Probable Maximum Loss: Definition & Calculation

KEY TAKEAWAYS

• The maximum loss that an insurer is anticipated to suffer as a result of an insurance policy is known as the probable maximum loss (PML).
• Insurers employ a variety of models and data to assess the risk involved in a policy’s underwriting, including the likely maximum loss (PML).
• Each insurance provider has a unique definition and method for determining probable maximum loss (PML).
• The following variables are taken into consideration while calculating probable maximum loss (PML): property value, risk factors, and risk mitigating variables.
• The probable maximum loss (PML) is lower the more risk mitigating factors there are.

What Is Probable Maximum Loss?

The probable maximum loss (PML) is the absolute maximum loss that an insurance company can be expected to incur on any given insurance policy. It is a term that is most commonly associated with insurance policies for properties. This tends to be things such as flood insurance or fire insurance. 

The probable maximum loss is regarded as the worst-case scenario for whoever the insurer is. This is under the assumption that there is no failure of existing safeguards. Common safeguards would be flood barriers or fire sprinklers. PML tends to be lower than the maximum foreseeable loss. Which is the potential damage if these safeguards fail to do their job. 

Probable Maximum Loss Assessment

When assessing the risk involved in insuring a new insurance policy, insurance firms employ a wide range of data sets, including probable maximum loss (PML). This also aids in setting the premium that is to be paid. To determine the premium, insurers look at historical loss data for comparable risks, demographic and regional risk profiles, and data from the entire industry.

An insurer would anticipate that a small percentage of the policies it underwrites may result in losses. But they would also know that the majority of them won’t. The expected maximum loss is one of many measures that helps calculate the amount of funds needed by an insurance business to ensure that it has adequate money to pay claims under policies.

How Do You Calculate Probable Maximum Loss?

There are five main steps when calculating PML:

1. Dollar value

The first step is determining what the dollar value of the property is. You can then arrive at the potential loss financially if the entire property was destroyed. 

2. Risk

You then need to determine the risk factors that are most likely to cause an event that would lead to the loss or damage of the property. 

3. Mitigation

The next step is taking the factors that are risk-mitigating into account. These are any factors that can prevent major loss or damage. 

4. Analysis

You will then need to perform a risk analysis to figure out the likelihood that the risk-mitigating factors will reduce the probability of such an event occurring. 

5. Calculation

The final step is multiplying the value of the property by the expected loss percentage. The expected loss percentage is the difference between the risk-mitigating factors and the expected loss.

Summary

For insurers, the probable maximum loss is an important aspect. This is especially true when considering the premiums of insuring property that has a risk of a major event happening to it. However, insurers will know that most of their insurance policies will never have any significant claim. This means that they can reliably make a regular profit and have enough spare capital to cover any significant losses.