In some cases these two terms are used interchangeably. They are both designed to give an actuarial measure of the risk that an insurer faces on a policy. They are both commonly used with respect to real estate insurance and in particular to fire risks. Yet they are slightly different and you need to use somewhat different assumptions and criteria to accurately factor each of them.
Estimated Maximum Loss
The Estimated Maximum Loss (or the EML) is an estimate of the maximum loss that can be sustained by the insurer on a single risk. That risk must be considered to be within the realms of probability. The estimate can (and usually will) ignore any “remote coincidences” even if they are possible. (That last sentence means that if something is considered particularly unlikely to happen – it should be ignored for the EML calculation).
Probable Maximum Loss
The probably maximum loss is an estimate of the maximum loss that can be sustained by the insurer on a single risk. That risk must be assessed with due care and “take into account all the elements of risk”. What that means is that you would consider the worst case scenario; that the incident that triggers the loss takes place in the worst place and at the worst time.
So Which is the Better Measure?
That’s a great question and as with all things in the world of finance and insurance; the right answer is “it depends”. It is up to the insurer to decide which they feel is the more valuable measure to base their premium calculations, etc. upon. There are advantages and disadvantages to either method and the insurer will normally use the measure that seems most reasonable for the calculation in hand based on their experience. The insurer is also free to use both methods in different circumstances.
What are the Practical Differences between the Two Measures?
The EML is calculated based on the idea that any protective equipment and/or alarms are not in service (or indeed that they don’t exist at all). It assumes that any competent assistance to deal with an event won’t arrive on time. It assumes that any fire (or other event that causes the loss) may spread freely but that any sealed wall will hold. The calculation ignores any other unlikely events (for example – there’s no effort spent calculating the risk that a plane will crash into the building).
In the case of the PML it assumes that alarms and protective equipment are not in service and that there is no competent assistance (e.g. the fire brigade turns up but fails to put out the fire). It assumes the worst case scenario wherever possible.
That’s Not a Huge Difference…
You’re right. In fact it’s a minor difference at best but if you’re talking about billions of pounds of coverage; minor differences can add up to substantial differences in your risk profile, your insured risk portfolio and the premiums you can collect on a policy.