Liability Insurance
Chapter 6
Underwriting
Underwriting Responsibility
The underwriting process is normally a combined effort performed with the insurance company, its agents, and some organization outside the insurance business. Insurance companies have the main responsibility for the selection and rating of insureds because they are accepting the risk of loss. However, the initial responsibility often falls on the agents themselves. The agents are the ones who solicit the prospects for insurance or accept applications.
This chapter may seem obvious as to the necessity of underwriting automobile insurance when we see the statistics of the rising costs of such accidents and the driving records of some drivers. This chapter will explore the different aspects of underwriting that people go through for insurance protection of any kind.
The role underwriting plays
Underwriting is the process of accepting or denying risks of the prospective insureds. If a prospective insured's risk is accepted, underwriting is further concerned with the term under which the particular risk is insured. The main purpose of underwriting is to maximize earnings by accepting a profitable distribution of risk. Adverse selection can occur if these risks are not properly balanced out. If an insurance company accepted all applicants selection occurs, but by insureds, especially if competing insurance companies practice selective underwriting. Selection by buyers is referred to as adverse selection because the insurance company is left with the short end of the stick. The insurance companies could be left with insureds that are ill, thus costing the insurance company money in claim payments. The premium dollar would not be sufficient to carry the financial burden of many claims.
A person may say, "Since insurance is based on the law of averages, why not accept all prospective insured and trust the laws of probability?" This sort of comment is deceptively simplistic. To rely of the law of averages would be inefficient and unprofitable for the insurance companies.
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A purpose of underwriting is to obtain a profitable distribution of exposures. |
Prospective insureds are not selected at random, nor do they have the same loss expectancies. Those prospective insureds with loss expectancies substantially higher than provided for in the rate should either:
1. be charged a higher rate (premium) or
2. be declined coverage.
If an insurance company (insurer) accepted applicants that did not meet the standards contemplated in the rate, the insureds would have to pay higher premiums for the insurance company to remain solvent. These higher rates would force policyholders to drop coverage or go to insurers that practice selective underwriting. Only people who were ineligible for coverage through insurers that practiced selective underwriting would pay the non-selective higher premiums. As the non-selective insurer charged continually higher premiums fewer and fewer healthy policyholders would stay with the company. Only those people with underwriting problems would remain. This would not allow an accurate prediction of losses. For this reason, underwriting is necessary.
Underwriting helps achieve equity in premium rates, thus a broad range of insureds are charged a proportionate amount with their loss expectancy. Automobile insurance underwriting includes function of selection and rating. As with any type of insurance, whether it be life insurance, disability insurance, or automobile insurance, the purpose is to obtain a group of insureds who will in total provide the insurance company with a reasonable profit and maintain its financial strength.
Insurance companies must develop a workable selection process to classify acceptable exposures accurately and to maintain enough insureds with loss expectancies low enough to offset the insureds with loss expectancies above the class average. The insurers must set a limit for the degree to which an applicant's loss expectancy can exceed the average without rejection or assigning to a higher premium classification. The primary purpose of this risk selection by the insurance companies is to obtain a profitable distribution of policyholders. With regard to automobile insurance, the insurance company may "drop" an insured if they experience too many accidents, or too many speeding tickets. The high-risk insured may be forced, if they live in a state that requires automobile insurance, to purchase insurance through another company at a much higher rate since they would classified as a high-risk driver.
The Agent's Role in Underwriting
As with any type of insurance, the agent asks preliminary questions to appraise the risk exposure of the prospective insured. In fact, many agents have completed extra schooling for such designations as a Chartered Life Underwriter (CLU) or Chartered Property-Casualty Underwriter (CPCU). Agents who complete this extra class work and pass a series of examinations are awarded these designation, regardless of the functions they perform in the business. Not only do the agents attend more schooling to be eligible for these designations, they are required to meet additional CE hours above the state-required CE hours to keep these designations. Some states have even began to reduce a CLU or CPCU state required continuing education requirements because these agents do go through this additional schooling.
Agents perform only a limited underwriting function. When writing any kind of policy, the agent learns of the high liability exposures or a driving record that is crammed with traffic violations, thus the risk to the insurer is too high for the insurer to accept. The agent has several choices:
1. Turn the application in with a check from the prospective insured. The insurer's underwriting department then has the decision to issue the policy with different terms or premiums.
2. The agent can reflect their experience to the applicant as being too high of a risk. Insurers may give certain driving requirements that have to be met, such as not having more than two accidents on the driving record. In this case the agents can weed out the unwanted prospective insureds.
3. Turn the application in on a COD basis; waiting to see if the insurer accepts the risk of the applicant to collect funds. This is not possible with auto insurance, but does apply to other types of insurance. This may alleviate the chances of a having to put the applicant through a refund process. If the prospective applicant's funds are limited, this may be a wise choice for them. As with the first choice, the insurer's underwriting office makes the choice.
The Underwriting Selection Process
Underwriting includes both preselection and postselection of risks. Preselection involves gathering pertinent information concerning the risk and deciding to accept or reject the risk of the prospective insured. Once this risk is accepted, the insurer must then practice postselection. Postselection is the process of reviewing insureds and dropping those which are no longer desirable. Postselection is available only if the policy is cancelable, not guaranteed renewable or state law permits the insurer to cancel the policy. As already mentioned, drivers that experience too many driving infractions can be dropped.
The application is normally a signed written statement by the prospective insured, which includes basic information about the automobile, its location and use, its drivers, the amounts and types of insurance desired and the insurance accidents and traffic infraction records. One of the goals of agents who can bind coverage immediately is to obtain a reasonable group of insureds for their insurers because if they do a poor job of selecting, many insurance companies do not want them as representatives. For agents that work for one company, it is appealing to insure a family with their agency for their home, health, life, boat, and car. Once the agent has submitted an application to the insurer, it is given to the underwriter. The underwriter then obtains information about the prospective insured to make an equitable and profitable decision. Some applicants show a higher probability of loss than other applicants. The obtaining of information may also help identify cases of possible adverse selection. The underwriter must deny or approve an application on obtainable information. The information is restricted by the cost and difficulty of gathering these facts. The most important types of information are:
1. the applicant's past driving record and use of the automobile,
2. the applicant's age, sex, marital status and/or living habits,
3. driver training and/or good student qualifications,
4. the physical condition of the applicant or property,
5. the zip code, in states where this is allowed, and
6. the financial standing of the applicant.
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The underwriting process consists of obtaining & analyzing information to arrive at a decision. |
To gather this information, the underwriter relies on the sources available to them. These sources chosen are a function of the particular risk, practicality and cost. The sources listed below may not apply directly to automobile insurance coverage, but is included to give an overall picture of the underwriter's sources. These sources include:
1. The Agent: Agents provide underwriters with valuable information beginning with the application containing the basic information regarding the risk of the applicant. Agents may be required to submit a report containing the application, answering questions regarding the risk and giving their recommendation as to the probability of risk. An underwriter can deny or accept an application solely on the agent's recommendation.
2. Motor Vehicle Department: A driving record of the person in question may be requested for a full picture of the individuals driving habits.
3. Inspection Reports: An inspection company provides underwriters with valuable information. These companies provide insurers with a nationwide investigating service. The inspection companies submit reports concerning an applicant. A typical insurance applicant would be amazed at the amount of information, accurate and inaccurate, these investigating companies can uncover. Since some of the information gathered by these companies can be inaccurate, several states have passed laws to permit consumers to examine information collected by credit rating bureaus. A federal statute, the Fair Credit Reporting Act, became effective in 1971 allowing the consumer to require disclosure of information on file and the sources of the information. If the consumer disputes some data in the report, the credit bureau must reinvestigate. The law also requires insurers to notify applicants on whom reports have been requested, and to specify if the insurer uses the report as a basis for denying the coverage or even charging a higher premium. The insurer must notify the applicant of this and provide them with the name and address of the reporting agency.
4. Underwriters Laboratories, Inc.: To best explain how important Underwriter Laboratories has become to the insurance industry, we must first become acquainted with their history. This company began as a cooperative organization of western fire insurers at the time of the Colombian Exposition of 1893. The world's fair was noted for the first large scale use of electric lighting. Insurance underwriters who were asked to insure the flimsy, combustible buildings of the Exposition organized a group to investigate the best ways to wire the buildings to prevent the risk of fire. This organization tested methods of wiring and the electrical equipment. The insurance companies, realizing the value of this work, expanded it so that now the mammoth testing organization exists today. This organization has been in business for so long that there is virtually no fabricated device or material in existence that has not been tested. Items meeting their high standards are permitted to bear the UL label. The UL label has become a hallmark of safety. Underwriters Laboratories, Inc. is important for the underwriting departments of property and liability insurers.
5. Medical Information Bureau (MIB): Underwriters can refer to the files prepared by the MIB, a cooperative organization of life insurers formed to centralize information of special interest to members about physical condition or previous applicants for life insurance in a member company. The files do not record the action taken by the insurer on the application. One of the services provided by the MIB may be of interest to insurers offering DI policies are the Disability Income Record System (DIRS). DIRS is a record of applications for DI coverage that request lengthy benefit periods and/or monthly benefits that exceed a specified amount. The purpose of this program is providing another avenue of avoiding over insurance.
6. Physical Examination: This may not apply to auto insurance, but for other types of insurance, this is one way to decline high risk individuals applying for coverage.
7. Other Sources: There are many other sources of information for underwriting purposes. Insurers often consult engineers who provide safety information. Commercial underwriters may seek information from companies publishing financial ratings and data useful for evaluating the moral hazard and the applicant's ability to pay. There are many other sources of information. This may be sub marginal when weighed against the cost and hassles involved in obtaining the information.
Auto Underwriting
As agents, we may run into the precept that everyone is entitled to insurance coverage, as everyone is entitled to own property. This precept has caused great concern to insurance companies because they want to have the right to screen or select their insureds. The complete freedom of an insurance company to choose its insured is impossible today. This is because all states have assigned risk plans through which almost all of the substandard, higher rated risk persons can obtain coverage. The complete right of an individual to own insurance is limited by several practical exceptions which are:
· motorists who regularly abuse alcohol,
· drug addicts, and
· habitual traffic offenders.
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Individuals who are extremely high risk may lose their right to own insurance coverage. |
This limitation affects less than one percent of the population. This means that individuals who are extremely bad risk may lose their right to own insurance. Some of these extremely bad risks may be able to buy it, but it will cost them a much higher premium than normally charged. In addition to paying higher premiums if the individual wanted to purchase broader coverage and/or limits they desire, they may also be limited by the insurance company.
Insurance companies have elected to have the right to cancel an insurance policy, which further illustrates the growing restrictions. Some insurance companies have started guaranteeing that the policy would not be canceled by the insurance company after an investigation period of about 60 days, except for a few very obvious reasons which include:
· nonpayment of premiums,
· fraudulent misrepresentation,
· loss of the driver's license by the insured,
· several serious motor vehicle offenses, such as driving while intoxicated, leaving the scene of an accident without reporting, or three moving traffic violations within 18 months.
This noncancellation agreement has been broadened by most insurance companies to include cancellation only for:
· nonpayment of premiums, or
· suspension or revocation of the driver's license or motor vehicle registration of the insureds who ordinarily drive the automobile.
Almost all state laws restrict the insurance company from canceling a policy today. Reasons for the cancellation must be given to the insured and, in most states, are required to give a 10 to 30 day notice before cancellation. Most states allow the insurance company to cancel a policy without restrictions during an underwriting period of about 60 days. These cancellation protections, however, only protect the insured during the policy period which can be from six months to one year. The insurance company does not have to renew the policy. Some insurance companies have extended the noncancellation provision to include a five-year renewal guarantee. There are a few additional exceptions to the basic ones mentioned above which are:
1. convictions for hit-and-run accidents,
2. driving while intoxicated or drugged, and
3. motor vehicle homicide.
Rating
We could probably safely say that nearly all motorists are insured, and if they are not, they should be. So with this many people, the emphasis of underwriting shifts from the selection process to the rating process, or pricing of the automobile insurance contract.
Automobiles are classified into five different groups:
1. private passenger,
2. commercial,
3. public,
4. dealers', and
5. miscellaneous.
These classifications are based in some portion upon the type of automobile and to a greater degree upon the use of the automobile. These designations are then used for the purpose of differentiating among the various major types of automobile risks. The miscellaneous category includes a number of automobiles designed for special purposes such as fire vehicles, police vehicles, ambulances, hearses, motorcycles, snowmobiles, and trailers or semitrailers to name a few. Automotive equipment not insurable under the automobile policy includes golf carts, lawn mowers and power shovels. Risks of this type are normally insured under separate inland marine or other contracts.
Commercial vehicles are classified by size of the vehicle and the business use classification of the insured. In addition to factors of weight and use, some areas give consideration to a mileage-radius factor. Commercial trucks involving long-distance operations usually more than 50 miles are definitely more hazardous than those confined to a local area. Public vehicles include private and public livery, taxicabs, and buses. Public vehicles are rated higher, but because there is no risk when the car is not in operation, a system has been devised on an earnings basis per $100 of gross receipts or on a mileage basis. Garage, service station and other automobile dealers are insured under special contracts. When there are five or more commercial or public cars under a single ownership, a "fleet" policy is issued, based upon discounts and the estimated average future exposure. The advance premium charged is adjusted at the end of the policy term by determining the actual number of vehicles and their use during the policy term.
Private passenger automobile liability premiums: the rating procedure illustrates the process of determining automobile insurance premiums. There are different factors that are important to determine the premium charged by the insurance company for the various basic coverages. These different rating factors are covered later in the chapter. The major portion of the price of automobile insurance applies to the liability and physical damage coverages. The medical payments coverage and the uninsured motorists’ coverage are relatively small parts of the total premium and therefore are not included in this description of the rating system.
The classification and rating system for private passenger automobile insurance in most states produces approximately 161 classifications. This does not include differences in territories. This is the plan described in the following paragraphs. There are some states that use plans which produce 260 classifications and about a half dozen use nine classes.
The base premium for bodily injury and property damage liability is determined by two factors:
· the territory (area), and
· the limits of liability chosen for the insurance contract.
Tables showing the basic premiums for the minimum limits for bodily injury liability coverage and property damage liability coverage are developed for each territory. Higher limits are also available. There is a newer type of personal auto policy on the market that uses tables with a single combined limit for all liability coverages.
The territorial designation used is according to the state and territory in which the automobile is principally garaged and used. Some states have as many 50 separate rating territories, while others have only a few. These differences are based upon the loss experience in the territory for several years. Claims statistics in changing the rates are determined by accidents charged to the location where the car is principally garaged and used. Thus an accident caused by a person from a large city is not charged to a small city where the accident may have occurred. The rates vary considerably by territory. Even within the same state, the rate for the same coverage may be several times higher in one section as in another. In the state of Washington, for example, the zip code of the insured's residence determines a portion of the rating of a vehicle, thus lowering or raising the premiums. Washington's rates are about half as much as Texas' rates are.
Primary Rating Factors
There are two sets of classification factors that are considered primary and secondary which determine the total that is applied to the base premium. The primary classification factors are:
· Age, sex and marital status of the automobile operators.
· The use of the automobile.
· Driver training and good student qualifications.
There has been a growing controversy over the use of age and sex differentials in automobile insurance rating. There have been about ten states that have passed laws which prohibit rate classifications based on age or sex, but several of these laws have been repealed. Research indicates that these characteristics are reasonably good predictors of actual loss experience and therefore do not constitute unfair discrimination.
Should the age of a driver be an important factor to determine a drivers' premium? Many research studies have shown that the younger groups of drivers cause many more accidents, particularly fatal and serious ones, than the proportion of the total number of drivers would indicate. The younger drivers may take chances that a prudent person would not take. Younger ones may be more likely to speed in conditions that warrant a lower speed. The rate does go down gradually from age 18 to 29, perhaps in correlation of the added responsibilities one has to their growing family. Older ages may also experience problems. Older drivers can no longer see and hear as well, handle stressful situations logically or react quickly. The older ones may experience blackouts, memory loss or panic attacks and cause an accident before they are willing to admit they should not be driving - thus taking away their independence.
Older operators are divided into three groups (no youthful drivers):
· Females, ages 30 - 64, only operator.
· Age 65 or over, one or more operators.
· All others.
The youthful operator classifications also reflect the fact that, in general, the youthful male drivers have more accidents that youthful female drivers and youthful unmarried men have more accidents than youthful married men. The classes developed are in four groups with further breakdowns for age 17 and under, each year to 20 and combined age classes for ages 21-24 and 25-29. The number of classes developed total more than 100:
1. Females, unmarried, under age 25.
2. Males, married, under 25.
3. Males, unmarried, under 25 and not owners or principal drivers of the insured automobile.
4. Males unmarried, under age 30 and owners or principal drivers.
Drivers affect the above classifications if they are residents of the same household as the insured or if they customarily drive the insured automobile. Unmarried females and males under 25 who are absent from home while attending school over 100 miles away are rated as being married. The above age-sex-marital factor is combined in tables with the use factor, based upon five classes. They are:
1. Pleasure use.
2. Used to or from work less than 15 miles one way. This can be 10 miles in some plans.
3. Used to or from work more than 15 miles one way. Again, this can be 10 miles in some plans.
4. Business use.
5. Farm use.
When the first group is rated as 1.00, the factor applied to the groups 2 to 4 is higher and the factor applied to group 5 is lower.
Driver training is important for youthful drivers from age 17 through age 20. Statistically it saves lives, reduces accidents and lowers insurance premiums. The standards for qualified courses are usually set by the state education departments. This often involves about 30 hours of classroom work and 6 hours of driving. Those with driver training receive a lower rating factor, about 5 to 10 percent less than that of drivers of the same age without driver training. This one factor can make a substantial dollar difference for many youthful drivers and their parents.
Good students also receive lower premiums from the some insurance companies by meeting certain qualifications. The insurance company may require the student be full-time and have a B average. The rates average about 20 percent less than those for other students. The theory is that the better students use automobiles less than others students.
Secondary Rating Factors
There are three types of secondary classification factors:
· multi-car,
· type of vehicle, and
· safe-driver rating plan.
The multi-car exposure factor is based on the idea that if more than one private passenger car is owned by one person, or by relatives of the same household in joint names, the cars will not each be used as much as if the household only owned one car. This factor results in a combined premium that is at least 15 percent less than the total premium for a single car exposure would otherwise be.
The type of vehicle is classified to automobiles into standard, intermediate and high performance cars and sport cars.
The safe-driver rating plan is used by many insurance companies to distinguish among drivers on the basis of their accident record, traffic convictions, and experience, applied for by principal drivers of the automobile only. The insurance companies have devised a type of point system which it uses to classify drivers into five groups. Chargeable accidents during the past three years count one point each whenever they involve bodily injury or property damage of more than $200. The premium rates could go up 30 percent for one accident, 70 percent for two accidents and as high as 120 percent for three accidents. These percentages could even go higher. Most plans vary somewhat, but 1 to 3 points are assigned against the insured for motor vehicle violations such as driving while intoxicated, hit-and-run accidents and license suspension or revocation. Lack of experience (licensed less than three years) by the principal driver of the insured automobile counts as one point against the insured right out of the running gate. Although it is a secondary factor, the importance of the safe-driver plan in preventing increasing rates is apparent in the indicated rate increases.
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TO RECAP: The primary classification factors and the secondary classification factors are combined to be applied against the base premium for each car insured to determine the insurance premium rate. |
Other Rating Factors:
Moral & Morale Hazards
Moral hazard is the possibility that an insured will deliberately bring about an insured loss. Moral hazards usually arise from a combination of moral weakness and financial difficulty. If, in the underwriting process, evidence is shown that an applicant intends to defraud the insurer, no underwriting is possible. Underwriters can be alert to the presence of moral hazards by looking at an applicant's credit report; excessive inventories, large unpaid bills, working capital deficiencies, etc.
A moral hazard is mostly found in property and health policies, but may even appear in life insurance policies.
Morale hazard is closely related to moral hazard. A morale hazard arises from indifference concerning loss, often brought about by the security of the insurance, which leads to carelessness. The morale hazard is difficult to underwrite. People leave cars unlocked; keys in the ignition, garage doors open in the middle of the night, and so on. Morale hazard may tend to merge into moral hazard.
In some states where canals are easily accessible, people sink their cars; report them stolen and collect on the insurance coverage. This represents a moral hazard.
There have been other systems used to determine premium rates in the past. Some of us may remember that during World War II mileage, based on gas ration cards, was a simple system. This changed to a use and age system for predicting losses. During the 1960's, discounts were given for compact cars. These were determined to be unjustified by most insurance companies as better statistical experience was obtained. In fact, it was learned that compact cars have been determined to have personal injury risk 40 percent or more greater than that of full-size cars.
The future is sure to bring revisions in the rating system now used, with some traditional factors being discarded and new ones accepted.
Underwriting for Business Liabilities
If the property covered is a business structure of high value, underwriters consider the risk more carefully. The factors involved in the decision process are essentially the same as those in underwriting a dwelling. Dwellings are classified according to construction, type of roof, number of dwelling units, occupancy and degree of fire protection. The degree of fire protection is a significant factor in determining the class and thus the premium rate.
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The degree of fire protection is a significant factor in determining the class and thus the premium rate. |
People may find it surprising that some factors that affect automobile insurance premiums also affect dwelling premiums. Some of these common factors are the dwelling's age, neighborhood, construction, value, size, occupancy and moral hazard. Underwriters weigh these factors and many other arrive at a decision.
The principal considerations in classifying and rating a business structure are the construction, occupancy, exposure and protection.
With regard to the construction, it refers to the building materials used. For fire insurance, buildings are classified as frame, brick or fire-resistant. Construction alone has a minimal effect on the building's acceptability for insurance coverage. All three types of construction are insurable. The construction of the building may not be the only thing an underwriter considers. The geographical location of the building and its occupancy may also weigh on the underwriter's decision.
The occupancy of a building is the purpose for which the building is used. To the underwriter a frame structure may be acceptable for office work but not acceptable as a dry-cleaning plant. The effects of occupancy may be divided into three parts:
· ignitability,
· combustibility, and
· damageability.
Ignitability measures the likelihood of a fire occurring as the result of a given occupancy. The ignitability may be high for buildings that warehouse chemicals, paints, gasoline and similar flammable products that are produced or used in large quantity present a considerable ignition hazard.
Combustibility is the measure of the likelihood of an existing fire fed by a given occupancy. For instance, a lumber yard or dry-cleaning plant may pose a high combustibility likelihood. And in the instance of the lumber yard, while the lumber itself may pose a small likelihood that it will cause an ignition, once started could burn quickly.
Damageability measures the susceptibility of contents to the amount of fire loss. The damageability of items is closely related to their values. For instance, a fire would have to destroy a great quantity of ink pens to produce a loss even closely approaching that of small fire in designer clothing store. Not because one burns faster or slower, but because the value of one to the other is so different. A characteristic of damageability also is susceptible to water or heat damage in addition to combustion.
An exposure is the likelihood of a damage occurring to the insured object caused by an outside source. Where the building is located may have an effect on the insurability of the building. For instance if a power plant or gasoline manufacturer were the neighbors, this may warrant a rejection of the policy even though the rate for the coverage supposedly reflects the adverse exposure.
Protection of the building may consist of private or internal protection such as fire alarm systems, fire doors, fire blocks in the walls, automatic sprinkler systems, etc. Protection also includes public protection furnished by city fire departments. Premium rates may be affected by how far the fire station is away from the premises.
End of Chapter 6