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Probable Maximum Loss Studies

Uncertainty grows as the number of buildings a PML is applied to decreases.

Damage to buildings from natural disasters is not unique to any one part of the country.

California is not the only state with high potential earthquake risk. Yet many buyers and investors request a Probable Maximum Loss study (PML) only for properties they are considering in California. This is often requested without understanding the basis of a PML or how to use the information.

What is a PML?

PML is a ratio, expressed as a percentage, initially developed by the insurance industry to quantify the expected insured loss after deductible for structural and contents damage from a large earthquake. After the Loma Prieta and Northridge quakes in California the demand for earthquake insurance increased, as did the exposure of the insurance companies. The risk from large earthquakes was deemed higher the more prolonged the duration of shaking.

Probable Maximum Loss is not, however, a precise measure. There is uncertainty in the measure, and that uncertainty grows as the number of buildings it is applied to decreases. In other words, when applied to all insured buildings in a geographic area, a PML has a fair degree of predictive or actuarial value. When applied to a single building, the value has the least certainty.

What Factors Contribute to Seismic Risk?

There are several factors in the calculation of Probable Maximum Loss. These include:

The Structure - Certain types of construction are more prone to damage than others. In addition, when the building was built is an important consideration. Code requirements for earthquake resistance have undergone periodic revisions as more is learned about how buildings perform in earthquakes. After each major earthquake, seismic design requirements have become more rigourous.

Geology - Soil considerations are a major concern. Is the soil prone to liquefaction (a high risk indicator), landslides, or other factors that could undermine the structural stability of the building?

Proximity to Faults - The nearness to an active geologic fault and the potential magnitude of an earthquake that may result from that fault are important considerations. In California, each building may be exposed to several faults. Across the country, there are several faults that have the potential to affect or damage buildings.

Probabilistic Considerations - The probability for any fault to cause an earthquake is stated as the likelihood one will occur within a period of time, usually expressed as 50, 100, 200 or 500 years. The fact that an earthquake may only occur once in 500 years does not mean that it will not occur tomorrow, however. A truer expression is that there is a 1 in 500 chance that it will occur in any given year.

What Methods are Used to Calculate PML?

Different companies use different methods to come up with a PML value. Some use computerized models of building type and location, first developed for the insurance industry.

A second approach is to combine a site inspection with a review of plans, available maps and data to arrive at a subjective determination of PML. These will often rely on the Modified Mercalli Scale which measures (on a scale of I to XII) how strong the earthquake felt, as opposed to the more quantitative (and more familiar) Richter Scale.

A more detailed approach is to perform a thorough structural analysis, calculate failure modes and estimate the cost to repair projected damages. These results are reviewed in relation to computerized models of potential seismic activity to calculate the PML.

PML calculations may also include the cost of business interruption. Investment property cannot produce income until repairs are made. This is an important element of the overall risk equation.

How Can PML Studies be Used in the Real Estate Process?

Since the 1989 Loma Prieta and the 1994 Northridge earthquakes in California, insurance coverage for commercial buildings in high risk areas (zones 3 and 4) has become difficult, if not impossible to obtain. Each investor must therefore determine his/her own risk tolerance. At least one large institutional investor has established a policy whereby any property with a PML of 20 percent or greater is not financed unless measures can be taken to reduce the PML below that level.

Such criteria may not make sense for everyone. Given the uncertainty of the PML, real estate professionals should look at going beyond the initial analysis to a more detailed evaluation of the property's earthquake risk.

Other factors to consider include the cost to upgrade a building to make it more resistant to earthquake damage. Exact costs for such upgrading are usually difficult to obtain without engineering studies, and even then, improvements may be subject to municipal approvals which would not be available until actual designs are complete. Nevertheless, a competent engineer will be able to render an opinion as to whether such potential to improve the property economically even exists. He or she should also be able to make recommendations regarding life safety concerns that when left unmitigated may cause the worst effects of an earthquake: human injury or loss of life from the failure of the structural system to support gravity loads and falling objects.

The real estate professional should also examine the return on investment. The PML for the subject property may be compared to PMLs for properties in the same class, and the difference capitalized as a function of risk.

When reviewing PML studies, be aware that many reports contain much interesting but generic information. The report should represent good value relative to its cost.


PML studies are far from standardized investment tools. An effort is underway through ASTM to develop a "Standard Guide for the Estimation of Building Damageability in Earthquakes." This may result in the creation of a new and more meaningful measure of potential risk.

The real estate investor should exercise caution in placing an overemphasis on PML values in one part of the country without also considering risks from natural disasters elsewhere. Qualified engineers can be of great assistance in helping to understand the significance of these values so that they can be placed in a proper perspective.

The Engineering Advisor is intended to enhance your knowledge of technical issues relating to buildings. For additional information on any subject, please feel free to call us. Our commitment is to provide you with timely, accurate information.

Criterium Engineers, Copyright © 1999