Insurers are in the business of accepting risks and insuring against financial loss associated with those risks. This does not mean that they want to (or have to) accept every application for insurance. Accepting too many bad risks threatens an insurer with insolvency.
An insurer’s underwriting department will carefully review each application for insurance to determine whether or not it represents an acceptable (standard) risk. The objective of risk selection is to provide equity among all classes of risks.
How do underwriters determine if 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, all of which helps the underwriter determine an adequate premium level. The questions on the application are intended to provide a complete picture of the applicant, revealing any physical, moral, or morale hazards. The applicant’s gender is important, because statistically, females live longer than males. Physical factors such as age, weight, and health condition are important, as are the applicant’s activities and personal characteristics.
One of the most important parts of the application is the notice regarding insurance information practices. By signing this form, the applicant gives the insurer authorization 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. An 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 and any past treatment, recommendation, or diagnosis received that was covered by insurance.
Another source of information is the medical examination. Insurers routinely send applicants to physicians for a physical examination. The cost of such an exam is borne by the insurer. Simplified issue insurance requires no medical exam and only asks very basic health-related questions on the application. Usually this type of insurance is only available in low face amounts, to reduce the risk of adverse selection.
HIV-related test results may only be disclosed with written consent, except as permitted or required by applicable state law.
Insurance producers are the first point of contact and often have personal relationships with applicants. It is becoming increasingly common for producers to be involved in field underwriting, which is a preliminary risk evaluation conducted through a face to face interaction, providing unique insights that may not show up on an application for insurance. 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, required by most companies. This report is completed by the agent and submitted with the application and should contain any information the agent observes 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 in some other way represent a greater risk than a healthy person must be expected to bear a heavier proportion of premium costs than an applicant of the same sex and age who does not possess such 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 expect to live a full life. Situations can exist to make an applicant less attractive (from a risk standpoint) than a standard risk but still qualify that person as 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 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 are rewarded through the use of preferred rates or some other 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. It is 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 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, which is 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 and 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 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 insurers accept risks and insure against financial loss but do not accept every application to avoid insolvency. The underwriting department carefully reviews each application for insurance to determine if 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 must consider factors like 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. Those 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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