Disability Insurance

Chapter 4

Occupations are classified into five different groups according to the degree of hazardous duties involved. This may be one of the most important parts of underwriting a prospective insured. The underwriter of the DI policy must assess not only the proposed insured's occupational title, but also the nature of the duties performed in that occupation.

  If insured #1 is applying for DI coverage and their occupation requires them to perform several different duties, the occupational classification is based upon the most hazardous duty performed.

  Dividing occupations into classifications has, therefore, limited the availability of policies in the top occupational classes, dividing the most desirable occupations into five classes. The classes are defined below.

Class 4AS: Certain professionals and corporate executives. The corporate executives must meet the following criteria:

Ø Primarily office duties with little or no travel

Ø  Compensated by salary

Ø  Employed by a well-established, stable firm for at least two years and earning more than $35,000 annually.

  Some of the professions included in this category are CPAs, anesthesiologists, architects, gynecologists, dentists, and psychologists. This list is not inclusive. It merely lists some of the occupations to give the reader an idea of the occupation categories.

Class 4A: A number of select professionals. Some of the professions in this category include physicists that partake in no lab work, engineers who work in an office or as a consultant only, accountants working for an accounting firm, chemists that consult or work in an office, and civil engineers with office work only.

Class 3A: People engaged mostly in mental work, primarily those with clerical duties or office only duties. Some of the professions included in this category are clergymen, comptrollers, computer operators, court bailiffs, anesthetists, draftsmen engaged only in office duties, speech therapists, travel agents, statisticians, stockbrokers, rabbis, real estate agents/brokers, and typists.

Class 2A: People who are supervisors, technicians, merchants with no delivery or repairing duties, those with special skills and other skills, and others not performing what is generally described as manual labor, although duties may require some physical activity. Some of the professions included in this category are taxidermists, timekeepers, bill collectors, chiropractors, apartment house managers, counter clerks, geologists in the field with no hazardous work involved, grocery managers, locksmiths, hotel/motel clerks, and newspaper reporters.

Class 2B: People in occupational classifications 2A and 3A who do not meet minimum income requirements, but who are employed by a professional organization to which disability coverage is provided.

Special Circumstances

  Government Employees (Federal civil service) are not eligible for disability insurance because of the accumulating sick leave and disability benefits automatically available with their jobs.

  State, county and municipal employees, including public school teachers, are ineligible for the disability insurance due to the substantial benefits available in their pension plans. Individual underwriting consideration may be given for limited coverage amounts provided full information, including the retirement plan booklet, is submitted preliminary to determining eligibility.

  Disability insurance coverage is not generally available to individuals who work at their residences. People who have a Businesses at Residence classification may be given exception in cases where some duties are performed at the residence, but a significant amount of outside activity is required. Normally, exceptions of this type will be granted only with a 60 or 90-day waiting period. This situation does not apply to doctors, dentists and attorneys who have established offices at their residence, nor to manufacturers' representatives who use their residence as business addresses but whose duties require them to spend almost all of their time calling on clients.

  DI coverage is not available for some occupations normally designated NE (Not Eligible). This list may change and different insurers may allow occupations that other insurers do not. Sometimes an occupation is not covered by DI policies because the occupation is out of the residence. Under certain circumstances, though, DI coverage may still be available depending on the insurer chosen. Some of the professions not covered are used car salesmen and dealers, authors, actors, singers, entertainers, air traffic controllers, acupuncturists, bartenders, barbers, bus drivers, butchers, cooks/chefs, flight attendants, musicians, guards, detectives, policemen, janitors, and teachers in the home.

Why the Necessity?

  Underwriting is the process of accepting or denying risks of 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.

  A person may ask: "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 insurers.

  Prospective insured 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:

· Be charged a higher rate, premium, or

· Be declined coverage.

  If an 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 are ineligible for coverage through insurers that practice selective underwriting would pay the higher premiums of the insurers that do not practice selective underwriting. The non-selective insurer would charge even higher premiums. This would result is a greater loss of applicants with a lower loss expectancy, thus driving up rates even farther. Thus 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. With DI policies, classifications are made to differentiate among exposures that are used for rating purposes. With other types of insurance the classifications may be broad to facilitate accurate loss predictions and to control rating expenses.

  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 higher 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.

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 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 designations, regardless of the functions they perform in their business. Not only do the agents attend more schooling to be eligible for these designations, they are required to meet additional CE requirements to keep these designations active.

  Agents perform only a limited underwriting function. When taking an application for any type of policy, if the agent learns of a health condition or, as with a DI policy, an occupational risk that is too high for the insurer to accept, the agent has a couple of 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. Turn the application in on a COD basis, waiting to see if the insurer accepts the risk. If the risk is accepted, the agent will collect premium upon delivery of the policy. This may alleviate the chances of having to put the applicant through a refund process. If the prospective applicant's funds are limited, this may be a wise choice. As with the first choice, the insurer's home-office makes the final decision.
3. The agent can advise the applicant that he or she may be viewed as high risk by the company underwriters. Some companies do issue guidebooks for the agents and prospective applicants that outline specifically which health conditions or occupations are not acceptable for policy issue.

The Underwriting Process

  Underwriting includes both preselection and post-selection of risks. Preselection involves gathering pertinent information concerning risks and deciding to accept or reject the risk of the prospective insured. Once this risk is accepted, the insurer must then practice post-selection. Post-selection is the process of reviewing insureds and dropping those that are no longer desirable. Post-selection is available only if the policy is cancelable, not guaranteed renewable or where state law permits the insurer to cancel policies.

  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 the:

· Applicant's past loss experience,

· Financial standing of the applicant,

· Applicant's living habits,

· Physical condition of the applicant or property, and

· The character of the person requesting insurance.

  To gather this information, the underwriter relies on the sources available to them. The sources chosen reflect the particular risk, practicality and cost. The sources listed below may not apply directly to DI coverage, but is included to give an overall picture of the underwriter's sources. The 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. Medical Exam: A medical examination is required for a DI policy. The insurance companies can request specific testing or medical examination related to a particular condition the applicant disclosed on the application. The application has basic medical questions that the applicant answers. This can prompt the underwriter to request an attending physician statement (APS) from physicians the applicant has consulted in the past and present.

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 which is used by insurers offering DI policies is the Disability Income Record System (DIRS). DIRS is a record of applications for DI coverage that requests lengthy benefit periods and/or monthly benefits that exceed a specified amount. The purpose of this program is to provide another avenue of avoiding over insurance.

6. 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, although their use must be weighed against the cost and hassles involved in obtaining the information.

Moral & Morale Hazards

  Moral hazard is the possibility that an insured will deliberately bring about a loss for which they have purchased insurance protection. Moral hazard usually arises 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, and so forth.

  Moral hazard is mostly found in property, health, and may even appear in life insurance.

  Morale hazard is closely related to moral hazard. Morale hazard arises from indifference concerning loss, often brought about by the security of the insurance, which leads to carelessness. 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 hazards may tend to merge into moral hazards.

  For the insurer, the disability risk involves considerable difficulty. Malingering and fraudulent claims have tended to swell the cost of benefits far beyond the expectation upon which premiums were predicted. Over-insurance has aroused the temptation to extend periods of disability that would unquestionably be shorter without insurance.

  Pertaining to DI coverage, reasonably estimating the amount of income needed during a disability can be a major problem in individual policies. Many insurance contracts limit the payment to an amount that will indemnify the insured for the loss. Over-insurance in paying for medical care costs is infrequent because most individual policies are based on services provided, or on actual reimbursement for expenses paid by the insured. The number of DI policies that an insured obtains or the total amount payable can be limited. The insurance companies developed provisions, like the other insurance provision also called the income insurance with other insurer’s provision, in the contract to protect themselves from this. Over-insurance creates a continuing moral hazard in the disability income insurance field. If over-insurance was allowed to continue, an insured may be tempted to prolong a disability. A provision particularly important for the long term guaranteed renewable policies is the average earnings provision. The amount payable at any time is typically reduced if the insurance in force under all policies exceeds a specified percentage, such as 85 percent, of the gross earned income of the insured at the time of the disability, or their average monthly earnings for the two year period preceding disability, whichever is the greater. The reduction is proportionate and a minimum monthly benefit may be included.

  The goal of avoiding the over-insurance threat is best achieved if the disability income policy pays no more than the net take-home pay, after taxes and expenses of the insured are considered. Underwriters may limit the amount of disability income insurance written to approximately 80 percent of the insured's gross income and may also use the average earnings clause to prevent over-insurance.

The Decision

  After obtaining the relevant facts, the underwriters analyze the information to make a decision. The reliability of the information, whether it is subjective or objective are important factors that the underwriter must weigh in their decision. At this point the underwriter has three options:

1. Accept the prospective applicant (standard risk),

2. Offer the applicant modified coverage (substandard risk), or

3. Deny coverage entirely (uninsurable risk).

  The standard risk (accepting the applicant) or the uninsurable risk (denying coverage entirely) is obvious. The middle option, modify coverage, is the decision of the underwriter. The applicant must then decide whether or not to accept the changes the underwriter chooses. These changes can include a number of things from higher premiums to added provisions. The insurer could add an Exclusion Rider. The rider does exactly as the name implies. It excludes or eliminates coverage otherwise provided for in the insurance policy. The positive aspect of an exclusion is that it keeps premiums within a reasonable level.

  In short, the underwriting process can be a combined force. Though conflicts between underwriting and production are inevitable, the agent's job is to produce as many insurance contracts as possible. The underwriting department's job is to obtain a safe and profitable distribution of exposure units. Agents may want borderline applicants accepted but underwriters will look at the applications from a different viewpoint. Underwriting and agents must work together. New clauses are continually added as new types of losses occur, and good agents do not take applicants indiscriminately, without regard to good underwriting procedure. However, each group may feel that the business would be much better, or more pleasant, without the other.

  The underwriting process is closely related to reinsurance and the underwriter must know how their ability to accept risks is both broadened and limited by reinsurance available to the insurance company themselves. Reinsurance is the transfer of insurance from one insurer to another. It is the insurance purchased by insurers.

Why the Need?

  The answer is quite easy when we look at natural disasters hitting different parts of the nation. An insurer's losses can be quite substantial. Fortunately, one insurer does not bear the brunt of all the losses. The fact that catastrophes do occur explains the important purpose of reinsurance, the diversification of exposures and losses. One insurer can write large amounts of insurance on a single property, then reinsurance shifts part of that risk to many others. Large losses are thus shared, and excessive losses in one occurrence do not cause financial instability of individual insurers. Without reinsurance, each insurer would be limited to its own financial ability to pay losses. With reinsurance, financial strength is enhanced by the spreading of losses throughout the entire insurance business.

Reinsurance, simply put, is

the insuring of insurance.

  Reinsurance also has other purposes. There are reserve requirements for insurers on insurance policies that, if a disaster were to occur, could cause a drain on surplus and restrict growth, particularly for newer and smaller companies. Reinsurance allows for more rapid growth by having a reinsurer take over from the insurer part of the requirement for maintaining reserves, thus permitting the insurer to increase their policies. Reinsurers offer many technical advisory services to new insurers or those expanding to new types of insurance or territories. For the reinsurer the motivation is obvious - profits.

Reinsurers are of two basic types:

1. Professional reinsurers: write nothing but reinsurance business.

2. Reinsurance departments: write mostly insurance but also some reinsurance.

  Reinsurers frequently reinsure part of their exposure. This process is called retrocession. The amount of business placed with the reinsurer is called the ceded amount. The placing of business placed with a reinsurer is called cession.

  Reinsurance may be classified broadly as the terms listed below:

· Treaty Reinsurance: the insurer must cede the amount of insurance required under the contract agreement and the reinsurer must accept the amount offered. Treaties may cover a range of perils and they avoid the time-consuming negotiations necessary when reinsurance has to be arranged for each contract.

· Facultative Reinsurance: the insurer determines for each case whether reinsurance is desired. If so, the reinsurer retains the right to accept or reject each proposal on its merits. A new contract must be negotiated for each case.

· A combination of the two.

  The policy may be written as proportional (pro rata) or non-proportional. Under proportional reinsurance an insurer shares with a reinsurer on a proportional basis both the premiums and the losses. Pro rata reinsurance may be used by new insurers that lack underwriting skills.

  Within the proportional or pro rata reinsurance are:

1. quota share, and

2. surplus share.

  Quota share reinsurance is shared with the reinsurer, having the same proportion of every policy - large and small. Surplus share reinsurance has the participation calculated separately for each policy.

  Non-proportional reinsurance can be classified into two major categories:

1. excess loss, and

2. stop loss.

  Under excess loss reinsurance the reinsurer is required to bear only those losses in excess of the ceding insurer's retention limit. This leaves the ceding insurer to bear losses in full up to the retention amount. Excess loss reinsurance may be written as individual per-risk reinsurance (the reinsurer agrees to pay losses on a single risk in excess of the ceding insurer's net retention limit) or catastrophe risks reinsurance (the reinsurer agrees to reimburse the reinsured, up to a stated maximum, for catastrophe losses in excess of a given retention amount per disaster).

  The ceding insurer uses stop loss reinsurance to control their loss ratio (the ratio of incurred losses to earned premiums). This plan has a stop-loss limit. The limit is the higher of a given percentage of the ceding insurer's net earned premium or a specified dollar amount. The reinsurer is liable only for the insurer's aggregate losses exceeding the applicable stop loss limit up to a specified maximum. This maximum is either a predetermined percentage of the insurer's net earned premium or a fixed dollar amount - whichever is less.

Reinsurance allows insurers to accept more business than their underwriting capacity otherwise would support.

  A special type of reinsurer is the reinsurance pool. This is an association for the exchange of reinsurance among two or more insurers according to an automatic agreement. Each of the insurers receives a certain portion of the risks or losses of the other reinsurers. Each gives to all the others a predetermined part of its risks or losses. These pools are also used for spreading infrequent catastrophic types of risks among insurers of a company group or fleet.

End of Chapter 4

United Insurance Educators, Inc.

2012