13.1 Underwriting Basics

What Underwriting Is

Underwriting is the process by which an insurer assesses a risk, decides whether to accept it, and sets the terms, conditions and premium. It is the gatekeeping function of insurance: without underwriting there is no risk selection, no risk-based pricing, and no viable insurance pool. The person who carries out this role is the underwriter.

Underwriting operates at two key points in the policy lifecycle:

• New business — when a proposal is first submitted, the underwriter decides whether to insure the risk and on what basis.
• Renewal — at each renewal, the underwriter reviews the risk in light of any changes (claims, exposure, occupation, sums insured) and decides whether to renew, on what terms, and at what premium.

Quick Answer: Underwriting = assess the risk, decide whether to accept it, set the terms, conditions and premium. It applies at new business and at renewal.

Factors the Underwriter Considers

The underwriter draws together several strands of information before reaching a decision:

Physical and Financial Underwriting

Underwriting is often divided into two complementary disciplines:

• Physical underwriting is the assessment of the risk itself — the physical hazard, the claims experience it has produced, and the exposure it presents. It asks: what is the risk, and how likely is it to produce a loss?
• Financial underwriting is the assessment of whether the sum insured and the scope of cover are proportionate to the need and to the insured's financial standing. It asks: is the insured asking for the right amount of cover, and could the cover create an incentive to claim? Financial underwriting guards against over-insurance and the moral hazard that follows when a policyholder stands to gain more from a loss than from continuing the insured activity. For life and property risks, financial underwriting means testing the sum insured against the property's value or the life assured's income and dependants' needs.

Adverse Selection

Adverse selection is the tendency for higher-risk individuals to be more willing to buy insurance than lower-risk individuals, because they know — or suspect — that they are more likely to claim. Left unchecked, adverse selection drives up claims costs, forces insurers to raise premiums, and pushes still more low-risk people out of the pool, until the insurance market becomes unstable.

The underwriter's answer to adverse selection is risk-based pricing and risk selection: probing the risk through the proposal form, requiring disclosures, rating the premium to reflect the hazard, and applying special terms where the risk is substandard. A simple example: a driver with two recent convictions for speeding is more likely to seek motor cover and more likely to claim, so the underwriter charges a higher premium or imposes an excess to reflect that.

Rating and the Build-up of Premium

Rating is the process by which the underwriter sets the premium for a risk. A premium is not a single figure pulled from the air; it is built up in layers:

1. Base rate. The insurer's book of rates for the class of business gives a starting premium for a risk of average hazard and a given sum insured.
2. Adjustment for hazard. The underwriter loads the rate where the physical or moral hazard is worse than average, and discounts it where it is better. A house with a fitted sprinkler system attracts a discount; a takeaway with a deep-fat fryer attracts a loading.
3. Deductibles and discounts. An excess (the amount the insured pays towards each claim) reduces the cost to the insurer and is reflected in a lower premium. No-claims discounts reward a clean claims record.
4. ** Expenses and margin.** The premium must cover the expected loss cost, the insurer's expenses (commission, administration, claims handling), and a margin that reflects the cost of the capital the insurer holds to underwrite the risk.

Declinature and Special Terms

Not every risk is acceptable on ordinary terms. The underwriter has a range of responses:

• Accept on ordinary terms — the risk is standard, and the book rate applies.
• Accept on special terms. The underwriter may modify the cover to bring the risk within appetite:
  • Exclusions — specific perils or circumstances are excluded (for example, theft cover excluded unless a burglar alarm is fitted).
  • Endorsements — a clause is added to shape the cover (for example, an endorsement requiring minimum security standards).
  • Increased premium — a loading is applied to reflect the higher hazard.
  • Increased excess — the insured must pay a larger first amount towards each claim, reducing the insurer's exposure to small claims.
• Declinature — the underwriter refuses to insure the risk at all. A declinature is a last resort, used where the risk is outside the insurer's appetite or cannot be priced responsibly. Under the Equality Act 2010 and FCA rules, declinature must not be based on a protected characteristic, and insurers must be able to justify their underwriting decisions.

Worked Scenario

A small manufacturing business applies for a £2 million buildings and contents policy. The proposer's factory is of steel-framed construction with a concrete floor (good physical hazard) but is located on a flood plain (poor physical hazard). The proposer has made two small fire claims in the last four years but has never been refused cover or cancelled (moderate claims history, low moral hazard). The insured's accounts show the £2 million sum insured reflects the rebuild cost and stock value (financial underwriting is satisfied).

The underwriter's response: rather than decline, the underwriter accepts on special terms — a flood exclusion endorsement is added unless the insured installs flood barriers, a £2,500 excess is imposed for fire claims, and a 15% premium loading reflects the claims history. This is risk-based pricing in action: the risk is placed, the insured gets cover for the perils that matter, and the insurer's exposure to the unmanageable flood peril is removed.

Key Takeaways

• Underwriting is the process by which an insurer assesses a risk, decides whether to accept it, and sets the terms, conditions and premium, at new business and at renewal.
• The underwriter weighs the physical hazard, moral hazard, claims history and exposure.
• Physical underwriting assesses the risk itself; financial underwriting tests whether the sum insured and scope of cover are proportionate to the need and the insured's financial standing, guarding against over-insurance and moral hazard.
• Adverse selection is the tendency for higher-risk individuals to be more willing to buy insurance; underwriters counter it through risk-based pricing and underwriting.
• Where a risk is substandard, the underwriter may decline, accept on special terms (exclusions, endorsements, increased premium, increased excess), or accept on ordinary terms.