Probable Maximum Loss: Definition and How to Calculate It

Probable Maximum Loss

Investopedia / Theresa Chiechi

What Is Probable Maximum Loss (PML)?

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 or flood insurance.

The probable maximum loss (PML) represents the worst-case scenario for an insurer, provided that there is no failure of existing safeguards, such as fire sprinklers or flood barriers. This is usually lower than the maximum foreseeable loss, the potential damage if such safeguards fail.

Key Takeaways

  • The probable maximum loss (PML) is the maximum loss that an insurer is expected to lose on an insurance policy.
  • Insurers use various models and data to determine the risk associated with underwriting a policy, which includes the probable maximum loss (PML).
  • Each insurance company defines and calculates probable maximum loss (PML) in a different manner.
  • Calculating probable maximum loss (PML) takes into account the following factors: property value, risk factors, and risk-mitigating factors.
  • The more risk-mitigating factors there are, the lower the probable maximum (PML) loss is.

Understanding 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 that 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. An insurance company must always ensure that it has enough funds to pay out claims on policies, and the probable maximum loss is one of many metrics that helps determine the amount of funds required.

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.

How to Calculate PML

There are several steps in calculating PML:

  1. Determine the dollar value of the property to arrive at the potential financial loss from a catastrophic event if the entire property was destroyed.
  2. Determine the risk factors that are likely to cause an event that would lead to damage or loss of the property. This can include the location of the property; for example, properties on the ocean's shore are more prone to flooding. It can also include building materials; buildings made of wood are more susceptible to fire.
  3. Take into consideration risk-mitigating factors that can prevent damage or loss, such as proximity to a fire station, alarms, and sprinklers.
  4. A risk analysis will need to be performed to determine the scale at which the risk-mitigating factors will reduce the probability of an event that would lead to damage or loss of the property.
  5. The last step involves multiplying the value of the property by the expected loss percentage, which is the difference between the expected loss and the risk-mitigating factors. For example, if a home is on the shore and its value is $300,000, and the house has been raised on stilts to avoid flooding as a risk-mitigating factor, which reduces the expected loss by 30%, then calculating the probable maximum loss would be $300,000*(100%-30%) = $210,000.

The example above is a simplified version and the more risk-mitigating factors that a property has, the further the probable maximum loss will be reduced. Most properties are at risk of damage by a variety of means and so ensuring protection against all variables will not only benefit an insurance company in the amount they will have to cover in case of a catastrophic event, but it will also reduce the premiums a policyholder will have to pay.

What Is EML Risk?

EML risk is "estimated maximum loss" in insurance. It is an estimate of the maximum loss that insurance companies can expect on a policy. To arrive at the estimate, insurance companies base the number on previous losses, so there is no specific formula they utilize to arrive at EML.

What Is an Example of Probable Maximum Loss?

An example of probable maximum loss (PML) would be an insurance company underwriting a fire policy for a small business. Based on the insurance company's modeling, it determines the PML on this policy is $150,000, meaning that the most it would have to pay out if the building of this small business burns down is $150,000.

Who Is Responsible for Calculating Probable Maximum Loss?

An insurance company is responsible for calculating probable maximum loss on all of the insurance policies that it underwrites. It helps an insurance company manage its finances.

The Bottom Line

The probable maximum loss (PML) is the worst-case scenario for an insurance company should it need to pay out on a policy. Knowing the PML helps insurance companies manage their underwriting, costs, and revenues, as well as their ability to make good on claims.