Normal Loss Expectancy

Normal loss expectancy is the amount of loss an insurance company expects to incur during standard conditions. Normal loss expectancy represents the amount of loss an insurer may face if, despite all risk mitigation systems and processes working correctly, damages still occur.

When an insurance company underwrites a new insurance policy, it agrees to cover the policyholder against a specific peril in exchange for a premium. The amount of premium charged has to be adequate to cover expected losses. If the established premium is too high, the potential policyholder may go to a competing insurer to obtain a lower rate. If the set premium is too low, the insurance company may find that it must dip into its capital reserves to cover losses. Rate-setting is thus a critical aspect of the underwriting process.

Insurance companies set premium rates based on loss expectancies. Three loss expectancy scenarios commonly evaluated by insurers include maximum foreseeable loss (MFL), probable maximum loss (PML), and normal loss expectancy. Both maximum foreseeable loss and probable maximum loss assume some systemic failure occurs.

For a normal loss expectancy, a fire may damage part of a warehouse. However, because the fire suppression system worked correctly, the fire was extinguished quickly. Alternatively, if no fire suppression system were in place, the normal loss expectancy would be based on a successful and timely fire department response.

With property insurance, insurers may require the insured to follow specific risk-mitigation procedures and maintain specific physical systems designed to limit losses. Looking at our fire example again, a property insurance policy may require a building have a fire suppression system in order to be insured. 

Insurance companies take mitigation options, such as fire suppression systems, into account as they evaluate loss expectancies for any policy they underwrite. If the insurer does not require risk mitigation systems be in place, it would likely have to increase its loss expectancy estimates. Increases in expected losses will, in turn, cause an increase in premium to the policyholder.