Insurance Underwriting

Insurance underwriting is the process through which an insurer evaluates a proposed risk and decides whether to insure it, at what price and on what conditions. The underwriter's aim is to accept risks whose premiums, taken together, will be enough to pay claims and expenses and leave a profit, and to avoid a portfolio that is concentrated in ways that could threaten the company. It is the insurance sense of the wider term underwriting, which is also used in lending and in securities offerings.

The word dates from the practice at Lloyd's of London, where those willing to accept part of a marine risk wrote their names under the description of the voyage. Underwriting is one of the two sources of an insurer's profit, the other being investment income, and its results are measured by the combined ratio.

An insurance pool works only if each member pays a premium in line with the risk it brings. Two problems stand in the way. Adverse selection arises because applicants know more about their own risk than the insurer does, and those most likely to claim are most eager to buy. Moral hazard arises because being insured can reduce a person's incentive to avoid loss. Underwriting addresses both by gathering information, classifying risks, pricing them differently and writing terms that keep the insured's interests aligned with the insurer's.

The information depends on the line of business. In life and health insurance it includes age, medical history, occupation and habits. In motor insurance it includes the driver's record, the vehicle and where it is kept. In commercial property and liability insurance it covers the nature of the business, its premises, safety measures, financial condition and past claims. The applicant must have an insurable interest in what is insured, and in most legal systems has a duty to disclose material facts or to answer the insurer's questions honestly.

• Submission. The applicant or a broker provides a proposal with the required information.
• Risk evaluation. The underwriter reviews the data, uses rating models and guidelines, and may order surveys, medical reports or inspections.
• Decision. The risk is accepted at standard terms, accepted with a higher premium or restrictions, or declined.
• Pricing and terms. The premium is calculated from rating factors and the underwriter sets the deductible, the limit of cover, conditions and any exclusions.
• Binding and issue. Cover is confirmed, sometimes first through an insurance binder, and the policy is issued and recorded in policy administration.
• Renewal review. At expiry the risk is reassessed in light of claims and changes in exposure.

For personal lines such as motor and home insurance, most of this is automated: rules and statistical models produce a quotation in seconds, and human underwriters handle only exceptions. Large or unusual commercial risks are still negotiated individually, often with several insurers each taking a share.

Each underwriter works within written guidelines and an authority limit that sets the classes of business and the maximum amount that person may accept. Risks above the limit are referred upwards. Insurers also give authority to agents and specialist intermediaries to accept business on their behalf, an arrangement that requires close monitoring, since the party selecting the risk does not bear the loss.

Beyond single risks, underwriting management looks at the whole book: how much exposure is accumulated in one region, industry or peril, and how a single event such as a storm or cyber incident could affect many policies at once. Risks beyond the insurer's appetite are passed on through a reinsurance treaty, which covers a defined class automatically, or through facultative reinsurance arranged for one risk at a time.

Property and casualty insurance tends to move through alternating periods. In a soft market, capital is plentiful, insurers compete for business, premiums fall and terms loosen. Losses then rise or capital is depleted by a major event, capacity is withdrawn, and a hard market follows, with higher prices and stricter terms, which in turn attracts new capital. Underwriting discipline, meaning a willingness to lose volume when prices are inadequate, is what distinguishes insurers that perform well across the cycle.

Supervisors expect insurers to have a documented underwriting policy approved by the board, and prudential regimes such as Solvency II treat underwriting risk as a core component of capital requirements. The law also limits what factors may be used. Rules against discrimination restrict the use of characteristics such as race, and in the European Union a 2011 court ruling ended the use of sex as a rating factor in insurance pricing.

Underwriting increasingly uses external data and predictive models: telematics devices that record driving, satellite and sensor data on property, and electronic health records. These can improve accuracy and speed, and are central to the business models of insurtech firms. They also raise concerns about privacy, about the explainability of automated decisions, and about very fine risk classification leaving some people unable to obtain affordable cover, which runs against the pooling of risk on which insurance rests. Good underwriting is tested later, in claims administration, when the terms agreed at the outset are applied to an actual loss.