Insurers accept risk in exchange for premium, and they promise to pay covered losses if they occur. That doesn’t mean an insurer must accept every application. If an insurer accepts too many poor risks, losses can exceed premiums and threaten the insurer’s ability to pay claims (insolvency).

An insurer’s underwriting department reviews each application to decide whether the applicant is an acceptable (standard) risk. Risk selection is meant to create equity among classes of risks - so people with similar risk characteristics are treated similarly.

Premium rates are influenced by several factors, including:

• Loss experience
• The occupancy or operation involved
• Construction of the structure (for example, brick or frame)
• Overall exposures

Underwriters also review loss ratios, which help with future pricing and underwriting analysis.

Underwriting involves a legal form of discrimination based on risk characteristics. Underwriters separate applicants into categories such as high-risk (substandard) and low-risk (preferred) to set appropriate premiums and, in some cases, encourage safer behavior.

Discrimination based on credible statistical evidence can be acceptable in underwriting. However, underwriting decisions must not be based on unfair discrimination. Unfair discrimination involves treating applicants differently based on protected classes such as race, national origin, sex, or religion.

How do underwriters decide whether an applicant is standard, substandard, preferred, or uninsurable? They rely on several information sources, including the following.

Application

The application is the most important source of information. It contains details the underwriter uses to evaluate the risk and determine an appropriate premium. Application questions are designed to build a complete picture of the applicant and identify potential:

• Physical hazards
• Moral hazards
• Morale hazards

Producer’s report

Field underwriting is an initial risk assessment completed by insurance agents or producers during client interactions. It helps determine whether a client meets basic underwriting criteria before a formal application is submitted. This can save time and resources, improve the client experience, and reduce insurer risk.

Field underwriting by producers may include:

• Gathering information
• Asking probing questions
• Observing client demeanor
• Identifying red flags
• Documenting observations

The producing agent or broker also provides information to the underwriter, including the agent’s opinion and/or recommendation about the applicant and the proposed insured.

Inspections

With property insurance, the underwriter needs to confirm that the property to be insured actually exists and is in the condition described. A physical inspection is often required. The inspection may be completed by:

• The producing agent or broker, or
• A company representative

Consumer reports

Sometimes an underwriter needs more detail than the application provides. When an applicant signs the application, the applicant authorizes the insurer to obtain a consumer report.

A consumer report may include:

• A credit report, and/or
• An investigative report (for example, interviews with current or previous employers or neighbors about the applicant and the exposure)

Sidenote

Know this...

A signed application authorizes the insurer to collect information for 30 months. If they have not done so by then, a new authorization must be obtained.

If an applicant is denied coverage due to information collected, this regulation grants access to the information and the reasons for the denial. After receiving notice that an adverse underwriting decision has been made, an individual has 90 business days to request a copy of the report.

Sidenote

Know this...

Note: This law does not allow the insured to require that the insurer send him/her a copy of the report. It allows them to request a copy of the report from the agency that provided the information.

Financial status

Independent rating services help consumers identify insurers that are financially sound. Consumers often check these ratings before choosing an insurer.

Ratings services evaluate a corporation’s financial ability to make the interest and principal payments on the bonds it has issued. Common rating services include:

• Moody’s
• Fitches
• A.M. Best
• Standard & Poor’s

It’s widely accepted that AAA is the highest financial rating and D is the lowest. A “D” rating indicates the insurer is in default and unable to pay its claims.

Sidenote

Know this...

Note: Rating services are private corporations and are not regulated by the NAIC.

Waiver & estoppel

The legal concept of Waiver & Estoppel often comes up in insurance, especially in underwriting decisions and during the claims process. The concept holds an entity (the insurer) to “standards of established behavior.”

• Waiver occurs when an insurer gives up a right. For example, an insurer may waive the right to cancel a policy for nonpayment by accepting a late payment and continuing coverage. Waivers can be express or implied.
• Estoppel prevents an insurer from changing its position when doing so would harm the insured. For example, an insurer can’t cancel a policy for a late payment if it has a history of accepting late payments from others, because that pattern implies late payments are acceptable.

Lesson summary

Underwriting is how insurers evaluate and classify risk so they can price coverage appropriately.

• Accepting too many poor risks can lead to financial trouble for insurers.
• Underwriters review applications to decide whether a risk is acceptable.
• Premium rates are based on multiple factors.
• Loss experience, occupancy, construction, and exposure affect rates.
• Loss ratios are important for future analysis.

Underwriters classify applicants as standard, substandard, preferred, or uninsurable using sources such as:

• Application: Contains key information used to evaluate the risk.
• Producer’s Report: Provides the agent’s observations and recommendation.
• Inspections: Confirm the property exists and verify its condition.
• Consumer Reports: May include credit and/or investigative reports.

Consumers can evaluate an insurer’s financial strength through rating services:

• AAA is the highest rating, and D indicates default.
• Ratings from Moody’s, Fitches, A.M. Best, and Standard & Poor’s help assess financial strength.
• Rating services are not regulated by the NAIC.

Chapter vocabulary

Definitions

Actuarial Report

A document or other presentation, prepared as a formal means of conveying to the state regulatory authority and the Board of Directors, or its equivalent, the actuary’s professional conclusions and recommendations, of recording and communicating the methods and procedures, of assuring that the parties addressed are aware of the significance of the actuary’s opinion or findings and that documents the analysis underlying the opinion. (In Life and Health) this document would be called an “Actuarial Memorandum.”

Actuary

An insurance professional skilled in the analysis, evaluation, and management of statistical information. Evaluates insurance firms’ reserves, determines rates and rating methods, and determines other business and financial risks.

Adverse Selection

The tendency of those exposed to a higher risk to seek more insurance coverage than those at a lower risk. Insurers react either by charging higher premiums or not insuring at all.

Class Rating

A method of determining rates for all applicants within a given set of characteristics such as personal demographic and geographic location.

Fair Credit Reporting Act

Federal laws that allow consumers who are denied insurance because of information contained in a credit report to be notified and allowed to obtain the information used in the report from the reporting agency.

Insolvency

Insurer’s inability to pay debts.

Law of Averages

A mathematical rule stating that as the number of exposure units increases, the closer the actual results will approach the predicted results of an event.

Law Of Large Numbers

The theory of probability on which the business of insurance is based. Simply put, this mathematical premise says that the larger the group of units insured, such as sport-utility vehicles, the more accurate the predictions of loss will be.

Preferred Risk

Insured, or applicant for insurance, who presents a likelihood of risk lower than that of the standard applicant.

Rate

Value of insured losses expressed as a cost per unit of insurance.

Representations

On an application, facts that the applicant represents as true and accurate to the best of his/her knowledge and belief.

Standard Risk

A person who, according to a company’s underwriting standards, is considered a normal risk and insurable at standard rates. High or low-risk candidates may qualify for extra or discounted rates based on their deviation from the standard.

Substandard Risk

Risks deemed undesirable due to medical condition or hazardous occupation requiring the use of a waiver, a special policy form, or a higher premium charge.

Underwriter

Person who identifies, examines and classifies the degree of risk represented by a proposed insured in order to determine whether or not coverage should be provided and, if so, at what rate.

Underwriting

The process by which an insurance company examines risk and determines whether the insurer will accept the risk or not, classifies those accepted, and determines the appropriate rate for coverage provided.