Underwriting a Risk: Construction, Protection and Adverse Selection
An underwriter decides three things about every application: whether to accept the risk, how to classify it, and what conditions to attach. The decision is only as good as the evidence behind it, so the work is mostly reading a risk for the features that predict loss and pricing those features fairly. The sections below apply hazards, construction, fire protection, adverse selection, loss ratios and the application to concrete risks. All figures in the examples are invented for illustration and are not rates, factors or statutory figures.
Reading Hazards on a Real Risk
A hazard is a condition that makes a loss more likely or more severe. Underwriters sort hazards into three kinds. A physical hazard is a feature of the property, vehicle or operation. A moral hazard is dishonesty in the person: a willingness to cause or exaggerate a loss. A morale hazard is carelessness: the insured has coverage and so stops taking ordinary care. The same three questions apply to every line.
| Line | Physical hazard | Moral hazard | Morale hazard |
|---|---|---|---|
| Home | Knob-and-tube wiring, a wood stove, a trampoline | Overinsured house listed for sale, with a history of fires | Smoke detectors with dead batteries because “insurance covers it” |
| Auto | A heavily modified engine, a vehicle used for delivery | Claims reported for damage that predates the policy | Leaving keys in an unlocked car |
| Liability | A loose handrail, an unguarded loading dock | A business that hides a prior suit | Skipping safety inspections because liability is insured |
An underwriter cannot see moral or morale hazard directly, so the work shifts to evidence. Prior claims, prior cancellations, gaps in coverage, and answers that do not agree with each other are the signals. A single odd answer proves nothing, and a pattern of them is a reason to ask more.
Construction
Construction is the first physical hazard a building underwriter reads, because it controls how fast fire spreads and whether the building can survive one. In practice the standard commercial classes run from the most to the least combustible:
| Class | Typical description | Fire behavior |
|---|---|---|
| Frame | Combustible exterior walls, such as wood siding over wood studs | Burns readily, collapses early |
| Joisted masonry | Masonry or fire-resistive walls, but combustible floors and roof | Walls stand, roof and floors burn |
| Noncombustible | Metal or other noncombustible walls, floors and roof | Does not feed the fire, but steel can warp and fail in heat |
| Masonry noncombustible | Masonry walls with noncombustible floors and roof | Better than either alone |
| Modified fire resistive | Walls, floors and roof of masonry or fire-resistive materials rated at least one hour but under two | Resists fire for a limited period |
| Fire resistive | The same materials rated at least two hours | Contains fire long enough for response |
Those descriptions are general practice, and an insurer’s filed classification rules control how a particular building is classed. A house with a brick veneer over a wood frame is still a frame house, because the veneer is a surface and not the wall structure. A building with brick walls and a wooden roof deck is joisted masonry, not masonry noncombustible.
Construction enters the premium through a rate that differs by class. Assume a building insured for $400,000, which is 4,000 units of $100, with invented rates per $100:
| Class | Rate per $100 | Premium (4,000 units) |
|---|---|---|
| Frame | $0.90 | $3,600 |
| Joisted masonry | $0.70 | $2,800 |
| Noncombustible | $0.62 | $2,480 |
| Masonry noncombustible | $0.55 | $2,200 |
| Modified fire resistive | $0.48 | $1,920 |
| Fire resistive | $0.40 | $1,600 |
The most combustible class costs more than twice the least, for the same amount of insurance. The same features matter on the liability side. An underwriter reviewing a store for premises liability reads the same building for exits, stairs and condition, because a fire or collapse that injures customers becomes a liability claim.
Fire Protection
The building does not burn alone. How quickly water reaches it matters nearly as much as what it is made of. Insurers use a community’s public protection classification, which grades fire department staffing, equipment, training and the water supply on a scale from 1, the best, to 10, the worst, where 10 means no recognized protection. Distance matters too. Commonly used limits are 1,000 feet to a hydrant and five road miles to a fire station, and a house inside both is a better risk than one outside them. Underwriters ask for both distances on the application, because one street in a poorly rated community can still sit next to a hydrant.
Construction and protection interact. Assume a base rate of $0.70 per $100 for joisted masonry and $0.90 for frame, and invented protection factors of 0.90 for a class 3 community and 1.30 for a class 9 community, on the same $400,000 building:
| Building | Rate before factor | Protection factor | Final rate | Premium |
|---|---|---|---|---|
| Joisted masonry, class 3 | $0.70 | 0.90 | $0.63 | $2,520 |
| Joisted masonry, class 9 | $0.70 | 1.30 | $0.91 | $3,640 |
| Frame, class 3 | $0.90 | 0.90 | $0.81 | $3,240 |
| Frame, class 9 | $0.90 | 1.30 | $1.17 | $4,680 |
A frame building in a class 9 community costs $1,440 more than the same building in a class 3 community, and $2,160 more than the masonry building in the better location. In Michigan the rule on home insurance lists what a classification may use. It includes fire protection class, the distance of the structure from a fire hydrant, and construction measured by structure size, building material components and number of units (MCL 500.2111(7)(d), (e), (h)). So a Michigan home insurer’s protection and construction relativities are filed and visible, and a producer can read them.
Adverse Selection
Adverse selection is the tendency of those most likely to suffer a loss to buy insurance, and to buy more of it, than those less likely to. It makes pricing from the average self-defeating, as this example shows. For this example, an insurer expects to sell coverage for damage from overflowing surface water to 1,000 homeowners. Eight hundred have a 1% chance a year of a $20,000 loss, so an expected loss of $200 each. Two hundred live next to a creek and have a 5% chance, an expected loss of $1,000 each. If the insurer cannot tell the groups apart, it prices on the average:
- Total expected loss: (800 × $200) + (200 × $1,000) = $360,000.
- Average expected loss: $360,000 ÷ 1,000 = $360 a policy.
To keep the arithmetic plain, ignore expenses and profit. The price of $360 is 1.8 times what a low-risk homeowner expects to lose and only 36% of what a creekside homeowner does. The creekside buyers all take the bargain, and suppose half of the low-risk buyers refuse the price:
- Remaining pool: 400 low-risk and 200 high-risk, 600 policies.
- Expected loss: (400 × $200) + (200 × $1,000) = $280,000, or $466.67 a policy.
The $360 premium is now $106.67 a policy short, and the higher-risk group has grown from 20% of the pool to one third of it. Raising the price to $467 drives out more low-risk buyers, and the cycle continues. Every tool an underwriter has is a way of breaking that cycle:
- Classifying the risk, so the creekside home pays its own rate.
- Asking the questions that reveal the hazard before the policy is issued.
- Inspecting, where the insurer’s filed rules call for it.
- Limiting the coverage, with waiting periods, deductibles or sublimits.
Michigan sets two limits on how these tools may be used. An insurer must not refuse to insure, continue to insure, or limit coverage because of the location of the risk, which Michigan treats as redlining (MCL 500.2108(8)). The remedy for the creek is therefore a filed classification and rate, not a refusal of the neighborhood. An insurer also must put its underwriting rules in writing and apply them uniformly and without exception (MCL 500.2119(1), (2)). A producer who hears “we can make an exception for you” is hearing a promise the insurer is not allowed to keep.
Loss Ratios as an Underwriting Tool
A loss ratio is incurred losses divided by earned premium. Underwriters read it by segment, not only in total, because a healthy total can hide a segment that is losing money. Assume an insurer’s homeowners book, with invented figures, has three segments:
| Segment | Earned premium | Incurred losses | Loss ratio |
|---|---|---|---|
| Masonry, protection classes 1 to 4 | $3,000,000 | $1,500,000 | 50% |
| Frame, protection classes 1 to 4 | $2,400,000 | $1,320,000 | 55% |
| Frame, protection classes 8 to 10 | $600,000 | $570,000 | 95% |
| Total | $6,000,000 | $3,390,000 | 56.5% |
Suppose the insurer’s target loss ratio is 65%. The book as a whole looks fine at 56.5%. The third segment is 30 points over target, and without it the other two together run at 52.2%. The insurer’s choices are to correct the rate for the segment, to change its underwriting rules, or both. Under Michigan law it can do these only through filed classifications, and written rules that conform to the permitted bases, such as a rule on objective physical condition (MCL 500.2117(2)(b)). It cannot respond by simply declining a territory.
The Application as the Underwriter’s Evidence
The application is the underwriter’s main source of facts, and the signed answers are representations, statements the applicant says are true to the best of knowledge and belief. Each question exists because the answer moves the rate or the decision.
| Question | What it tells the underwriter | What the producer should do |
|---|---|---|
| Year built, construction, roof type and age | Combustibility, wind and hail exposure, how soon the roof must be replaced | Get the facts from the owner or inspection, not from memory |
| Distance to hydrant and fire station | Protection class | Verify from the local map or the community’s classification |
| Prior losses and cancellations, last five years | Frequency, and the possible moral hazard | Ask for details and dates, and do not paraphrase |
| Business use of the premises | Whether the home or the liability form fits | Name the business exactly, including home day care |
| Vehicle use and annual mileage | Rating class and exposure | Record the actual use, not the cheapest class |
| Other insurance and liens | Insurable interest and mortgagee | List every lienholder |
Take a producer who is completing a homeowners application for Dana, who mentions her husband runs a small welding repair from the detached garage. The producer, wanting the sale, enters “no business use.” The welding is a physical hazard and a source of liability the underwriter would have priced or declined. If a fire starts in the garage, the insurer may investigate the answer, and a material misrepresentation can void coverage. The producer has also failed to report what the producer knew. The safe course is to record the facts and let the underwriter decide.
If the insurer declines, an insurer or an agent must tell the applicant each specific reason, in writing when the application was written (MCL 500.2122(1)). When the insurer inspects homes to decide eligibility, it must not choose homes to inspect on race, color, creed, marital status, sex, national origin, residence, age, disability or lawful occupation (MCL 500.2121(1)). A good application file shows what was asked, what was answered, and what the producer observed.
One caution applies to the first row of the table. Michigan does not allow an objective physical-condition rule to turn on the age of the structure (MCL 500.2117(2)(b)). The year built is evidence about wiring, plumbing and roof, and the insurer’s rule has to rest on the specific code, manufacturer’s specification or similar standard the statute requires, and not on age alone.
Lesson summary
- Hazards divide into physical, moral and morale. Physical hazards are read from the property, and the other two from evidence such as prior claims and inconsistent answers.
- Construction classes run from frame through joisted masonry, noncombustible and masonry noncombustible to modified fire resistive and fire resistive, and the class changes the rate.
- Protection class and distance to a hydrant and fire station change the rate again. Michigan permits protection class, hydrant distance and construction as home classification factors.
- Adverse selection occurs when higher-risk buyers take insurance in greater numbers, so an average price becomes inadequate as lower-risk buyers leave.
- Underwriters counter adverse selection by classification, questions, inspection and limits on coverage, and in Michigan must not refuse a location (redlining) and must apply written rules uniformly.
- A loss ratio is incurred losses divided by earned premium. Reading it by segment shows where rates or rules need correcting when the total looks healthy.
- The application’s signed answers are representations. A producer records the facts accurately and never improves an answer to make a sale.
- A declination must state each specific reason, and the Michigan inspection rules forbid selecting homes for inspection on protected characteristics.