While writing these blog posts, I just had a thought – no kid would ever just come across or read these insurance blog posts. Like there’s just no way some kid would Google, “What is underwriting in insurance?” and actually read these articles. Makes me wish I was a kid again and didn’t have to learn about this stuff, ha. But anyway, that wasn’t exactly a profound thought. I digress. Welcome to the third post of my AINS 101 series!
You can check out the introduction to this series in my previous post. To recap, I am in the process of obtaining the Associate of Insurance (AINS) certification, of which the first step is to complete the AINS 101 course that covers the core basics of insurance. In our last post, we went over How Do Insurers Succeed? and came across a term you may be unfamiliar with – underwriting. In this post, we will look at what underwriting is and how it works.
1. Walking Through the Underwriting Department
What Is Underwriting?
Underwriting decisions affect many aspects of an insurance company, including issuing policies, collecting premiums, handling claims, auditing accounts, and marketing. But what is underwriting?
Underwriters are the gatekeepers of insurance policies and acceptance or rejection of potential insureds. The purpose of underwriting is to create a profitable book of business and make sure an insurance organization succeeds. It is the process of
- evaluating risks
- selecting insureds
- pricing coverage
- determining policy terms and conditions
- monitoring underwriting decisions
Primary Underwriting Activities
To ensure a growing and profitable book of business, underwriters perform these key activities:
- Minimizing adverse selection – Adverse selection generates unprofitable business by allowing an individual or business with a high probability of loss to obtain insurance at a lower cost than an insurer would normally charge for that risk because the insurer was not fully aware of the actual risk involved. Underwriters guard against this by
- carefully selecting applicants with manageable loss exposures
- charging appropriate premiums
- monitoring applications and books of business for unusual patterns of policy growth or losses
- Ensuring adequate policyholders’ surplus – Underwriting practices should generate policy premiums that exceed losses and expenses, thus increasing its policyholders’ surplus. A surplus is necessary for insurers to operate and pay out claims as well as increase the insurer’s capacity to write new business. Underwriters ensure a surplus by
- following underwriting guidelines
- effectively evaluating and selecting loss exposures
- charging adequate premiums
- Enforcing underwriting guidelines – These guides specify what underwriters should look for before offering coverage. They also include the levels of underwriting authority given to various underwriters as well as to agents and brokers.
Valuable Risk Control and Auditing Information
Underwriters work with representatives of other insurer functions, such as risk control professionals and premium auditors, to improve the quality of information available to underwriters and ultimately the quality of insurance services. Here are examples of types of valuable information provided:
- Field inspection reports on premises and operations of insureds pursuing or renewing their policies
- Descriptions of operations that can help classify loss exposures
- Technical information on the health and fire hazards of new building materials and production processes
- Loss control measures that could help an applicant meet underwriting guidelines
- New loss exposures at an insured’s premises
- Changes in an insured’s commercial operations
2. Understanding Underwriting Activities
The Two Types of Underwriters
There are two distinct types of underwriters:
- Field (Line) Underwriter – Works in the fields by working directly with producers (brokers or agents) and applicants. Here are some of their duties:
- Selects insured
- Ensures accurate classification and pricing
- Recommends or provides coverage by working with producers
- Manage a book of business
- Support producers and insureds
- Support marketing objectives
- Corporate (Staff) Underwriter – Works in the insurer’s corporate office and helps establish and maintain the insurer’s overarching underwriting policy. Here are some of their responsibilities:
- Research the market
- Formulate underwriting policy
- Revise underwriting guidelines
- Develop coverage forms
- Review rates
- Educate and train field underwriters
- Arrange reinsurance
- Assist with complex accounts
- Conduct underwriting audits
3. Getting to Know the Underwriting Process
Making Informed Decisions
Underwriters are tasked with selecting insureds whose covered losses are unlikely to exceed the anticipated amount earned by their premiums. As underwriters cannot see the future (assuming they’re not fortune tellers on the side), they follow a series of steps to help them make informed decisions.
Taking the First Steps in the Underwriting Process
These are the steps an underwriter will take to assist them in making an informed decision:
- Evaluate the application – The underwriter will review the application (submission) for insurance from a producer and try to understand the risks associated with the applicant. They may either accept or reject the application as it is, or they can modify it.
- Develop underwriting alternatives – The underwriter can modify an application and make a counteroffer to the applicant, of which the applicant can accept or reject. Some examples of modifications may include the following:
- Suggest the applicant implement a control risk so a loss is less likely to occur.
- Change the premium if it is unreasonable.
- Adjust the policy terms and conditions.
Making Key Decisions
An underwriter’s next steps are to make decisions.
- Select an underwriting alternative – Underwriters try to make applications acceptable whenever possible as rejections only lead to expense.
- Determine an appropriate premium – Underwriters must make sure that each loss exposure is accurately classified so that each account is properly rated.
- Implement the underwriting decision – Once an application is evaluated, adjusted if necessary, and has its premium determined, the underwriter will need to make the final decision of whether to accept or reject the applicant. They will need to:
- communicate decisions to the producer
- issue required documents
- record information about the applicant and policy
Monitoring Underwriting Decisions
The last step is to monitor the underwriting decision to make sure satisfactory results are achieved by doing the following:
- Monitoring claims activity
- Being alert to policy change requests that could alter the loss exposure
- Reviewing the results of risk controls, safety inspections, and premium audits, which can reveal new loss exposures and hazards
4. Determining a Policy Premium
Factors Needed to Calculate a Policy Premium
Determining the premium is known as rating. This is one of the main activities that an underwriter performs. Premiums are calculated as follows:
Policy Premium = Insurance Rate x Exposure Units
This is the basis of premium calculation; however, other factors, such as purchase of optional coverages, may also affect the final premium.
Insurance Rate and Exposure Unit
An insurance rate is the unit price for insurance coverage. In an insurer’s rating manual (a resource used for classifying accounts and developing premiums), there is typically a separate rate for each rating classification it uses. Manual rates represent the average risk in a class.
An exposure unit is the fundamental measure of loss exposures used in insurance rating to determine an insurance policy premium. It may represent different items depending on the type of insurance we are dealing with.
- In homeowners insurance, a unit is usually expressed in $1,000 of insured value.
- However, in personal auto insurance, an exposure unit may be one vehicle.
- In general liability, it represents each $1,000 of gross sales.
- For worker’s compensation, it is $100 of payroll.
It is calculated by
Exposure Units = Value of Insured / Expression in Units
So, a home insured for $400,000 is equal to 400 exposure units. We figure that out with the following math:
400 exposure units = $400,000 / $1,000
Calculating a Policy Premium
Underwriters determine a rating classification by calculating an insured’s characteristics and their loss exposures. Insurers set an insurance rate for each rating classification, which could be something like $0.50 per unit.
So if a $400,000 home is insured for 400 units, the rate will be $200.
$200 (policy premium) = $0.50 (insurance rate) x 400 (exposure units)
Collaborating with Premium Auditors
Premium auditors are important contributors to the pricing process and help underwriters in these ways:
- Ensuring accurate classification of exposures – An audit is conducted at the end of the policy period and can reveal any necessary classification changes should an underwriter’s submitted information be incomplete or inaccurate.
- Comparing anticipated loss exposures with actual loss exposures – Audits help an insurer assess a commercial operation and verify that the loss exposures were calculated accurately.
- Identifying new exposures – Insureds may not communicate changes in operations that may create a new exposure. A auditor may identify these new exposures and their classifications.
- Assessing an account’s desirability – Auditors may visit an insured’s premises and observe their business to provide insights for underwriting.
- Identifying physical, moral, and morale hazards – These are hazards that an auditor reports to underwriting.
Other Factors That Can Affect the Premium
Underwriters may deviate from a manual rate situationally. For instance, a percentage of premium reduction may be applied to an better-than-average risk while a premium increase may be applied to a worse-than-average risk. Here are some factors that can affect the premium:
- Increasing policy limits
- Purchasing optional coverages
- Good-student discounts
- Installing fire-protection systems
- Positive loss experience in the recent past
- The care and condition of premises
- An insured’s employees receiving training that reduces risk
5. Conclusion
I hope you now have a better understanding of why underwriters are essential in insurance and what they do. I admit, I didn’t know much about what underwriting was myself until I finished writing this post! Next up, we’ll answer the question of How Do Insurers Handle Claims?