5: Multiply the property value by the expected loss percentage.
This is the difference between the expected loss and risk mitigating factors.
6. What’s the difference between Estimated Maximum Loss and Probable Maximum Loss?
Both these terms are used to understand the extreme consequences of loss for a given risk.
EML is similar to PML; however, it may rule out “remote coincidences,” so it tends to be slightly lower than PML.
7. What’s the difference between maximum foreseeable loss and probable maximum loss?
Probable maximum loss tends to be lower than the maximum foreseeable loss.
MFL (maximum foreseeable loss) designates the damage if the safeguards put in place to protect against major events fail to do their job.
8. What is the normal loss expectancy?
The normal loss expectancy assumes that all the safeguards worked correctly.
In this case, the damage will be limited to 10 percent of the insured value of the property.
9. What is the maximum probable loss from an investment?
The maximum probable loss from an investment is the maximum percentage of risk that can be subject to a major loss at any given time.
Final Thoughts
Understanding probable maximum loss is important when acquiring insurance (especially for a commercial real estate property) because it represents the worst-case scenario for an insurer.
Knowing what this figure is will allow you to be prepared should your property ever undergo a fire, flood, or another tragedy.
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Disclaimer: we are not lawyers, accountants or financial advisors and the information in this article is for informational purposes only. This article is based on our own research and experience and we do our best to keep it accurate and up-to-date, but it may contain errors. Please be sure to consult a legal or financial professional before making any investment decisions.
Prior to starting Gokce Capital, Erika received a Bachelor of Architecture from the University of Southern California and a graduate degree in Urban Policy from Columbia University. She worked as both an architectural designer and engineer in New York before joining the New York City Department of Housing Preservation and Development.
Erika currently lives in the New York Metropolitan area with her spouse, daughter and cat. She is originally from Chicago and still considers herself a midwesterner at heart.
Erika also loves to read, write and travel (fun fact, she has visited all 50 states and more than 30 countries!). Her new book, Land Investing Mistakes: 11 True Stories You Need To Know Before Buying Land, is now available on Amazon.