What is Insurance Underwriting?
Let’s take a look at the concept of underwriting.
“Underwriting is a core insurance function. It is a methodological approach to ensure that the insurance business is conducted on sound lines and that risks are evaluated for loss potential on both frequency and severity over a period of time.”
Underwriting is the process of:
- Determining the level of risk presented by a proposer
- Deciding whether to accept the proposal
- Deciding the terms and price of the accepted proposal
Each underwriting decision involves balancing the insurer’s desire to earn premium often in competitive conditions with margins required to pay claims and expenses and also to ensure compliance with regulatory requirements. Underwriting is essential in all forms of insurance. For example, an automobile insurer will charge higher rates to young drivers, old models of vehicles, or may refuse coverage to drivers with a history of accidents. The underwriter may offer discounts for vehicles fitted with anti-theft devices. Fire insurers may inspect properties, offer reduced premiums for safety features such as sprinkler systems, and so on.
Understanding Risk Sharing
Understanding the concept of risk sharing or pooling will make it easier for you to understand the role of underwriting and risk classification in insurance.
All risks are not equal. For example, in the field of property and casualty insurance, wooden structures are at a greater risk of burning than stone structures. Therefore, a higher premium is required to insure a wooden structure. The same concept applies to life insurance. An individual with a serious illness such as cancer or diabetes is at a greater risk of premature death than an individual without the illness.
Since all risks are not equal, it would be inequitable to make all insured contribute the same amount. Thus, underwriting attempts to classify risks based upon their characteristics so that each insured in a specific class pays a premium in proportion to the risk involved.
The issue of fairness to the other participants is at the core of this risk classification (underwriting) process. When viewed from a perspective of fairness, proper risk classification becomes a central obligation of insurers to the policyholders who participate in their risk pools. This applies for all risks – life, assets or earnings.