5.3 Life Insurance Underwriting and Risk Classification

Underwriting is the process of evaluating applicants, classifying their risk, and deciding whether to accept the risk and on what terms. The underwriter weighs physical, moral, and morale hazards to set a premium that fairly matches the applicant's expected mortality. Physical hazards are health conditions; moral hazard is the chance someone deliberately causes a loss for gain; morale hazard is carelessness because insurance exists. The overarching goal is to keep the risk pool balanced so that premiums collected are adequate to pay claims.

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Adverse Selection

Adverse selection is the tendency of people with a higher-than-average chance of loss to seek insurance more eagerly, and in larger amounts, than average or better risks. A person who has just been diagnosed with a serious illness, for example, has a strong incentive to apply for a large policy. If insurers accepted all such applicants at standard rates, claims would exceed premiums and the pool would collapse. Underwriting and the insurable interest requirement are the primary defenses against adverse selection.

Exam Tip: Underwriting exists primarily to protect the risk pool from adverse selection and to ensure premium adequacy. "Selection of risks" is another name for underwriting.

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Sources of Underwriting Information

Underwriters gather information from several sources, weighing cost against the size and age of the case. Smaller, younger applicants may be approved on the application alone; larger or older cases trigger fuller investigation.

MIB Rules

The Medical Information Bureau is a nonprofit cooperative whose member insurers report coded impairments to a shared database; it stores codes, not full medical records. An insurer may not decline or rate a policy solely on an MIB report. The code merely flags an area to investigate further with an APS or exam. If adverse action is taken, the applicant must be told and given the chance to correct inaccurate MIB data.

Fair Credit Reporting Act and Investigative Reports

When an inspection (investigative consumer) report is ordered, the federal Fair Credit Reporting Act (FCRA) requires the applicant be notified that such a report may be obtained, told it may include interviews about character and lifestyle, and allowed to request the nature and scope of the investigation. These consumer-protection steps are commonly tested.

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The Four Risk Classifications

Most applicants fall into the standard class. A preferred class rewards superior health, nonsmoker status, and a clean history with the lowest rates. Substandard applicants present extra risk but are still insurable at a higher cost, while declined applicants present risk the insurer will not accept at any price. Classification draws on factors such as age, build (height-to-weight), tobacco use, family medical history, occupation, avocations (hobbies like scuba diving or aviation), driving record, and foreign travel.

The Human Life Value and Financial Underwriting

Underwriters also perform financial underwriting to confirm the amount applied for is justified, guarding against over-insurance and moral hazard. Two common approaches estimate the appropriate face amount.

The human life value (HLV) approach multiplies the insured's annual earnings devoted to dependents by the number of working years remaining, discounted to a present value. The needs analysis approach instead totals the family's actual obligations (final expenses, debts, income replacement, education) and subtracts existing assets and coverage. For example, an applicant earning $60,000 who contributes $45,000 a year to the household with 20 working years left has an HLV in the rough range of $900,000 before discounting, supporting a sizable policy.

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Rating a Substandard Risk

When an applicant is substandard, the insurer can still issue coverage but charges more to reflect the added mortality risk. Three methods are common:

A flat extra suits a temporary hazard (such as a dangerous occupation that may end) because it can be removed later. A table rating is used for ongoing medical impairments, with each table adding a fixed percentage to the standard premium. A rated-up age simply prices the policy as if the insured were several years older.

Worked Example — Flat Extra

Worked Example — Table Rating

Exam Trap: A substandard classification does not mean the applicant is denied. It means the policy is issued at a higher (rated) premium. Only a declined applicant gets no coverage at all.