Structured finance is back, and with it comes all of the due diligence requirements, including the often misunderstood Probable Maximum Loss Report. Credit officers and underwriters need to understand a few basics about the Probable Maximum Loss Report to meaningfully use these reports as an underwriting tool.
The goal of the process of rating buildings for seismic risk is to protect your portfolio and downstream investors from a double helping of seismic risk. The PML Report cannot completely eliminate risk from a seismic event—we don’t report the distance of the asset to a nuclear reactor—but the PML will fail buildings that are at greatest risk during an earthquake. Note lenders that don’t require PMLs might find that their portfolio suffers from adverse selection; essentially getting a double helping of seismic risk.
To use the Probable Maximum Loss Report well a lender needs consistency. If you are going to measure anything, you want to do it by the same method every time. So here are four basic steps to get consistency.
SEL vs. SUL. Understand the basic vocabulary: Scenario Expected Limit (SEL) and the Scenario Upper Limit (SUL) are two ways to express the Probable Maximum Loss for an asset. An engineer really builds a curve of expected out comes during the 475-year seismic event (see picture). The center of the curve is the Scenario Expected Limit and the point where 90% of the expected outcomes are lower is the Scenario Upper Limit. These numbers are not in conflict with each other, they are just two ways of describing the same curve.
New ASTM Standards for PMLs. In 2007, ASTM published two new standards for Probable Maximum Loss Reports: ASTM E2026-07 Standard Guide for Seismic Risk Assessment of Buildings, and ASTM E2557 Standard Practice for Probable Maximum Loss (PML) Evaluations for Earthquake Due-Diligence Assessments. ASTM E2557 Specifically recommends that CMBS Lenders consider the SEL as the PML. The SEL should be compared to 20%–buildings that rate above 20% typically require some sort of mitigation. Mitigation can be structural (seismic retrofit) or financial (earthquake insurance).
Improve PMLs. These new ASTM Standards improve the process, but are too flexible. For example, the standards do NOT specify how an engineer should calculate a PML and some engineers perform calculations that are out of the mainstream or worse, do no math at all; they just call it based on their judgment. Of course my colleagues may be very good engineers, but what the industry needs is an objective measurement of seismic risk. The process should be transparent and peer reviewable.
Objective reliable Probable Maximum Loss Reports are easily achievable; we just need some help from our clients. Yes, the clients must do their part. If clients require the following we will be more than half of the way there:
1. Only order reports from firms with registered engineers on staff;
2. Require the engineer to show his/her math;
3. Require that the engineer call the Scenario Expected Limit as the PML, but also report the Scenario Upper Limit.
I have participated in writing the Probable Maximum Loss Scope of Work for several lenders and my rational for my recommendations is presented more thoroughly in my RMA Journal article titled Managing Seismic.
The overall goal is not predicting the future, but using the Probable Maximum Loss report consistently as an underwriting tool; and therefore, protecting your portfolio from undue seismic risk.