5.3 Life Insurance Underwriting and Risk Classification

Life Insurance Underwriting and Risk Classification

Underwriting is the process of evaluating, classifying, and pricing risk so that each insured pays a premium proportional to the hazard they bring to the pool. The goal is to avoid adverse selection - the tendency of higher-risk individuals to seek insurance more than lower-risk ones. Underwriters use the law of large numbers to predict losses across the pool and price accordingly.

Underwriting balances two errors: charging too little for a bad risk (insurer loses money) and charging too much for a good risk (the applicant buys elsewhere). The exam focuses on sources of information, the legal limits on their use, and the resulting risk classifications.

Sources of Underwriting Information

The MIB does not contain dollar amounts or claims data - only coded medical conditions previously reported. Insurers may not decline solely on an MIB code; it is a flag for further investigation.

Fair Credit Reporting Act (FCRA)

The federal Fair Credit Reporting Act governs consumer and investigative consumer reports used in underwriting:

• The applicant must be notified that a report may be obtained.
• For an Investigative Consumer Report (ICR), the insurer must give written notice within 3 days of the request and disclose the nature and scope on request.
• If insurance is declined or rated because of a report, the applicant must be told and given the name of the reporting agency so they can correct errors.
• Negative information generally cannot be reported after 7 years (bankruptcies, 10 years).

Trap: FCRA notice is required even when no adverse action ultimately occurs - the applicant has a right to know a report may be ordered.

Risk Classifications

After review, the underwriter assigns a rate class that determines premium:

• Preferred - better than average health/habits; lowest premium.
• Standard - average risk; baseline premium reflected in the rate tables.
• Substandard (rated) - higher-than-average risk; premium is increased.
• Declined - risk too high to insure at any price.

Substandard risks may be charged using a flat extra premium (a fixed dollar amount per $1,000 of face for a temporary hazard) or a table rating (a percentage above standard, e.g., Table 2 = standard +50%, with each table step often adding 25%).

Worked Example: Table Rating

A 45-year-old applicant qualifies for a $500,000 policy with a standard annual premium of $3,000. Because of elevated blood pressure, the underwriter assigns Table 4, where each table step adds 25% to the standard premium.

• Table 1 = +25%, Table 2 = +50%, Table 3 = +75%, Table 4 = +100%.
• Rated premium = $3,000 x (1 + 1.00) = $6,000 annually.

If instead a flat extra of $5 per $1,000 were applied for a temporary aviation hazard: $5 x (500,000 / 1,000) = $5 x 500 = $2,500 added, for a $5,500 premium. Flat extras can be removed once the temporary hazard ends; table ratings are usually permanent.

Insurable Interest and Stranger-Originated Life Insurance

At application, valid insurable interest must exist between the policyowner and the insured - the owner must stand to suffer a genuine loss from the insured's death (love and affection, or a financial/business relationship). In life insurance, insurable interest must exist only at policy inception, not at the time of the claim, which is why a divorced spouse can remain a beneficiary if interest existed when the policy was issued.

Underwriters guard against Stranger-Originated Life Insurance (STOLI) and Investor-Originated Life Insurance (IOLI) schemes, where investors finance a policy on someone with whom they have no insurable interest, intending to profit on the death benefit. STOLI arrangements are illegal in most states and are a flagged underwriting concern. This contrasts with a legitimate life settlement, where an owner sells an existing, validly issued policy.

Risk Selection Factors and Build Charts

Underwriters weigh medical and non-medical factors. Medical factors include current health, medical history, family history (especially heart disease, cancer, diabetes), and build - the relationship of height to weight, evaluated against a build chart. Non-medical factors include occupation and avocation (hobbies such as scuba diving or aviation), moral and morale hazard, foreign travel, driving record, and finances.

Adverse selection is countered by accurate classification: charging each risk its fair share keeps healthy insureds from subsidizing - and abandoning - the pool.