Umbrella Insurance

Chapter 5

Underwriting the Umbrella Policy

  With few exceptions, all policies are underwritten to some degree.  Some types of policies may be underwritten easier than others, but most are underwritten in some way.

Assessing Policy Risks:

  There will be a difference in underwriting when it comes to personal or business umbrella policies.  Each has their own risks.  Agents, of course, want to offer the best policy they can for the least amount of money.  Therefore, as an agent, you will want to check around for the best offering from those companies with a secure financial rating.  Unfortunately, those consumers shopping for an umbrella policy are often doing so because they have found themselves to be a higher than average risk.

  Insurance companies are perhaps the best score keepers around.  They know from past experience and other accounting methods approximately what their losses will be on a block of business over a given time period.  For insurance companies, one of the most important elements has to do with "selection."  By that, we mean selecting risks that are likely to be profitable as a group.  There will be claims, of course, within the block of business.  That is expected.  As a block of business, however, profit is likely.

Books of Business:

  Insurance companies do have other goals besides profit.  Because profit is based upon a growing book of business (also called a "block" of business), they also strive to provide proper insurance coverage, while maintaining risk and pricing standards.  By doing so, this block of business will grow because it will be something that consumers wish to purchase.  Only when consumers want to buy something can it be profitable, whether that happens to be a computer, furniture, or an insurance policy.  For insurance companies, this means properly selecting, classifying, rating and monitoring umbrella liability contracts.

  Insurance itself is fairly basic.  For a premium (a predetermined small financial loss), the insured transfers the threat of a large financial loss over to another entity, the insurance company.  The insurance company then spreads the risk out over a group of similar policyholders with similar risks of financial loss, so that payout of benefits can be somewhat predictable.

For a premium (a predetermined small financial loss), the insured transfers the threat of a large financial loss over to another entity, the insurance company.

  Insurance companies are careful to select members of the group so that claims do not overpower premiums taken in.  The insurers want a "pooling" effect, with everyone paying into the pool of money, but only a few needing to take out of it.

Underwriting Based on Exposures & Risks:

  Any risk exposure can be underwritten, if someone is willing to do it and the price charged is enough to cover the exposed risk.  Therefore, underwriting and pricing are interrelated; one function cannot be discussed without the other.  Both parties are also interested in both functions - the insurance company is interested in underwriting and the consumer is interested in price.

  Underwriting itself is the process of either accepting or rejecting the applicant in exchange for a given financial payment in return for a specified protection from financial loss.  This rather long sentence is really only saying one thing: what benefits for how much money?  Once the applicant is deemed acceptable, other concerns then take priority: the terms under which the company is willing to accept the applicant.  This would relate to the policy itself, the insuring agreements, exceptions and other provisions of contract.

Adverse Selection:

  Adverse selection is always a concern.  A student of theory might say: "Because insurance is based on the law of averages, why not simply insure anyone wanting insurance trusting in the laws of probability?"  If every person would apply for the contract, that might work.  The problem is, not everyone would apply.  Therefore, those most likely to apply for the policy would be those with the largest risk factors.  This is called adverse selection.  Those needing the protection most apply; those needing the protection least do not.  Therefore, claims rise as more and more of the "insurance needy" collect benefits.  In any competitive market, such as insurance, selection always occurs, either by the insurance companies or by the consumers themselves.

Risk Classifications:

  All consumers do not have the same risks.  Some drive automobiles; some do not.  Some consumers work at jobs that carry special risks.  Some consumers do not work outside of the home at all.  Some consumers are very conscience of safety; others are not.  Some consumers are older than others, and experience special risks due primarily to age (such as the risk of entering a nursing home).  These are not the only factors, of course, that determines risks for given insurance contracts.  The types of risks vary extensively and often depend upon the actual policy being applied for.

Pricing Specific Contract Risks:

  Insurers look at the contract being applied for and then consider the particular risks involved.  Within each type of contract, or class variation, there will be common loss expectancies.  Of course, not all the insureds will experience the loss; only a portion of them will.  The insurance companies strive to eliminate those applicants who are likely to have higher-than-average loss expectancy.  By doing so, the companies will see a profit.  The more selective the insurance company tends to be, the lower the premium charged often is.  This is because they have fewer losses so can afford to charge a lower premium.  Those companies who accept virtually everyone will have higher losses and, therefore, be forced to charge higher premiums to cover those losses.  As the premiums continue to rise, those policyholders who can, will change to companies with more severe underwriting and lower premium costs.  Gradually, the company who accepts virtually everyone will be left only with the highest risk people and this will drive the premiums up even higher.  Adverse selection has now occurred.  Anytime selection is left up to the buyers rather than the sellers of insurance, the insurance company is likely to experience loss.

Gradually, the company who accepts virtually everyone will be left

only with the highest risk people and this will drive the premiums up even higher.  Adverse selection has now occurred.

Actuarial Equity:

  Sometimes government branches or consumer advocates claim that insurers are overly selective and perhaps even unfair in their underwriting practices.  Usually such claims are aimed at social issues.  The term actuarial equity may be used in such references.  This typically implies conditions where each risk is charged a premium in accordance with its chance of loss.  This tends to deal with issues where insurance is necessary, such as mortgage insurance or auto insurance, and the consumer's difficulty in meeting the premium rate charged.  This can be a common issue in city areas where claims against homeowners may be extremely high, for example.  In poorer areas claims may be higher driving rates up.  Because it is a poorer area, those who live there may be the least able to handle the higher premium rates.  In such cases, consumer advocates may pressure the companies to broaden the area's boundaries so that lower risk areas are combined with higher risk areas.  This would bring down the rates in the higher risk areas but raise the rates in the lower risk areas (giving an average rate somewhere in the middle of the two).

Subsidizing Rates:

  There may be other ways to lower rates. Those high-risk individuals can be subsidized by charging lower than actuarially fair rates. This loss would be subsidized by those who experience lower rates due to lower risks because the lower risk individuals would pay higher than their actuarially fair rates in order to offset the company's losses on the high-risk consumers.  Government subsidies may also be imposed to allow lower premiums for the higher risk groups.

  Although some advocates seem to feel that insurance companies are unfair in their selection practices, seldom is a better system suggested.  Rather, it tends to fall on those who have, to subsidize those who have not. Although it is not morally feasible to allow the poor to suffer, most insurance companies also feel it is not fair to put the burden on their backs entirely.  They are, of course, a business entity following standard business practices.  Therefore, a mix is usually the best answer: some allowance for business practices and some allowance for subsidization by one group in favor of another.

Exposure Distribution:

  The primary purpose of underwriting is no surprise: the profitable distribution of policyholder risks.  This does not necessarily mean that insurance companies try to avoid all losses (payout of claims), but it does mean that they try to minimize those payouts.  Insurance companies expect some claims to happen.  It is the nature of their business to experience claims.  Without claims, consumers would have no reason to even purchase insurance.  In fact, some well-publicized claims are actually good for their business because it shows consumers the need for their products.  This pushes sales.  However, insurance companies do not want an excess of claims that cause financial losses for the company itself.

  The book Fundamentals of Insurance by Robert I. Mehr tells this story:

  A client who just bought a fire policy one morning asks his agent: "Now that I've just bought this fire policy, what would I get if my house burned this afternoon?"

  Replied the agent: "About 10 years."

Recognizing the Underwriters:

  It is not uncommon to hear of insurance fraud, most notably arson.  For the most part, luckily, consumers are honest people. Insurance companies do certainly experience claim abuse, but abuse is not the same as fraud.

  To consider underwriting procedures, we must first consider who the underwriter actually is.  Consumers probably picture a studious person with eyeglasses, a frown, and little awareness of the "real" world.  In fact, underwriters consist of those considered to be experts in the type of policy being written.  Therefore, the persons underwriting cancer policies are likely to be different than those underwriting auto policies.  Both persons will have common factors, however.  They will be schooled in mathematics (or probabilities of exposures), schooled in their particular field of expertise, and they will be realists.  They know what to expect from those being underwritten.

The Agent as a Preliminary Underwriter:

  The writing agent is also an underwriter in a way.  He or she makes a preliminary appraisal of the possible risk exposure.  This is done through the use of an application process.  The agent asks the potential policyholder questions and judges from the answers received whether or not that person should be considered for insurance.  If the answers given are unfavorable, the agent knows that the application should not be completed.  Although agents help in the underwriting procedure, they are not underwriters according to the true meaning of the word.  They simply aid the process of underwriting.

  Many agents have heard the phrase "red flagging."  It is often used in relation to agents or their applications that are submitted to the underwriting departments.  When an underwriting department notes a particular agent who continually fails to find or disclose important underwriting information, or whose clients seem to have an unusually high claim experience, that agent may find themselves "red flagged."  It means that the underwriters feel that agent is either disregarding required procedures or intentionally ignoring them.  Whatever the reason, the underwriters will begin to pay special attention to their applications and will reject any questionable person simply based on the agent submitting the application for insurance.  In some cases, the insurance company may even cancel the agent's writing contract.

  It is important to understand that insurance companies keep records of the loss experience of their agents.  Whether the agent is simply uninformed, poorly trained, or truly fraudulent does not matter.  No company will keep an agent who falls outside of the normal boundaries on a consistent basis.

Staff Underwriters:

  Once applications for insurance are submitted, the actual underwriting falls on the underwriting departments.  Seldom are they made up of a single person; more likely they are groups of people.  Most are made up of two sections, called staff and line.  Staff underwriters concern themselves with the company's general underwriting requirements.  They make recommendations, as an overall picture, to the company regarding product development, rate structures and general guidelines.  They analyze operating statistics to determine if the guidelines they are using are working as they anticipated.  The staff underwriters are generally located in the home office, rather than field posts.

Line Underwriters:

  Line underwriters are responsible for the actual acceptance or rejection of applicants.  They may be located in the home office or in field branches of the company.  The line underwriters are the ones who will be most familiar with the individual insurance agents.  These are the underwriters that are referred to when policy application is discussed.  They are, in fact, the true underwriters because it is their decision that will decide whose application is accepted and whose is rejected.  Expert line underwriters are the lifeline of the company; their decisions can make a company a good profit or cause them to experience losses.

Actual Underwriting Processes:

  Underwriting effectively requires that all parties act responsibly.  This includes the agent, but also the consumer.  It is the responsibility of the consumers to give correct information, but it is also the responsibility of the agent to ask application questions in a way that is understandable and easily answered.  Many states have mandated application language in an effort to minimize misunderstandings.

  Underwriting itself includes both preselection and post-selection of applicants.  Preselection is the process of gathering relevant information regarding possible risk exposures and arriving at a decision regarding the acceptance or rejection of the applicant.  Post-selection happens after the risk has been accepted by the insurance company.  It is the process of reviewing those already insured and terminating those no longer desirable, if the termination is both possible and acceptable under the terms of the contract and under the state laws where the policy was issued.  Post-selection is not possible under some insurance policies, most notably in most health insurance policies.  This is understandable.  If health insurance policies could terminate those persons with the highest claims experience, no one would be safe when sickness or injury occurred.  The point of having health insurance is to protect oneself from catastrophic losses.  However, in automobile insurance, post-selection does make sense.  If a person consistently drives poorly, there is no reason why the insurance company should be forced to continue to insure the risk.  The insured, in some types of policies, does bear the responsibility of acting in a safe and acceptable manner.

Information:

The Agent's Role:

  Obtaining information is one of the most important parts of insurance operation.  The underwriter needs information to make an informed opinion regarding possible claim losses.  Insurance companies do, of course, desire to make a profit.  Consumers may not realize that it is also important to them that companies maintain a profit level; otherwise the company would fold, and insurance protection would be lost.

  The amount and type of information needed will depend, to some degree, on the type of policy being underwritten.  Automobile insurance wants different types of information than does health insurance, for example.  There are basic pieces of information that all policies will want:

1. the applicant's name;

2. the applicant's address;

3. the applicant's Social Security number;

4. and usually, the applicant's date of birth.

  Underwriters will then require detailed information in specific areas.  The more common types of information requested include:

1. past loss experience;

2. financial information to determine certain qualifications;

3. living habits (how safe are they?);

4. the property's or applicant's physical condition;

5. the applicant's personal character.

  Not all these things will apply in all circumstances and there may be additional areas of interest for some types of policies.

  Information sources will vary, but the underwriter will have specific methods that he or she routinely uses.  The sources used will depend upon the specific risks involved, practicality and certainly costs.  Some information sources can be expensive.

  Agents are one of the best information sources because they have been to the applicant's home or place of business and personally talked with them.  The agent will (hopefully) have noticed the oxygen tank in the corner of the living room, or the walker that the applicant used. 

  Since the agent personally talked with the applicant, he or she will have gotten a "feel" for the person.  The agent, once experienced, will develop the ability to suspect when the consumer seems to be holding something back, telling less of the story, or appears over-anxious to receive the coverage.  Through general conversation and a feeling of one-on-one, the consumer may open up and give full disclosure.  Certainly, the agent will also ask the pertinent questions that determine the consumer's eligibility.

  Some applications require the agent to submit an Agent's Report form.  This form asks questions regarding specific things, such as the presence of an oxygen tank sitting in the corner.  Of course, the questionnaire does not specifically say "Was an oxygen tank in the corner?"  Rather, it asks the agent to disclose anything that would not be compatible with the policy application.  The Agent's Report, in effect, is asking the agent to state anything that seemed unusual in relation to the application.  On it will be questions relating to risk and asking for a recommendation from the writing agent as to acceptability.  It is not unusual for the underwriter to accept or reject an application solely on the basis of the Agent's Report form.  This may especially be true when the underwriter knows from past applications that the writing agent is truthful and experienced.

Information & the Inspection Company:

  Insurance companies commonly hire outside companies to aid in their underwriting process.  These companies are usually referred to as Inspection Companies.  They are often nationwide investigating firms which utilize all public information sources.  They submit a report concerning the applicant to the insurance company, with specific attention to certain areas of desired information.  For example, an umbrella application would not require the same information that a health application would.

   In the past, there has been some controversy regarding much of the information that these Inspection Companies offer.  The controversy usually centers on how the information was obtained and how reliable it happens to be.  Ultimately, of course, it is the insurance underwriters who must determine whether the information is relevant.  The typical consumer would probably be shocked at the amounts and types of information (and misinformation) that is held on them by these reporting firms.

  Perhaps the best known of the inspection companies is Underwriters' Laboratories, Inc. of Chicago, Illinois.  We generally know them as a testing facility.  Many policies require companies to use items bearing their label in order to get insurance coverage.  The UL label has become the symbol for safety.

  The actual sources used will depend upon the company issuing the policy and the type of policy being issued.  There are many inspection companies available.  Insurance companies also may use loss-control engineers, who provide safety information to help identify liability exposures.  Sometimes the value of additional information is simply not worth the cost, so the insuring companies do not bother obtaining it.  Again, this is why the Agent's Report can be so important to the underwriters.

Accepted or Rejected:

  Once the information desired has been obtained, the underwriter will decide whether to accept the applicant or reject the applicant.  The information that was obtained will be the deciding factor.  Since underwriters know that some information may be limited or perhaps even wrong, they use their experience and knowledge in their decision making, along with the Agent's Report.  Some types of policies can be only accepted or rejected.  Other types can be accepted, but with restrictions in the policy due to the information obtained.  These are often referred to as modified policies.

Standard Risk Applicant:

  Applicants tend to be one of three categories of risk: standard, preferred, or substandard.  Standard risk applicants could be compared to an average risk.  They do not represent higher claim risks for the insuring company, but neither do they represent lowered claim risks.  They are an average or standard risk.

Preferred Risk Applicant:

  In some cases, the information gathered by the agent and underwriters may indicate that the applicant has a lower-than-average loss experience or potential loss experience, which allows them to be considered a preferred risk applicant.  This usually means they also pay lower premium rates, so it is a desirable risk category for many applicants.  The coverage itself would usually be a standard policy, with the only difference being lower premium rates.

Substandard Risk Applicant:

  When an applicant appears to have higher-than-average loss expectancy, they are classified as substandard risk applicants.  This usually means they pay a higher premium than either the standard risk classification or the preferred risk classification.  Because the insuring company is taking on higher risk expectancies, the policy may be issued with modifications in the coverage.  This is not always true.  Some types of policies are dictated by state mandates, which do not allow modifications.  In those cases, the company must decide whether the increased risk is worth the premium collected.  Substandard risk applicants do, of course, have much higher rejection rates than would a standard risk applicant.

  When state laws allow policy modifications, substandard risk applicants are likely to be issued policies that restrict certain coverages and may also contain larger deductibles.  In some cases, substandard risk applicants can receive a standard policy, but at higher premium rates.  How substandard risk applicants are handled will vary according to the issuing company.  That is why such applicants really should shop around.

When state laws allow policy modifications,

substandard risk applicants are likely to be issued policies that

restrict certain coverages and may also contain larger deductibles.

  Of course, some applicants will simply present too many potential losses.  In such cases, they may find that they are ineligible for the desired policy.  Insurers do not believe that those with substantial risk factors can be profitable at any feasible premium or with any policy modifications.  As a result, these applicants are totally rejected and cannot receive a policy at all.  It should be noted that we stated: "at any feasible premium."  The key word here is feasible.  If companies were allowed to charge unlimited premium, at some point some amount of premium would make the risk acceptable.  However, the premium charged would be outrageous and probably beyond the applicant's ability.

Post-Selection:

  As we said earlier, post-selection is the process of reviewing those individuals who are already insured and terminating those who are no longer desirable.  Underwriters periodically review renewal applications, using state approved techniques similar to those that were utilized upon the original application.  Some types of policies do not allow the company to terminate the contract due to loss experience, but other types do allow this.  Those policy types that do allow post-selection allow it because the loss experience is due not to circumstances beyond the policyholder's control, but rather to actions or non-actions that they themselves are responsible for.

Policy types which allow post-selection do so because the

loss experience is not due to circumstances beyond the

policyholder's control, but rather to actions or non-actions

that the policyholder themselves are responsible for.

  One claim does not necessarily mean that the policyholder will be terminated.  However, if the insuring company's investigation of the claim reveals information either not discovered when the original policy was issued or shows a lack of responsibility on the insured's part, then termination could be a possibility.

Unique Aspects of Post-Selection:

  Post-selection has several unique aspects.  There has been much public criticism from consumers and consumer groups regarding post-selection.  There are those who feel that insurance companies are obligated to provide coverage at affordable prices regardless of the circumstances.  This, of course, could fuel consumer irresponsibility.  Auto insurance is a prime example.  If the insured did not have to worry about his or her driving responsibilities, knowing that insurance must be provided no matter how many claims occur, would there be any reason for the driver to become more responsible?  Is it not the cost of insurance that encourages people, at some point, to become responsible drivers?  Less claims mean lower rates.  If rates were not dictated by driving behavior, would there be less inclination to drive within legal limits?  These are questions whose answers have become a dividing line between insurance companies and consumer groups.

  Because post-selection does cause image problems, rather than terminate contracts, insurance companies prefer to simply refuse renewal of them.  The companies feel consumers are less irritated by a "non-renewal" than they are a "termination" notice.  Of course, agents know that either type of notice may still create difficulties for them.  They live and work in the neighborhood and consumers expect the agents to keep them insured.

  When a company decides that one of their policyholders has become an undesirable risk, they have to make a choice:

1. wait for the policy to expire, and then do not renew it; or

2. terminate the policy before renewal time.

  Of course, whatever the company does, they must comply with any applicable state laws.

  If the insurance company decides to simply wait until the policy is due for renewal, even though they realize the policyholder is a bad risk, they still must cover any claims due under the policy terms.  Once the agent is notified that the company will not renew the policy, he or she may then place the business elsewhere, if other companies are available.

  If the insurance company decides to terminate the existing policy (where state law allows this), there must generally be some compelling reason for doing so.  For example, if a follow-up inspection of insured property were to reveal a problem or an unsound business practice, the underwriter might recommend immediate cancellation.  This would especially be true if the policyholder were causing the problem in some way.

  Post-selection is available only if the policy can be canceled.  Some types, as we mentioned, will not allow cancellation.  For those types of policies which are not cancelable, all underwriting information must be obtained by the insurer prior to issuance.  In such policies, the insurer has only a two-year period in which they may cancel the policy for misrepresentations or concealment of information.  After two years, even if the applicant misrepresented the facts, the insurance company cannot cancel the policy.

Retention:

  Once the underwriters have accepted an application, decided the type of policy to be issued and determined the appropriate premium rate, they must decide how much of the insurance they want to retain.  Insurance companies do not necessarily keep the full amount; sometimes they offer a portion of the business to other insurers, who then assume the risk for the amount they insure.  This process is called reinsurance.

Line Limits:

  Even under the best of circumstances, there are limitations established on the amounts of insurance that one insurer can sell.  Underwriters seek a safe distribution of exposure units.  The financial condition and size of the insurer are important in determining how much one company can safely underwrite.  A basic question always asked is "What is the largest single amount the insurer can afford to lose on one exposure?"  Although insurance companies underwrite to minimize their potential losses, losses can still occur.  The answer to the question must be supplied by the insurer's financial officers and approved by the board.  The answer helps to establish line limits, which is the maximum amount of insurance an insurer will write on one exposure.  Line limits for particular exposures are compiled into a line book, which serves as a general guide to underwriters.

  The actual line limits vary.  Their establishment in the property insurance field is more complicated than in the life field, because there are more variances.  It is important to realize that line limits do not represent the amount that can be written on the property, but rather the amount the insurance company is willing to lose on one of them.

Underwriting & Production:

  There is always some amount of conflict possible between underwriting and production.  Those selling want to be able to write applications and those underwriting want to weed out potential risks.  Therefore, some conflict in inevitable.  Those selling often believe that underwriting is too conservative.  Sellers would like borderline applicants to be accepted.  Underwriters must obtain a safe and profitable distribution of exposure units.  Communication between the two is not only necessary, but vital.

  There are, in some areas of insurance, pressure from the government regarding underwriting.  This is especially true concerning property and auto insurance in inner-city areas.  It can also be true for liability insurance.  Underwriters do not view insurance companies as charitable institutions; rather they are business entities desiring to use sound business practices.  It is not surprising that government and insurance companies should have some disagreements.

Premium Rates:

  Premium is the name given for the price paid for insurance.  Premium is the rate per unit of coverage multiplied by the number of units of insurance purchased.  Different types of insurance measure units of insurance differently.  For example, nursing home insurance typically prices their units in $10 daily benefit increments while property insurance may measure by square footage where a building is concerned.

  At one time rates were often figured individually.  Each case was judged by the underwriter separately.  This eventually became too expensive to do as the volume of business continued to rise.  Cooperative rate-making bureaus were formed in most insurance lines to develop equitable rates.  They published rates which are used by most insurers.  Subscribers sometimes deviate from these rates, but they are still used as a foundation.

End of Chapter 5