Insurers accept risk in exchange for premium, and they agree to pay for covered financial losses. That doesn’t mean an insurer must accept every application. If an insurer accepts too many poor risks, it can threaten the company’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 analysis.

Underwriting involves a legal form of discrimination based on risk profiles. Insurers separate applicants into higher-risk (substandard) and lower-risk (preferred) categories to set premiums and to encourage risk-reducing behavior.

Discrimination based on statistical evidence can be acceptable in underwriting. However, underwriting decisions must not be based on unfair discrimination. Unfair discrimination targets 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 determine an appropriate premium level. The questions are designed to build a complete picture of the applicant and to 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 the underwriter with an 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 covered 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
• A company representative

Consumer Reports

Sometimes the underwriter needs more detail about the applicant. When the applicant signs the application, they authorize the insurer to obtain a consumer report.

A consumer report may include:

• A credit report
• 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 because of 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.

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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 deciding which insurer to buy coverage from.

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

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

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

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

Waiver & Estoppel

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

• Waiver occurs when an insurer gives up a right, like the right to cancel a policy for nonpayment, by accepting a late payment and continuing coverage. Waivers can be express or implied.
• Estoppel stops an insurer from changing its stance if it harms the insured, assuring policyholder protection. For example, an insurer can’t cancel a policy for a late payment if it has a history of accepting late payments from others, as this implies late payments are acceptable.

Lesson Summary

Underwriting is how insurers assess and insure risks. Key points include:

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

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

• Application: Contains vital information for the underwriter.
• Producer’s Report: Provides the agent’s input.
• Inspections: Verifies the property condition.
• Consumer Reports: May include credit or investigative reports.

Consumers can check an insurer’s financial status 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.