Probable Maximum Loss (PML) is the maximum loss that an insurer would be expected to incur on a policy. Probable maximum loss (PML) is most often associated with insurance policies on property, such as fire insurance. The probable maximum loss represents the worst-case scenario for an insurer.
Breaking Down Probable Maximum Loss (PML)
Insurance companies use a wide variety of data sets, including Probable Maximum Loss (PML), when determining the risk associated with underwriting a new insurance policy, a process which also helps set the premium. Insurers review past loss experience for similar perils, demographic and geographic risk profiles, and industry-wide information to set the premium. An insurer assumes that a portion of the policies that it underwrites will incur losses, but that the bulk of policies will not.
Insurance companies differ on what probable maximum loss means. At least three different approaches to PML exist:
- PML is the maximum percentage of risk that could be subject to a loss at a given point in time.
- PML is the maximum amount of loss that an insurer could handle in a particular area before being insolvent.
- PML is the total loss that an insurer would expect to incur on a particular policy.
Commercial insurance underwriters use probable maximum loss calculations to estimate the highest maximum claim that a business most likely will file, versus what it could file, for damages resulting from a catastrophic event. Underwriters use complex statistical formulas and frequency distribution charts to estimate PML and use this information as a starting point in negotiating favorable commercial insurance rates.
Basic Probable Maximum Loss Calculation
There are several steps in calculating PML:
- Figure out the dollar value of business property to establish the potential financial losses of a catastrophic event. This could be the amount of your property insurance coverage. Otherwise, add real property and business personal property together to reach the valuation.
- Identify risk factors that increase the chances of a catastrophic event could demolish your business. For example, fire risks could include combustible construction materials, clutter, flammable liquids, or other substances used to operate or maintain your business, and distance to the nearest fire station. Risks associated with flooding include the physical location of a business.
- Identify risk mitigation actions that can decrease the chances of said catastrophic losses. These risk mitigation factors could include functioning protection systems, such as alarms, automatic sprinklers, and portable fire extinguishers. Also, consider elements in your emergency action plan that address emergency reporting procedures and policies for protecting business assets.
- Conduct a risk analysis to figure out which risk mitigation factors could decrease the chance of a catastrophic event that would demolish your business.
The difference between these factors determines the maximum loss your business is likely to incur. Insurance companies typically use percentages that increase incrementally by 1 percentage point. For example, an analysis might determine that risk mitigation decreases the chance of a total loss by 21 percent.