Insurance Underwriting

Underwriting is selecting and classifying risk exposures. To earn a profit in insurance, a proper rate must be set to cover the losses of the insured, to cover the related expenses, and to earn a reasonable profit. To find the proper rate, or premium, actuarial studies are used to determine what characteristics of the insured can be used to forecast future losses. The proper rate, then, depends on those characteristics. The 2nd requirement to earn a profit in insurance is to make sure that those rates are applied only to those insurance applicants that have those characteristics. Underwriting is accurately classifying insurance applicants according to those rating variables; otherwise, the rates based on actuarial studies may not cover the exposure that the insurance company is undertaking if they misclassified the applicants or selected the wrong applicants. In essence, underwriting strives to charge the right rates to the right applicants. Stated another way, the primary goal of underwriting is to minimize the difference between actual losses and expected losses for each insured.

Successful underwriting requires that there be an adequate volume of exposures for each rating class, with a minimum concentration of exposures. It also requires good judgment and thorough knowledge of the underwriting criteria and knowing how to avoid mistakes in selections that often occur with each type of coverage.

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Every insurance company has an underwriting guide that specifies the underwriting policy: what lines of insurance will be covered; prohibited exposures; amount of coverage allowed for each exposure; permitted geographic areas for each line of insurance; and any other restrictions deemed pertinent to the underwriting process; forms rating plans to be used; acceptable, borderline, and prohibited business; amounts of insurance to be written; insurance applications that require approval by a senior underwriter.

Underwriting policies conform to company objectives, which may be to sell large-volume at low profit or vice versa.

The underwriting policy may also have specific procedures for rating applicants. For instance, most life insurers use a numerical rating system, assigning a point for each type of physical disability or other variable that increases expected mortality above standard risks, with the premium surcharge applied commensurate with the increased risk. Surcharges may only apply for the 1st few years or for the entire term of the policy. In the 1st few years, the life insurance benefit may be limited to the premiums paid.

Because much of the underwriting is done by agents in the field, they are sometimes referred to as field underwriters. A desk underwriter, also known as a line underwriter, ensures that the insurance applicants have been properly classified by the insurance sales agents. Although the term underwriter is often applied to life insurance agents, underwriting is generally more important for property and liability insurance, because there is much greater variation in the ratemaking variables, and thus, in the underwriting criteria. Indeed, property and liability insurance agents are often paid a contingency contract or profit-sharing contract, which pays them an additional commission if the insurance business they underwrite is profitable.

In many cases, such as for property and liability insurance, the insurance agent often has the authority to bind the insurance company when the policy is sold. However, the company underwriter can cancel the policy afterwards, within certain time limits, if the application does not conform to underwriting guidelines.

Nowadays, underwriting decisions are computerized for those lines of insurance that are standardized, such as auto and homeowner's insurance. Nonetheless, the information provided to the computers must still be accurate.

Primary Objectives of Underwriting

The primary purpose of careful selection is to avoid adverse selection, to reject those insurance applicants who are posing as a standard risk, even though they are actually a higher risk.

The 2nd underwriting principle is to have proper balance within each rate classification, meaning that those with higher than expected losses should be offset by those with lower than expected losses. Insurance applicants with similar loss-producing characteristics are grouped together.

Each member of the class is charged the same rate, but not all will have the same actual losses. Therefore, the basis for establishing the premium will not be valid unless those with higher actual losses are offset by those with lower actual losses.

The final underwriting principle is that there must be equity among policy owners, where the same rate should be charged for each insurance applicant that has the same expected losses. Otherwise, charging the same rate to a group where the individuals have a different expected loss would create a situation where those with lower losses or subsidizing those with higher losses. Eventually, the overcharged subgroup will eventually find lower insurance rates offered by other companies, leaving the individuals with higher expected losses in the subsidized group, which will create losses for the insurance company.

Underwriting Process: Getting Enough Information about the Insurance Applicant

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Selecting insurance applicants means selecting those whose expected loss ratio does not exceed the expected losses assumed in the ratemaking analysis. To prevent adverse selection and to ensure the accurate classification of the insurance applicant, underwriters must obtain as much knowledge about the insurance applicant as permitted by time and cost. Generally, desk underwriters examine each insurance application submitted by the agents and will usually obtain additional information from other sources. The underwriter gets this information from: the insurance application; information provided by the agent or broker; from external agencies; and from physical examinations or inspections. The weight given to the information provided by the agent or broker depends on his experience and his relationship with the desk underwriter. In certain cases, where the insurance company wants to retain a valuable agent or client, the company may accept some risks, known as accommodation risks, that it would otherwise not accept.

Information provided by external agencies includes credit reports; public agencies, such as the Department of Motor Vehicles; cooperative information bureaus in the insurance industry; and for commercial insurance, a Dun & Bradstreet report. Additionally, insurance companies put information into specialized databases that other insurance companies can use to investigate underwriting variables and claims history. For instance, LexisNexis Risk Solutions, formally known as ChoicePoint,  maintains a database called the Comprehensive Loss Underwriting Exchange (CLUE database) listing an insurance applicant's history of property and liability claims; information provided in applications for life insurance are stored in the Medical Information Bureau (MIB). Companies that belong to the Medical Information Bureau (MIB.com) report any health impairments to the Bureau, which is then made available to other member companies.

Any physical examinations are typically conducted by physicians selected by the insurance company in the case of life insurance, or by the agent or company representative, in the case of property and liability insurance.

After obtaining adequate information, the underwriter has 3 choices in regards to the application: accept the application; accept the application but with restrictions or modifications; reject the application. An insurance applicant will be rejected if the rate being charged does not seem adequate to cover the expected losses.

You can request your own file from the Medical Information Bureau at MIB.com - Request Your MIB Consumer File , which will allow you to correct any mistakes, and you can see what they have on you. Likewise, for the CLUE reports: You can obtain free copies of your CLUE Auto Report and CLUE Personal Property Report at LexisNexis Personal Reports.

Insurance Scores

Insurance scores, based on the same information used to calculate credit scores, but using a slightly different algorithm, have long been used to underwrite auto insurance and homeowners' insurance. This policy is based on actuarial studies that have shown that people with lower credit scores are more likely to file claims.

LexisNexis Risk Solutions, formally known as ChoicePoint, which was a spinoff of Equifax, the credit reporting agency,  provides most of the information used to calculate insurance scores. An insurance company may also use credit scores, in addition to insurance scores, although they are not likely to differ by much. The use of insurance scores has been criticized, since it results in higher rates for people with a poor credit history, which includes many poor people and minorities, but actuarial studies have shown undisputedly that insurance scores and even credit scores, are effective prognosticators of future claims. There is some plausibility to the fact that if a person manages their credit effectively, they will also manage other risks effectively.

Some states, such as California, Georgia, Hawaii, Maryland, Oregon, and Utah have prohibited the use of credit-based scores, at least under certain conditions. Additionally, some states require that some insured be re-rated if the original rate was based on an incomplete or incorrect credit history.

Postselection Underwriting

Underwriting may also be used after the insurance applicant has been accepted in cases where the insurance is cancelable or renewable. A re-examination of the risks may be undertaken for major claims by the insured. An investigation or re-examination of the policy may occur before a policy is renewed, if the insurance company suspects that risks have increased, in which case, the insurance company may increase the deductible or the premium, or even decline to renew the policy.

Restrictions on postselection underwriting/cancellation or nonrenewal of a policy may place undue hardship on some individuals or businesses. Therefore, most states have laws restricting postselection underwriting.

Some of these restrictions merely require advance notice to the insured that the policy will not be renewed, thereby giving the insured time to seek replacement coverage. Some states prohibit cancellation for some lines of insurance after the policy has been in effect for a certain duration. Federal law also mandates that underwriting may not be based on age, sex, occupation, race, or domicile. To enforce these laws, the insurer must explain the reason for the cancellation or for refusing to ensure a particular applicant.

With greater restrictions on postselection underwriting, Insurers are performing greater due diligence before accepting new insurance applicants.

With increased automation and the increased use of databases, more information is becoming available for insurers and other companies to collect about an individuals and businesses. Predictive analytics is mining this data in databases to forecast future outcomes, such as losses or behavior. Underwriting is almost certainly going to use more of this information in the future to better assess risk and to refine their underwriting models.

Group Underwriting

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For group insurance, individual evidence of insurability is usually not required, so a different set of underwriting principles are followed: insurance must be incidental to the group; continual flow of younger persons through the group, replacing older members of the group who leave; automatic determination of benefits; minimum participation requirements; third-party sharing of cost; simple and efficient administration.

Insurance should be incidental to the group, meaning that the group should not be formed solely to obtain the insurance, because otherwise people with larger than average losses will be inclined to join the group, resulting in adverse selection. The continual flow of younger persons entering the group and older persons leaving the group maintains equity and helps to maintain average premiums for the employer. Benefits that are determined by some formula rather than having the individual select the insurance amounts helps to reduce adverse selection. Minimum participation ensures that the insurance pool is large enough to lower expenses administering the group and also helps to prevent adverse selection.

A third-party sharing the cost of insurance is usually employer, which is necessary since if the employee were paying the entire amount, then younger employees would be subsidizing the older employees, with the result that the younger employees may seek insurance from other companies that would be cheaper. Third-party plans also make it more likely that all members of the group will participate in the insurance.

Paying the premiums through payroll deductions reduces the insurer's administrative expenses and maintains high retention of the insured.

Underwriting Cycles

Underwriting continually moves through a cyclical pattern of varying underwriting stringency, premium levels, and profitability.

Insurance often fluctuates between periods of tight underwriting standards and high premiums and loose underwriting standards and low premiums. The former is referred to as a hard insurance market, whereas the latter is a soft insurance market. The cycle occurs as insurance companies compete for more business during years of greater profitability, then decreasing risk and lowering losses through tighter underwriting standards and higher premiums when profits are lower or even negative. In soft insurance markets, insurance companies compete for more customers by not only offering lower premiums, but also providing broader coverage with fewer exclusions. Underwriting will also generally be more liberal if there is favorable reinsurance available.

A hard insurance market is the opposite. When insurance companies start losing money, their underwriting requirements become more restrictive, with higher premiums and more restrictions and exclusions. Other causes of losses in the insurance industry is excess insurance industry capacity and lower investment returns. Insurance industry capacity is the relative level of surplus, how much the insurer's assets exceeds its liabilities. Surplus declines when excessive competition or lower investment returns causes premiums to be inadequate to cover losses. Additionally, some catastrophes can be so great, that many insurance companies, including those in different lines of insurance, simultaneously suffer horrendous losses, resulting in what is called a clash loss, such as the losses that occurred in the 2001 World Trade Center terrorist attack.