Confidence Insurance Group s.a.l

Underwriting has to do with the selection of subjects for insurance in such a manner that general company objectives are met. The main objective of underwriting is to see that the risk accepted by the insurer corresponds to that assumed in the rating structure. There is often a tendency toward adverse selection, which the underwriter must try to prevent. Adverse selection occurs when those most likely to suffer loss are covered in greater proportion than others. The insurer must decide upon certain standards, terms, and conditions for applicants, project estimated losses and expenses through the anticipated period of coverage, and calculate reasonably accurate rates to cover these losses and expenses. Since many factors affect losses and expenses, the underwriting task is complex and uncertain. Bad underwriting has resulted in the failure of many insurers.

In some types of insurance major underwriting decisions are made in the field, and in other types they are made at the home office. In the field of life insurance the agent’s judgment is not accepted as final until the home-office underwriter can make a decision, for the life insurance contract is usually noncancelable, once written. In the field of property and liability insurance, on the other hand, the contract is cancelable if the home-office underwriter later finds the risk to be unacceptable. It is not uncommon for a property and liability insurer to accept large risks only to cancel them at a later time after the full facts are analyzed. The insurance underwriter must tread a thin line between undue strictness and undue laxity in the acceptance of risk. The underwriter’s position is not unlike that of the credit manager in a business corporation, in which unreasonably strict credit standards discourage sales but overly weak credit standards invite losses.

An important initial task of the underwriter is to try to prevent adverse selection by analyzing the hazards that surround the risk. Three basic types of hazards have been identified as moral, psychological, and physical. A moral hazard exists when the applicant may either want an outright loss to occur or may have a tendency to be less than careful with property. Apsychological hazard exists when an individual unconsciously behaves in such a way as to engender losses. Physical hazards are conditions surrounding property or persons that increase the danger of loss.

An underwriter may suspect the existence of a moral hazard on applications submitted by persons with known records of dishonesty or when excessive coverage is sought or the replacement value of the property exceeds its value as a profit-making enterprise. Underwriters are aware that fire losses are more likely to occur during business depressions. The underwriter can detect moral hazard in various ways: An applicant’s credit may be checked; courthouse and police records may reveal a criminal history or a history of bankruptcy; and other insurance companies can be queried for information when it is suspected that an individual is trying to obtain an excessive amount of coverage or has been turned down by other insurers.

The psychological type of hazard can take a number of forms. Some persons are said to be “accident-prone” because they have far more than their share of accidents, suggesting that unconsciously they want them. It is well known that persons applying for annuities tend to have longer than average lives, and consequently a special mortality table is used for annuitants. Certain types of insanity have to be watched for—notably the impulse to set fires.

Physical hazards include such things as wood-frame construction in buildings, particularly in areas where such properties are densely concentrated. Earthquake insurance rates tend to be high where geologic faults exist (as in San Francisco, which is built almost directly over such a fault).

Each kind of insurance has its characteristic hazards. In fire insurance the physical hazards are analyzed according to four major factors: type of construction, the protection rating of the city in which the property is located, exposure to other structures that may spread a conflagration, and type of occupancy.

In underwriting automobile insurance, the underwriter considers the following factors: the age, sex, and marital status of the driver and members of the driver’s household; length of driving experience; occupation; stability of employment and residence; physical impairments; accident and conviction record; extent of use of alcohol and drugs; customary use of the vehicle; age, condition, and maintenance of the vehicle; and records of insurance cancellation or refusal. In some cases tests of emotional maturity are administered. Some underwriters even consider such factors as the school records of student drivers and whether or not driving courses have been taken.

The hazards considered in the underwriting of general liability insurance depend on the type of business and the record of the person applying for coverage. In the field of contracting, for example, the underwriter is interested in the type of equipment owned or rented by the applicant; the applicant’s losses in the past, attitude toward safe practice, cooperation with building inspectors, and financial position and credit standing; the stability of supervisory employees; and the degree to which the applicant has been a successful contractor in the past.

Closely associated with underwriting is the rate-making function. If, for example, the underwriter decides that the most important factor in discriminating between different risk characteristics is age, the rates will be differentiated according to age.

The rate is the price per unit of exposure. In fire insurance, for example, the rate may be expressed as $1 per $100 of exposed property; if an insured has $1,000 of exposed property, the premium will thus be $10. The rate reflects three major elements: the loss cost per unit of exposure, the administrative expenses, or “loading,” and the profit. In property insurance, approximately one-third of the premium covers expenses and profit, and two-thirds covers the expected cost of loss payments. These percentages vary somewhat according to the particular type of insurance.

Rates are calculated in the following way. A policy, for instance, may be written covering a class of automobiles with an expected loss frequency of 10 percent and an average collision loss of $400. The expenses of the insurer are to average 35 percent of the premium, and there must be a profit of 5 percent. The pure loss cost per unit is 10 percent of $400, or $40. The gross premium is calculated by the formula L/[1 - (E + P)], in which L equals the loss cost per unit, E equals the expense ratio, and P equals the profit ratio. In this case the gross premium would be $40/[1 - (.35 + .05)], or $66.67.

Four basic standards are used in rate making: (1) the structure of rates should allocate the burden of expenses and costs in a way that reflects as accurately as possible the differences in risk—in other words, rates should be fair; (2) a rate should produce a premium adequate to meet total losses but should not bring unreasonably large profits; (3) the rate should be revised often enough to reflect current costs; and (4) the rate structure should tend to encourage loss prevention among those who are insured.

Some examples will illustrate the nature and application of the criteria outlined above. In life insurance, the rate is generally more than adequate to meet all reasonably anticipated losses and expenses; in other words, the insured is charged an excessive premium, part of which is then returned as a dividend according to actual losses and expenses. The requirement that the rate reflect fairly the risk involved is much more difficult to achieve. In workers’ compensation insurance, the rate is expressed as a percentage of the employer’s payroll for each occupational class. This may seem fair enough, but an employer with relatively high-paid workers has fewer employees for a given amount of payroll than one whose workers are paid a lower wage. If the two employers fall into the same occupational class and have the same total payroll, they are charged the same premium even though one may have a larger number of workers than the other and hence greater exposure to loss. Fairness may be an elusive goal.

Insurance rates are revised only slowly, and, since they are based upon past experience, they tend to remain out of date. In life insurance, for example, the mortality tables used are changed only every several years, and rate adjustments are reflected in dividends. In automobile insurance, rates are revised annually or even more often, but they still tend to be out of date.

Two basic rate-making systems are in use: the manual, or class-rating, method and the individual, or merit-rating, method. Sometimes a combination of the two methods is used.

A manual rate is one that applies uniformly to each exposure unit falling in some predetermined class or group, such as people of the same age, workers of one employer, drivers meeting certain characteristics, or all residences in a given area. Presumably the members of each class are so homogeneous as to be indistinguishable so far as risk characteristics are concerned.

Merit rating is used to give recognition to individual characteristics. In commercial buildings, for example, fire insurance rates depend on such individual characteristics as the type of occupancy, the number and type of safety features, and the quality of housecleaning. In an attempt to reflect the true quality of the risk, a percentage charge or credit may be applied to the base rate for each of these features. Another example is found in employer group health insurance plans where the premium or the rate may be adjusted annually depending on the loss experience or on the amount of claims service provided.

In order to obtain broader and statistically sounder rates, insurers often pool loss and claims experience by setting up rating bureaus to calculate rates based on industry wide experience. They may have an agreement that all member companies must use the rates thus developed. The rationale for such agreements is that they help insurers meet the criteria of adequacy and fairness. Rating bureaus are used extensively in fire, marine, workers’ compensation, automobile, and crime insurance.

Profits in property and liability insurance have tended to rise and fall in fairly regular patterns lasting between five and seven years from peak to peak, this phenomenon is termed the underwriting cycle. Stages of the underwriting cycles may be described as follows: initially, when profits are relatively high, some insurers, wishing to expand sales, start to lower prices and become more lenient in underwriting. This leads to greater underwriting losses. Rising losses and falling prices cause profits to suffer. In the second stage of the cycle, insurers attempt to restore profits by increasing rates and restricting underwriting, offering coverage only to the safest risks. These restrictions may be so severe that insurance in some lines becomes unavailable in the market place. Insurers are able to offset a portion of their underwriting losses through earnings on investments. Eventually the increased rates and reduced underwriting losses restore profits. At this point, the underwriting cycle repeats itself.

The general effect of the underwriting cycle on the public is to cause the price of property and liability insurance to rise and fall fairly regularly and to make it more difficult to purchase insurance in some years than in others. The competition among insurers caused by the underwriting cycle tends to create cost bargains in some years. This is especially evident when interest rates are high, because greater underwriting losses will, in part, be offset by greater investment earnings.

A significant insurance practice is that of reinsurance, whereby risk may be divided among several insurers, reducing the exposure to loss faced by each insurer. Reinsurance is affected through contracts called treaties, which specify how the premiums and losses will be shared by participating insurers.

Two main types of treaties exist _ pro rata and excess-of-loss treaties. In the former, all premiums and losses may be divided according to stated percentages. In the latter, the originating insurer accepts the risk loss up to a stated amount, and above this amount the reinsures divide any losses. Reinsurance is also frequently arranged on an individual basis, called facultative reinsurance, under which an originating insurer contracts with another insurer to accept part or all of a specific risk.

Reinsurance enlarges the ability of an originating insurer to accept risk, since unwanted portions of the risk can be passed on to others. Reinsurance stabilizes insurer profits, evens out loss ratios, reduces the capital needed to underwrite business, and offers a way for insurers to divest themselves of an entire segment of their risk portfolio.