Probable Maximum Loss Considerations in Commercial Fire Insurance Underwriting: An ISO Perspective

By William Raichle, Vice President, ISO Risk Decision Services and John Vorbeck, Manager, Risk Engineering Group, ISO Risk Decision Services

Fire is generally considered the most critical hazard in the underwriting process, whether covered separately or as part of a package. In comparing the potential loss among buildings and in evaluating a single building, underwriters consider the Probable Maximum Loss (PML). The most common definition of PML — and the definition ISO adopts for commercial fire purposes — is an estimate of the largest loss a building or a business in the building is likely to suffer because of a single fire, assuming proper functioning of the existing mitigation features (sprinklers, local fire department response, etc.). The PML is usually expressed in terms of dollar value or as a percentage of the building’s value. PML analytics and calculations are generally based on engineering.

PML analytic assessments, as well as the amount of reinsurance ceded on a risk, often influence underwriting decisions. But the extent to which such decisions reflect PML varies among insurers. It deserves more universal appeal, in part because the variance in PML among otherwise similarly appearing property risks is simply too great to ignore.

ISO’s engineering unit accounts for variance in construction, occupancy, and fire protection in developing PML assessments.

Construction

The construction factor may be based simply on the overall construction class:

  • Construction Class 1 — Frame
  • Construction Class 2 — Joisted masonry
  • Construction Class 3 — Non-combustible (metal)
  • Construction Class 4 — Masonry non-combustible
  • Construction Class 5 or 6 — Fire resistive

Or it can involve more detail and take into account:

  • walls, considering combustible, noncombustible, and fire-resistive components
  • floors and roofs, considering combustible, noncombustible, and fire-resistive components
  • special features of concern, such as combustible expanded plastic insulation and exterior insulation finish systems (EIFS)
  • building size, taking into consideration the mitigating effects of fire walls in limiting the spread of fire damage to one area
  • year built, recognizing improvements in building codes

Occupancy

Occupancy should take into account the combustibility of contents, which measures the fire-loading effect of contents on damage to the building structure, and the susceptibility of contents, which measures damage to merchandise or materials from either the direct or resultant effects of fire, smoke, and/or water. Occupancies containing food products have an unusually high potential for loss. Some products, such as clothing or electronics, lose their value and you may not be able to restore them to original condition.

Fire Protection

Fire-protection features include both private and public protection. Private, on-site protection may include automatic fire-detection services and automatic fire sprinkler systems. The sprinkler component may simply be based on whether or not such a system exists. It can also take into consideration additional details from the ISO Automatic Sprinkler Grading, such as the adequacy of the system for the potential demands of the building and contents, its relative reliability, maintenance records of system components, and unsprinklered areas. Sprinkler system demand may be based upon National Fire Protection Association occupancy classifications.

For example:

  • Light Hazard includes occupancies, such as churches, schools, and offices, where the quantity and/or combustibility of contents are low and where the fires release relatively low rates of heat.
  • Ordinary Hazard Group 2 occupancies are those with moderate to high contents combustibility, such as dry cleaners, libraries with large stack room areas, and markets.
  • Extra Hazard Group 1 covers occupancies with very high contents combustibility, where dust, lint, or other materials introduce the probability of rapidly developing fires with high rates of heat release, such as die casting, plywood manufacturing, and printing (using low-flash-point inks).

Public protection takes into account the protection provided by the responding local fire department and its access to water supply for fire suppression. This analysis typically accounts for the at-risk ISO Public Protection Classification (PPCTM).

Interdependencies

The damage to the building structure will vary greatly depending on the construction, occupancy, and protection. For example, a match manufacturing operation within a frame building with no sprinkler system located within a PPC 9 fire district is far more likely to suffer a maximum loss than a fully sprinklered, fire-resistive office building in a PPC 3 community.

Nonsprinklered apartment buildings, condominiums, and hotels of superior construction and well-compartmentalized are normally built to confine a typical fire to the room or apartment of origin.

Zoning changes may come into play in partial-loss situations where regulations may no longer permit you to rebuild or restore a particular type of building or occupancy. In other cases, there may be significant environmental damage associated with contamination resulting from a fire. Changes in occupancy may affect loss potential. A mill-type building now used for only ordinary hazard storage may have originally been a manufacturing occupancy. Oil-saturated wood floors may no longer be evident but still contribute significantly to fire load.

Better Underwriting Decisions

PML analytics and assessments provide important information to help insurers recognize their exposure to exceptional losses. Insurers that incorporate PML in their underwriting guidelines can better understand the extent of risk involved — and better manage it through hazard and loss analyses. The analytic tools of PML also help insurers address the underlying intent of company underwriting guidelines, determine the amount of reinsurance, and satisfy reinsurance arrangements — leading to better underwriting decisions.