HOW INSURANCE COMPANIES
EVALUATE RISK AND RATE YOUR EXPOSURE
By David Hampson
Cross Insurance, Exeter
Insurance companies have underwriting departments to evaluate a risk and appropriately rate the exposure in much the same way as a mortgage company underwrites a loan application. When you consider the amount of money that can be on the line with an insurance company’s promise to pay, it’s easy to recognize the importance of underwriting before taking on a risk. Most people are surprised todiscover the low margins at which an insurance company operates. A combined loss ratio of 95-98% is generally considered excellent performance when an insurance carrier reviews its overall annual results. This means that, with exemplary performance, the sum of all claims and expenses amount to 95-98% of the premiums paid by all insureds. Irresponsible underwriting can easily tilt the loss ratios in the wrong direction and be the source of financial ruin for an insurance carrier (this is what happened in the mortgage industry!). Although we may not individually submit a claim each year, it’s easy to forget about the amount of money an insurance company has to pay out collectively to settle claims. Nonetheless, the underwriting process can be a source of frustration for insureds whom are eager to secure coverage and feel bombarded by the number of questions asked and inspections required.
It can be helpful to know in advance some of the underwriting information insurance carriers are looking for before seeking coverage. Generally when applying for a homeowner’s policy or commercial property coverage the insurance company will want to know various characteristics of the building such as year built, type of construction, square footage, updates and protective equipment. Depending on the carrier, there may be additional information required, such as interior and/or exterior pictures, and details with regards to the occupancy and type of tenants, if any. When applying for liability coverages, insurance companies will require the exposure base such as sales, payroll, or area. For auto policies underwriters will need a list of the vehicles, radius of operations, use, and list of drivers. Workers compensation applications will require information on payroll broken down by class of work, and information on any safety programs implemented.
Your prior loss history is another important criteria underwriters review for all lines of coverage. If a risk has a high loss frequency or severity it may be to be quoted at a higher rate in order for the insurance carrier to collect enough premium dollars to cover future predicted losses. Actuarially, it has been demonstrated that a risk with poor loss history is more likely to sustain future losses. Although individually your claims may have just been a streak of bad luck, insurance companies practicing sound underwriting generally need to base their rating on statistics accumulated from many insureds (law of large numbers).
Another underwriting variable most insurance companies now use for rating personal lines policies is your credit score. This has been a controversial practice, which has been questioned by consumer advocates since it was implemented several years ago. However, there does seem to be a clear correlation between credit score and claims submitted when large data sets are analyzed. Why this certainly does not imply that a poor credit score causes one to have more losses, there does seem to be a propensity for people on the low end of the credit scale to put in more frequent claims. Industry experts have not been able to explain the correlation beyond this, but one can surmise that individuals with less debt and more funds available may decide to pay for small losses on their own and not submit a claim.
Many insurance underwriters will also order a loss control inspection after a policy has been issued. This is to identify hazards that are likely to cause a loss and make recommendations to correct them. These inspections are actually a value-added service as they help you prevent a property loss or liability lawsuit that can be frustrating, time-consuming, and ultimately an expense to you via deductible payments and higher insurance rates. Many carriers also perform a replacement cost estimator to evaluate whether your property is adequately insured to value. If approached with the right attitude, the inspections can be a constructive benefit to your insurance policy and part of your overall risk management program.
In summary, obtaining underwriting information is critical for insurance companies to maintain responsible business practices that generate enough revenue to cover all possible claims and operating expenses. Although some underwriting variables may not be relevant to you specifically, they have proved to be reliably predictive with large data sets. The underwriting process can make you feel like you’re going through the “third-degree” at times, but hopefully this article has helped explain the background and rationale behind gathering this information. Ultimately, by keeping insurance companies financially strong, sound underwriting practices are in the best interest of policyholders and the health of our country’s entire insurance infrastructure.