Is Probable Maximum Loss (PML) a good Approach??
PML is defined as the maximum estimated loss that an insurance company will incur in case of any unforeseen events.
So why does PML is an important concept and why do companies often take the conservative approach?
The below example illustrates how does the PML concept works in pricing:
Let us say, a customer approached an insurance company to insure his industry, which is located at Cat4 Seismic Zone. The customer had declared details like occupancy, valuation report, claims history, Manufacturing equipment, risk mitigation controls in the industry etc.. Basis the survey, the surveyor estimated the probable maximum loss is 80%.
With the provided details, the industry is categorized under class D, and as per UW guidelines for class D, insurer can retain Max.25% and should cede 75% to reinsurer as per treaty contract. But insurance company followed a conservative approach and considered PML as 100%. Below mentioned is the calculation for pricing:
- Building cost = 100 Million INR
- PML = 100%
- Sum insured = 100 Million INR
- For Class D Risk: 25% is the retention and 75% is ceding to reinsurer as per treaty contract. So the cedant retains 25 Million and cedes to reinsurer: 75 Million. So the pricing for customers is based on 100 Million INR and reinsurance cost is based on 75 Million INR.
In the same scenario, if the PML is 80%
- Sum insured would be = 80%*100 million = 80 Million
- Cedant= 25%*80 = 20 Million
- Reinsurer = 75%*80 = 60 Million
So the pricing for customers is based on 80 Million INR and reinsurance cost is based on 60 Million INR. Because of PML approach, the insurance company can retain more and cede less (Note: not exceeding treaty limits). When we cede less, our reinsurance cost will be cheap.
So the insurance companies should estimate the accurate PML, so that they can retain more and can save the reinsurance cost. In the case of a conservative approach, the cedant is inadvertently utilizing ceding capacity and ceding more to reinsurer.
Similarly, the benefit of the conservative approach is to secure the position of the insurance company if there is a 100% loss. If the actual loss is greater than the PML, the reinsurer will not pay for the unceded portion and that amount will be a dent on the insurer pocket.
"So its the strategy of the insurance company how they wanted to play the game!!! If it is binded by the regulator, then insurer should comply with. As a best practice it is recommended to use PML approach atleast for Class A and B, however PML can be 100% for Class C and D"