Insurers are in the business of accepting risks and insuring against the financial loss associated with those risks. That doesn’t mean they want to (or have to) accept every application for insurance. Accepting too many bad risks can threaten an insurer with insolvency.
An insurer’s underwriting department carefully reviews each application to decide whether it represents an acceptable (standard) risk. The objective of risk selection is to provide equity among all classes of risks.
How do underwriters decide whether an applicant is standard, substandard, preferred, or uninsurable? The most important source of information is the application.
The application contains a considerable amount of information that helps the underwriter determine an adequate premium level. The questions are designed to provide a complete picture of the applicant and to reveal any physical, moral, or morale hazards.
For example:
One of the most important parts of the application is the notice regarding insurance information practices. By signing this form, the applicant authorizes the insurer to access personal medical records from any doctor or hospital that may have examined or treated the proposed insured. This authorization typically remains valid for up to 30 months from the date signed, unless revoked sooner.
Another valuable source of information is the Medical Information Bureau (MIB). The MIB is a nonprofit organization to which most life and health insurers subscribe. The MIB contains medical information on insurance applicants, including past treatment, recommendations, or diagnoses that were covered by insurance.
Another source of information is the medical examination. Insurers routinely send applicants to physicians for a physical examination, and the insurer pays the cost.
Simplified issue insurance requires no medical exam and asks only very basic health-related questions on the application. Usually, this type of insurance is available only in low face amounts to reduce the risk of adverse selection.
HIV-related test results may be disclosed only with written consent, except as permitted or required by applicable state law.
Insurance producers are often the first point of contact and may have personal relationships with applicants. It’s becoming increasingly common for producers to be involved in field underwriting, which is a preliminary risk evaluation conducted through a face-to-face interaction. This can provide insights that may not appear on the application.
Field underwriting involves gathering key information to determine whether a potential client meets the insurer’s basic underwriting criteria before submitting a formal application.
An important source of underwriting information is the producer’s report, which most companies require. The agent completes this report and submits it with the application. It should include any observations that might affect the underwriter’s decision.
Still another source of information is the investigative consumer report. An investigative consumer report may shed light on an applicant’s character, reputation, personal habits, credit history, and mode of living. If an investigative report is obtained, the applicant must be notified within 3 days of the date the report was requested.
Applicants who smoke, are overweight, have a questionable medical history, or otherwise represent a greater risk than a healthy person should be expected to bear a heavier proportion of premium costs than an applicant of the same sex and age who does not have those hazards. The same is true for people who may be perfectly healthy but, because of their occupation or hobbies, represent a greater risk. Deep sea welders are a good example. The premium charged must fairly represent the mortality risk represented by the insured.
Under the federal Fair Credit Reporting Act (FCRA), if a consumer is denied insurance based on a report, they have 60 calendar days from the date of the adverse action notice to request a free copy of the report. Some states may extend this timeframe to 90 days.
Underwriters must also guard against adverse selection, which is the tendency of those who are high risk (and know it) to try to obtain insurance. Many people who are not in perfect health can still expect to live a full life. Even so, situations can make an applicant less attractive (from a risk standpoint) than a standard risk while still leaving that person insurable. Applicants in this gray area, between standard and uninsurable, are considered substandard risks.
While different insurers use different criteria to determine who is acceptable as a substandard risk, there are common techniques used to rate them. A rated policy is one that has been modified in its premium requirement to compensate for an additional risk. A policy can be rated in three different ways:
1) Flat extra premium
2) Extra percentage premium
3) Rated-up
Some insurers recognize people who take extra steps to improve or maintain their good health. These people may be rewarded through preferred rates or another form of premium discount.
There are three components in the calculation of a life insurance premium rate:
The number of exposure units is not used in calculating individual premium rates, even though it affects statistical accuracy in broader underwriting assumptions.
Mortality is the key variable in establishing premium rates for life insurance because it’s the basis for predicting future claims. When calculating premium rates, a charge is made for anticipated mortality. For example, the mortality charge for a 70-year-old applicant would be much higher than the mortality charge for a 30-year-old applicant. Mortality is the reason life insurance becomes more expensive with age. Mortality tables are based on average death rates for large groups of people.
Another charge, loading, is made for expenses. This represents the basic operating cost of the company and includes a profit factor. When a policy owner makes a premium payment:
These funds are placed in investments that earn interest. The net effect is to reduce the amount of premium that would otherwise be required.
The mortality and expense factors make up what is called the net premium. The addition of an interest factor creates the gross premium charged to the insured. All premiums are calculated on an annual basis, but the policy’s mode of payment may be more frequent.
Underwriting is how insurers decide which risks to accept and how to price them. Insurers accept risks and insure against financial loss, but they don’t accept every application because accepting too many bad risks can lead to insolvency. The underwriting department reviews each application to determine whether it represents an acceptable risk.
The main sources of underwriting information are the application, medical examination, producer’s report, and investigative consumer report. The signed authorization is typically valid for 30 months.
Underwriters consider factors such as age, gender, health condition, activities, and personal characteristics to place applicants into risk categories such as standard, substandard, preferred, or uninsurable. Premium costs are adjusted based on the level of risk an applicant poses. Applicants in the gray area between standard and uninsurable are considered substandard risks and may be rated with a higher premium.
Overall, underwriters aim to provide equity among all classes of risks, guard against adverse selection, and ensure fair premium rates based on an applicant’s risk level.
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