Underwriting

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 goal of risk selection is to provide equity among all classes of risks.

Sources of underwriting information

How do underwriters determine 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:

• The applicant’s gender matters because, statistically, females live longer than males.
• Physical factors such as age, weight, and health condition are important.
• The applicant’s activities and personal characteristics can also affect risk.

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 invaluable 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 any past treatment, recommendation, or diagnosis received that was covered by insurance.

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Know this...

By signing the notice regarding insurance information practices, the applicant also gives the insurer the authorization to add information (including HIV test results) to the MIB.

Medical examination

Another source of information is the medical examination. Insurers routinely send applicants to physicians for a physical examination, and the insurer pays the cost of the exam.

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.

If an insurer obtains confidential HIV-related information during the underwriting process, disclosure may be made only to authorized parties as permitted by law, such as the applicant, attending physicians, health providers involved in treatment, insurers involved in payment, and public health officials. Confidential HIV-related information may not be disclosed to an applicant’s employer without proper authorization.

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Know this...

No one may require the administration of an HIV-related test without first receiving written consent of the applicant.

Field underwriting

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 an 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 information the agent observes that might affect the underwriter’s decision.

Investigative consumer report

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 doesn’t 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.

Different insurers use different criteria to decide who is acceptable as a substandard risk, but 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

• The premium for the policy is increased by a flat dollar amount per $1,000 of coverage to cover the additional risk. The flat extra premium may be permanent or temporary, depending on the reason for the rating. This is often appropriate when one clearly defined problem (that may go away) causes the substandard classification.

2) Extra percentage premium

• The premium amount is increased by a certain percentage. The percentage increase is based on tables used by underwriters. Generally, the extra percentage premium is used when the extra risk is expected to be permanent and/or is caused by a variety of hazards.

3) Rated-up

• With this approach, the applicant’s age is “rated up,” and the applicant is considered older than their actual age. As a result, the premium is higher.

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Know this...

The concept of Waiver and Estoppel dictates that the insurer has the right to exclude certain perils at time of application, but cannot retroactively add exclusions to a policy already in force.

Some insurers recognize people who take extra steps to improve or maintain good health. These people are rewarded through preferred rates or another form of premium discount.

Establishing premium rates

There are three components in the calculation of a life insurance premium rate:

• Mortality
• Expenses
• Interest

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. 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 why 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 covers the basic operating cost of the company and includes a profit factor. When a policy owner makes a premium payment:

• Part of the premium is used to meet expenses.
• Part is held in reserve to meet future claim commitments.

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 net premium is based on mortality and an assumed interest rate. The gross premium is the amount charged to the policyowner and includes the net premium plus operating expenses (loading), which cover the insurer’s expenses and profit. In short: mortality and interest combine to form the net premium, and adding loading (expenses, commissions, contingencies, and profit) to the net premium produces the gross premium. All premiums are calculated on an annual basis, but the policy’s mode of payment may be more frequent.

Lesson summary

Underwriting 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.

• The application provides important information about the applicant’s physical, moral, and morale hazards. It includes a notice regarding insurance information practices, allowing access to personal medical records and the Medical Information Bureau (MIB).
• Medical examinations are routine and may include confidential HIV-related information. Simplified issue insurance may not require a medical exam but has limitations.
• HIV testing requires written consent, and results may only be disclosed as allowed by law.
• Producer’s reports contain observations from agents that could affect the underwriter’s decision. Investigative consumer reports shed light on an applicant’s character, reputation, and lifestyle.

Underwriters consider factors such as age, gender, health condition, activities, and personal characteristics to determine risk categories like 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.

• Rated policies have modified premium requirements to compensate for additional risks. They can be rated with a flat extra premium, an extra percentage premium, or through rated-up age.
• Preferred risks may receive lower premiums.
• Insurers establish premium rates for life insurance based on mortality, expenses, and interest. Mortality is a key factor affecting premium rates, leading to higher costs for older applicants.
• The net premium is based on mortality and interest; the gross premium is the net premium plus loading for expenses, commissions, contingencies, and profit. Premium payments are used for expenses and reserves for future claims, with funds invested to earn interest.

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.

Chapter vocabulary

Definitions

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.

Gross Premium

The premium charged to the policyowner. It consists of the net premium plus loading for operating expenses, commissions, contingencies, and profit. Dividends are not part of the gross premium.

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.

Medical Information Bureau (MIB)

An organization formed and supported by insurers and serving as a database of medical information reported to it by members and used by members as a source of underwriting information.

Mortality Table

Chart that shows the death rates of a particular population at each age displayed as the number of deaths per thousand.

Pre-existing Condition

An injury occurring, sickness contracted, or physical condition that existed prior to the issuance of a health policy.

Preferred Risk

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

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.